Underwriting: Definition and How the Various Types Work

What Is Underwriting?

Underwriting is the process through which an individual or institution takes on financial risk for a fee. This risk most typically involves loans, insurance, or investments. The term underwriter originated from the practice of having each risk-taker write their name under the total amount of risk they were willing to accept for a specified premium.

Although the mechanics have changed over time, underwriting remains a key function in the financial world.

How Underwriting Works

Underwriting involves conducting research and assessing the degree of risk each applicant or entity brings to the table before assuming that risk. This check helps to set fair borrowing rates for loans, establish appropriate premiums to adequately cover the true cost of insuring policyholders, and create a market for securities by accurately pricing investment risk. If the risk is deemed too high, an underwriter may refuse coverage.

Risk is the underlying factor in all underwriting. In the case of a loan, the risk is whether the borrower will repay the loan as agreed or will default. With insurance, the risk may involve the likelihood that an individual prospective insured might file a claim, or that too many policyholders will file claims at the same time. With securities, the risk is that the underwritten investments will not be profitable.

Underwriters evaluate loans (particularly mortgages) to determine the likelihood that a borrower will pay as promised and that enough collateral is available in the event of default. In the insurance industry, underwriters seek to assess a policyholder's health and relatedfactors, a driver's safety record, or the security of a home. They aim to price insurance premiums appropriately while spreading the potential risk among as many people as possible. Underwriting securities, most often done via initial public offerings (IPOs), helps determine the company's underlying value compared to the risk of funding its IPO.

Types of Underwriting

There are three major types of underwriting: loans, insurance, and securities.

Loan Underwriting

All loans undergo some form of underwriting. In many cases, underwriting is automated, It involves appraising an applicant's credit history, financial records, and the value of any collateral offered, along with other factors that depend on the size and purpose of the loan. The appraisal process can take a few minutes to a few weeks, depending on whether the appraisal requires a human being to be involved.

The most common type of loan underwriting that involves a human underwriter is for mortgages. This is also the type of loan underwriting that most people encounter. The underwriter assesses income, liabilities (debt), savings, credit history, credit score, and more depending on an individual's financial circumstances. Mortgage underwriting typically has a turnaround time of a week or less.

Refinancing often takes longer because buyers who face deadlines get preferential treatment. Although loan applications can be approved, denied, or suspended, most are approved with conditions, meaning the underwriter wants clarification or additional documentation before the agreement can be finalized.

Insurance Underwriting

Insurance underwriters receive customer applications and decide whether to offer them a policy on the basis of various criteria. If they do approve the application, the underwriters also set premiums and coverage amounts.

With insurance underwriting, the focus is on the potential policyholder—the person seeking health, home, auto, or life insurance. In the past, medical underwriting for health insurance looked at the applicant’s pre-existing conditions to determine how much to charge an applicant, or whether to offer coverage at all, often based on the applicant’s pre-existing conditions. Beginning in 2014, under the Affordable Care Act, insurers were no longer allowed to deny coverage or impose limitations based on pre-existing conditions.

Life insurance underwriting seeks to assess the risk of insuring a potential policyholder based on their age, health, lifestyle, occupation, family medical history, hobbies, and other factors determined by the underwriter. Life insurance underwriting can result in approval—along with a range of coverage amounts, prices, exclusions, and conditions—or outright rejection.

For property and casulty insurance, underwriters look at numerous criteria, including characteristics of the person and the property being insured. For example, if someone applies for automobile insurance, the carrier looks at their driving record, how often their make and model of car is in an accident, and the average cost of repairs. Similarly, to ensure a home, underwriters focuses on such factors as replacement cost, age of the dwelling, and any significant risks (such as being in an area prone to wildfires) to decide whether to offer the applicant homeowners insurance and how much to charge.

Securities Underwriting

Investment securities underwriting, which seeks to assess risk and the appropriate price of particular securities—most often related to an IPO—is performed on behalf of a potential investor, often an investment bank. Based on the results of the underwriting process, an investment bank would buy (underwrite) securities issued by the company attempting the IPO and then sell those securities in the open market.

