Underwriting
Underwriting services are provided by some large financial institutions, such as banks, insurance companies and investment houses, whereby they guarantee payment in case of damage or financial loss and accept the financial risk for liability arising from such guarantee. An underwriting arrangement may be created in a number of situations including insurance, issues of security in a public offering, and bank lending, among others. The person or institution that agrees to sell a minimum number of securities of the company for commission is called the Underwriter.
The name derives from the Lloyd's of London insurance market. Financial backers, who would accept some of the risk on a given venture in exchange for a premium, would literally write their names under the risk information that was written on a Lloyd's slip created for this purpose.
Securities underwriting
underwriting is the process by which investment banks raise investment capital from investors on behalf of corporations and governments that are issuing securities. The services of an underwriter are typically used as part of a public offering in a primary market.This is a way of distributing a newly issued security, such as stocks or bonds, to investors. A syndicate of banks underwrites the transaction, which means they have taken on the risk of distributing the securities. Should they not be able to find enough investors, they will have to hold some securities themselves. Underwriters make their income from the price difference between the price they pay the issuer and what they collect from investors or from broker-dealers who buy portions of the offering.
Risk, exclusivity, and reward
Once the underwriting agreement is struck, the underwriter bears the risk of being unable to sell the underlying securities, and the cost of holding them on its books until such time in the future that they may be favorably sold.If the instrument is desirable, the underwriter and the securities issuer may choose to enter into an exclusivity agreement. In exchange for a higher price paid upfront to the issuer, or other favorable terms, the issuer may agree to make the underwriter the exclusive agent for the initial sale of the securities instrument. That is, even though third-party buyers might approach the issuer directly to buy, the issuer agrees to sell exclusively through the underwriter.
In summary, the securities issuer gets cash up front, access to the contacts and sales channels of the underwriter, and is insulated from the market risk of being unable to sell the securities at a good price. The underwriter gets a profit from the markup, plus the possibility of an exclusive sales agreement.
Also if the securities are priced significantly below market price, the underwriter also curries favor with powerful end customers by granting them an immediate profit, perhaps in a quid pro quo. This practice, which is typically justified as the reward for the underwriter for taking on the market risk, is occasionally criticized as unethical, such as the allegations that Frank Quattrone acted improperly in doling out hot IPO stock during the dot-com bubble.
Bank underwriting
In banking, underwriting is the detailed credit analysis preceding the granting of a loan, based on credit information furnished by the borrower; such underwriting falls into several areas:- Consumer loan underwriting includes the verification of such items as employment history, salary and financial statements; publicly available information, such as the borrower's credit history, which is detailed in a credit report; and the lender's evaluation of the borrower's credit needs and ability to pay. Examples include mortgage underwriting.
- Commercial underwriting consists of the evaluation of financial information provided by small businesses including analysis of the business balance sheet including tangible net worth, the ratio of debt to worth and available liquidity. Analysis of the income statement typically includes revenue trends, gross margin, profitability, and debt service coverage.
Of late, the discourse on underwriting has been dominated by the advent of machine learning in this space. These profound technological innovations are altering the way traditional underwriting scorecards have been built, and are displacing human underwriters with automation. Natural language understanding allows the consideration of more sources of information to assess risk than used previously. These algorithms typically use modern data sources such as SMS / Email for banking information, location data to verify addresses, and so on. Several firms are trying to build models that can gauge a customer's willingness to pay using social media data by applying natural language understanding algorithms which essentially try to analyse and quantify a person's popularity / likability and so on, with the premise being that people scoring high on these parameters are less likely to default on a loan. However, this area is still vastly subjective.
Insurance underwriting
underwriters evaluate the risk and exposures of potential clients. They decide how much coverage the client should receive, how much they should pay for it, or whether even to accept the risk and insure them. Underwriting involves measuring risk exposure and determining the premium that needs to be charged to insure that risk. The function of the underwriter is to protect the company's book of business from risks that they feel will make a loss and issue insurance policies at a premium that is commensurate with the exposure presented by a risk.Each insurance company has its own set of underwriting guidelines to help the underwriter determine whether or not the company should accept the risk. The information used to evaluate the risk of an applicant for insurance will depend on the type of coverage involved. For example, in underwriting automobile coverage, an individual's driving record is critical. However, the type of automobile is actually far more critical. As part of the underwriting process for life or health insurance, medical underwriting may be used to examine the applicant's health status. The factors that insurers use to classify risks are generally objective, clearly related to the likely cost of providing coverage, practical to administer, consistent with applicable law, and designed to protect the long-term viability of the insurance program.
The underwriters may decline the risk, or may provide a quotation in which the premiums have been loaded or in which various exclusions have been stipulated, which restrict the circumstances under which a claim would be paid. Depending on the type of insurance product, insurance companies use automated underwriting systems to encode these rules, and reduce the amount of manual work in processing quotations and policy issuance. This is especially the case for certain simpler life or personal lines insurance. Some insurance companies, however, rely on agents to underwrite for them. This arrangement allows an insurer to operate in a market closer to its clients without having to establish a physical presence.
Two major categories of exclusion in insurance underwriting are moral hazard and correlated losses. With a moral hazard, the consequences of the customer's actions are insured, making the customer more likely to take costly actions. For example, bedbugs are typically excluded from homeowners' insurance to avoid paying for the consequence of recklessly bringing in a used mattress. Insured events are generally those outside the control of the customer, for example death by automobile accident, contrasted with death by suicide. Correlated losses are those that can affect a large number of customers at the same time, thus potentially bankrupting the insurance company. This is why typical homeowner's policies cover damage from fire or falling trees, but not floods or earthquakes.