Underwriting
It determines the magnitude of the risk of a financial venture.
Underwriting determines the magnitude of risk of a financial venture, such as a loan, insurance policy, or investment, and whether to accept that risk. Its process determines how much to charge if the risk is considered worth taking.
The term underwriter originated from the practice where risk-takers write their name under the amount of risk they were willing to accept for a specified premium.
Although the mechanics have evolved over time, it is a key function in the world of contemporary finance.
There are mainly two functions in corporate finance:
- M&A Advisory
- Underwriting
M&A advisory is usually provided by the advisory side of an investment bank, transaction advisor, or in-house by the corporate development group. It includes assisting in negotiations, structuring, and performing a valuation of a merger or an acquisition deal.
How does it work?
It involves researching and assessing the degree of risk each individual or entity brings to the table before assuming that risk.
This research helps the underwriters to set a fair borrowing rate for loans, establish appropriate premiums to adequately cover the actual cost of insuring policyholders, and create a market for securities by accurately pricing investment risk.
A risk is an underlying factor in all underwritings. An underwriter may refuse coverage if the risk is deemed too high.
In the case of a loan, the risk associated with a loan is the borrower's ability to pay back the loan.
In the case of insurance, the risk involved is the likelihood that too many policyholders will file claims at once. The risk associated is that the underwritten investments will not be profitable with securities.
Underwriters evaluate loans, particularly mortgages, to determine whether the borrower will pay as promised or default and whether enough collateral is available in case the borrower defaults.
In the case of insurance, underwriters assess a policyholder's health, family medical history, and other influential factors.
Underwriting securities is most often done via Initial Public Offerings (IPO), which helps determine an entity's underlying value compared to the risk of funding the company through its IPO.
Types of Underwriting Processes
These processes respond to different needs and take from hours to even years, depending on the size of a deal and the industry it is used in. The following are the most common types of processes used for various purposes:
Securities Underwriting
In Investment Banking, it is a process where an investment bank raises capital for a client (government, institution) from investors in the form of equity or debt securities.
It seeks to assess risk, and the reasonable price of particular securities is most often related to an IPO. It is performed on behalf of a potential investor, usually by investment banks.
Based on the outcome of the process, an investment bank would buy (underwrite) securities offered by the company in an attempt to launch its IPO and then sell those securities in the market. Investors benefit from the process as they can make informed investment decisions.
The process includes selling stocks or bonds to investors as Initial Public Offerings (IPOs) or Additional Public Offerings (APOs).
It can involve debt securities and individual stocks, including corporate, government, or municipal bonds. Underwriters or their employers purchase these securities to resell them for a profit to investors or dealers (who then sell these to other buyers).
Advisory Services
The services provided by an underwriter can be divided into various phases. There are three phases:
1. Planning
Planning is of utmost importance to identify the investor themes in this phase, obtain a preliminary view of the investor's demand or interest in this type of offering, and translate the rationale for the investment.
2. Timing and Demand
The timing and the demand of an offering are very crucial to successful capital raising.
A few factors that influence the assessment of the timing and demand of an offering are listed below:
Current market condition
Current investor appetite
Investor experience
Precedents and benchmark offerings
Current news flow
These factors influencing the assessment raise certain questions:
What is the risk profile and appetite of the current investor? Is it aggressive or conservative? Are investors risk-preferring, neutral, or averse?
Are the investors experienced in this field or market?
Has a similar company (based on industry, size, and geographical location) issued an IPO in the past? What are some other companies that can be used for benchmarking the IPO?
What is the prevailing market condition? Is it a cold or a hot issue market?
3. Structure
The final phase is deciding the structure of an offering. Factors that influence the issue structures are as follows:
How will the sale occur?
Is it going to be an international or a domestic issue? Are the investor demands located overseas or domestically? Are investors from other countries interested in this offering?
Is the focus on retail investors or institutional investors?
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Commitment Types
When an underwriter enters a contract with a client to help them raise capital, there are a few commitments made by the investment bank:
1. Best Efforts Commitment
The best efforts are the most common commitment by the investment bank out of the three listed.
Although the underwriter, in good faith, commits to selling as much of the issue as possible at the agreed price, no financial or legal responsibility is imposed on the underwriter for any unsold shares or deal performance.
2. Firm Commitment
In a firm commitment, the underwriter agrees to buy the entire issue at a predetermined price. If the underwriter cannot sell the whole issue, it is required by law to take full financial responsibility for the unsold shares.
In the event of unsold issues, the underwriter pays the issuer and keeps all the shares in inventory to sell them in the future.
3. All-or-none
In this form of commitment, the deal turns void unless the entire issue is sold at the offering price, and the underwriter will not receive any compensation if the entire issue is not sold.
Loan Underwriting
In most cases, the process is automated and involves appraising an applicant's financial records, credit history, the value of the collateral offered, and other factors that depend on the purpose and size of the loan.