Underwriting ensures that the company's IPO will raise the capital needed and provides the underwriters with a premium or profit for their service. Investors benefit from the vetting process that underwriting provides and its ability to make an informed investment decision.

This type of underwriting can involve individual stocks and debt securities, including government, corporate, or municipal bonds. Underwriters or their employers purchase these securities to resell them for a profit either to investors or dealers (who sell them to other buyers). When more than one underwriter or group of underwriters is involved, this is known as an underwriter syndicate.

How Long Does Underwriting Take?

The time frame for underwriting varies among different investment products, as the underwriter will have to spend some time examining the risk profile of each investment. Personal loans and insurance products are generally fairly simple to underwritem while securities are more complex. However, underwriting periods for mortages and insurance can vary by state.

Personal Loans and Mortgages

For car loans, the process is often managed by an algorithm that compares the applicant to other borrowers with a similar profile. This process takes only a few days at most, and, in some cases, it is almost instantaneous.

Home mortgages tend to take longer because the underwriter will need to verify the borrower's income, employment, and credit history, which can take some time. Full approval for a home loan can take up to 45 days, although the underwriting process itself accounts for only a small part of this time time. The underwriting process can last from a few days to a few weeks.

Insurance

Underwriting insurance is similar to underwriting a loan, except that the insurers weigh the probability and size of the average claim compared to the premiums that they expect to collect. In the case of property and auto insurance policies, this is based on factors like the age of the insured, their geographical location, and their past history of making claims. For homeowners and commercial property coverages, they must avoid a large concentration of risks in the same geographic area, as a catastrophic event (such as a hurricane) would mean huge losses for the company.

Life insurance policies are more complicated because they also account for the insured's medical history and other personal details. Underwriting life insurance can also take a month or longer, although most decisions are issued in a few days.

Stocks and Bond Issues

Securities are the most complicated products to underwrite. When a company issues a bond or a stock offering, the underwriter (usually an investment bank) examines the company's accounts, cash flows, assets, and liabilities, and checks for any discrepancies. This can take anywhere six to nine months.

What Information Do Underwriters Look at?

Whether they are lending money or providing insurance, underwriters examine the financials of each applicant to determine how much risk they are taking on and the likelihood of losing money. This is generally done by comparison to historical data: If applicants with a similar risk profile tend to default X% of the time, then the premiums or interest rate will be priced at a rate that assumes an X% probability of default.

Underwriters for personal loans and insurance will look at available data about the applicant. For loans, they might examine the borrower's income, savings, employment status, and credit history. Underwriters will also assess the capacity for repaying the loan and the value of any assets that are used for collateral. For life insurance, they might also look at medical history plus such risk factors as dangerous hobbies, hazardous occupations, and smoking or drinking habits.

Securities underwriters will look at the financial situation of the issuer, such as their income statements, cash flow, debts, and any other potential liabilities, before pricing a bond or stock issue. They will also examine the issuer's credit rating, the institutional equivalent of a personal credit score.

How Underwriting Sets the Market Price

Creating a fair and stable market for financial transactions is the chief function of an underwriter. Every debt instrument, insurance policy, or IPO carries a certain risk that the customer will default, file a claim, or fail—all sources of potential loss to the insurer or lender. A big part of the underwriter's job is to weigh the known risk factors and investigate an applicant’s truthfulness to determine the minimum price for providing coverage.

Underwriters help establish the true market price of risk by deciding on a case-by-case basis which transactions they are willing to cover and what rates they need to charge to make a profit. Underwriters also help expose unacceptably risky applicants—such as unemployed people asking for expensive mortgages, those in poor health who request life insurance, or companies that attempt an IPO before they are ready—by rejecting coverage.

This vetting function substantially lowers the overall risk of expensive claims or defaults. It allows loan officers, insurance agents, and investment banks to offer more competitive rates to those with less risky propositions.

The Bottom Line

Underwriting is the process of examining the financials of a loan or insurance application to determine how much risk they pose to a lender or insurer. This usually means checking the applicant's income, assets, and credit history to determine the likelihood that they will end up costing the underwriting institution more than the customer pays in premiums.