What is Underwriting?
How Does Underwriting Work?
Underwriting refers to the structured process used by financial service companies, such as banks, investors, or insurers, to determine and price the risk from a potential client. The underwriting process is a detailed and systematic analysis of a potential borrower's credit-worthiness, including employment history, salary, financial statements and performance, publicly available information, and independent credit reports. The underwriting process is intended to determine the credit needs, the quality of the collateral assets to be used to support the borrowing, and the borrower's ability to repay the debt. Upon completion of a formal underwriting process and a summary presented to a credit committee within the lender, the lender will either approve or reject the request for a loan.
Similarly, an insurance company will evaluate the risks of a potential candidate for insurance, based on a variety of actuarial factors. The bottom line from such an underwriting process is to price the insurance in accordance with its associated risk.
In securities trading, underwriting also includes assessing the risk and pricing the security accordingly. However, the formal underwriting process also involves agreeing to buy the security (by the underwriter) and then selling the security for a profit. The underwriter effectively takes a risk by agreeing to buy the security at the established price. In most instances, underwriters will line up buyers for the securities before they take on the security, so that it can "flip" the security to the buyer immediately.
Why Does Underwriting Matter?
Underwriting is a critical step in the credit analysis and risk pricing process for almost all financial service companies. For companies, understanding the underwriting process and the requirements at each stage of the process will allow a company to prepare and present itself accordingly. For investors, the information contained in an underwriting is crucial to understanding the risks and potential rewards from a security's underlying asset.
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