The appraisal process varies from minutes to a few weeks, depending on whether the appraisal requires human intervention.
The most common type of appraisal involves a human underwriter for mortgages. This is also the type that most people encounter.
The underwriter assesses the loan requestee's income, liabilities, creditworthiness, savings, and many other factors depending on the individual's financial circumstances.
It generally has a "turn time" of a week or less whereas refinancing often takes longer due to the buyer's preferential treatment as they face deadlines.
Although loan applications can be approved, suspended, or denied, most applications are "approved with conditions," meaning the underwriter requires clarification or additional documentation.
Insurance Underwriting
It focuses on studying the potential policyholder-the person seeking life or health insurance.
Previously, medical underwriting for life/health insurance was used to determine how much to charge a potential policyholders based on their health and whether to offer them coverage based on their pre-existing conditions.
After the Affordable Care Act, insurers were no longer allowed to impose limitations or deny coverage based on pre-existing conditions.
Life insurance underwriting evaluates the risk of insuring a potential policyholder based on their health conditions, age, family medical history, lifestyle, occupation, hobbies, and other factors that could impact their health.
It can be approved along with a range of coverage amounts, prices, exclusions, and conditions-or outright be rejected.
Other forms
1. Continuous
It is the process that involves continuously assessing, evaluating, and analyzing the risks involved in insuring people or their assets.
It evolved from the traditional, in which the risks only got assessed before the policy was renewed or signed.
It was first used in workers' compensation, where the insurance premium was updated monthly based on the insured person's submitted payroll. It is also used in life and cyber insurance.
2. Real Estate
It evaluates a real estate investment, either of equity ownership or a real estate loan.
Generally, the process involves a detailed analysis of supply and demand, the local market, expected cash flows, and risks such as the physical state of the property, environmental or geotechnical risks, zoning, taxes, and insurance.
In evaluating a real estate loan, lenders assess the risk of lending to a specific borrower and the risk of the underlying real estate asset.
Loan underwriters use various metrics, including debt yield ratio, loan-to-value ratio, and debt service coverage ratio in order to assess whether the property can make debt payments.
3. Forensic
It is the "after-the-fact" process used by lenders to determine what went wrong with a mortgage.
It is a borrower's ability to work out a modification scenario with their current lender, not to qualify/disqualify them for a new loan or a refinancing.
This is generally done by an underwriter with a team of experienced people in every aspect of the real estate field.
4. Sponsorship
It may sometimes refer to financial sponsorship or funding of a venture. It is used as a term within public broadcasting to describe the funding provided by an investor, company, or organization for the operations of the service in exchange for a mention of their product or service.
5. Thomson Financial League Tables
These activities in the mergers and acquisitions, syndicated loans, equity issuance, debt issuance, and U.S. municipal bond markets are reported in the Thomson Financial league tables.
FAQs
The term "underwrite" originated in the 17th century when marine vessels would be underwritten for insurance risk for overseas voyages. The insurance company would sign their name at the bottom of the document and acknowledge that the policy is in force.
With the widespread availability of technology, the process for lenders and insurers has shortened the cycle to just a few days or even hours in some cases.
An Underwriter's syndicate involves more than one underwriter or group of underwriters.
It evaluates the risk of a proposed deal or agreement, whether for an equity issue, loan, or insurance policy.
For a lender, the purpose is to determine the risk of non-payment or default. Similarly, securities underwriting by investment banks evaluates new offerings to determine their risk-adjusted value.
For an insurer, the purpose is to determine the risk of a policyholder filing a claim before the policy has become profitable.
Creating a fair, stable market for financial transactions is the primary function of an underwriter.
Every loan, debt instrument, insurance policy, or IPO carries a risk associated with it; for example, the customer will default on the loan, file a claim, or have a potential loss to the lender or insurer.
A significant chunk of the underwriter's job is to weigh the known risk and the factors affecting it and to investigate an applicant's truthfulness in determining the minimum price for coverage.
Underwriters help establish the accurate market price of risk by deciding on a case-by-case basis, i.e. which transactions are they willing to cover and what rates they should offer to make a surplus.
Underwriters also expose unacceptably risky applicants such as those in poor health who request life insurance, unemployed people asking for expensive mortgages, or entities that attempt an IPO before they are ready by rejecting the coverage.
This vetting function lowers the overall risk substantially of defaults or expensive claims. It allows insurance agents, loan officers, and investment banks to offer more competitive rates to those with less risky propositions.
Yes, an underwriter can deny a loan or an insurance policy as long as they are not violating any anti-discrimination laws and only evaluating objective risk metrics.
Suppose the riskiness of a borrower or insurance policy applicant is deemed too risky. In that case, the underwriter usually sets higher rates or denies the application entirely.
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