Underwriting refers to the process that a large financial service provider (bank, insurer, investment house) uses to assess the eligibility of a customer to receive their products (equity capital, insurance, mortgage, or credit). The name derives from the Lloyd's of London insurance market. Financial bankers, who would accept some of the risk on a given venture (historically a sea voyage with associated risks of shipwreck) 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.
Risk, exclusivity, and reward
Once the underwriting agreement is struck, the underwriter bears the risk of being able 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 nice profit from the markup, plus possibly an exclusive sales agreement.
Also, if the securities are priced significantly below market price (as is often the custom), the underwriter also curries favor with powerful end customers by granting them an immediate profit (see flipping), 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.
Securities underwriting
Securities underwriting refers to the process by which
investment banks raise investment capital from investors on behalf of corporations and governments that are issuing securities (both
equity and
debt capital).
This is a way of selling a newly issued security, such as stocks or bonds, to investors. A syndicate of banks (the lead-managers) underwrite 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 (the "underwriting spread") between the price they pay the issuer and what they collect from investors or from broker-dealers who buy portions of the offering.
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 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. Underwriting can also refer to the purchase of
corporate bonds,
commercial paper, government securities, municipal general-obligation bonds by a
commercial bank or dealer bank for its own
account or for resale to investors. Bank underwriting of corporate securities is carried out through separate holding-company affiliates, called
securities affiliates or Section 20 affiliates.
Insurance underwriting
Underwriting may also refer to
insurance; insurance 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 acquire—or to "write"—business that will make the insurance company money, and to protect the company's book of business from risks that they feel will make a loss. In simple terms, it is the process of issuing
insurance policies.
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. As part of the underwriting process for life or health insurance, medical underwriting may be used to examine the applicant's health status (other factors may be considered as well, such as age & occupation). The factors that insurers use to classify risks should be 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 either 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 (line of business), 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 (auto, homeowners) insurance.
Other forms of underwriting
Real estate underwriting
In evaluation of a real estate loan, in addition to assessing the borrower, the property itself is scrutinized. Underwriters use the
debt service coverage ratio to figure out whether the property is capable of redeeming its own value or not.
Forensic underwriting
Forensic underwriting is the "after-the-fact" process used by lenders to determine what went wrong with a mortgage. Forensic underwriting refers to a borrower's ability to work out a modification scenario with their current lien holder, not to qualify them for a new loan or a refinance. This is typically done by an underwriter staffed with a team of people who are experienced in every aspect of the real estate field.
Sponsorship underwriting
Underwriting may also refer to financial
sponsorship of a venture, and is also used as a term within
public broadcasting (both
public television and
radio) to describe funding given by a company or organization for the operations of the service, in exchange for a mention of their product or service within the station's programming.
Thomson Financial League Tables
Underwriting activity reported in
Thomson Financial League Tables(numbers in $ billion) (number of issues in parentheses):
Global Debt, Equity & Equity-related
{| class="wikitable"
|-
! Year !! Underwriting Activity !! Source
|-
|-
|2008||4,715 (13,542)||Q4 2008 report
|-
|2007||7,510 (22,256)||Q4 2007 report
|-
|2006||7,643 (21,818)||Q4 2006 report
|-
|2005||6,511 (20,118)||Q4 2005 report
|-
|2004||5,693 (20,066)||Q4 2004 report
|-
|2003||5,326 (19,706)||Q4 2003 report
|-
|2002||4,257 (14,070)||Q4 2002 report
|-
|2001||4,112 (NA)||Q4 2001 report
|}
See also
Investment bank
Predictive analytics
Thomson Financial League Tables
Medical Underwriting
Underwriting contract
References
External links
Underwriting explained on Investopedia
Financial Underwriting and Life Insurance
Category:Securities
Category:Insurance
Category:Actuarial science
