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Underwriting (UW) services are provided by some large
financial institution Financial institutions, sometimes called banking institutions, are business entities that provide services as intermediaries for different types of financial monetary transactions. Broadly speaking, there are three major types of financial insti ...
s, such as banks, insurance companies and investment houses, whereby they guarantee payment in case of damage or financial loss and accept the
financial risk Financial risk is any of various types of risk associated with financing, including financial transactions that include company loans in risk of default. Often it is understood to include only downside risk, meaning the potential for financia ...
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.


History

The term "underwriting" derives from the Lloyd's of London insurance market. Financial backers (or risk takers), 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 Premium may refer to: Marketing * Premium (marketing), a promotional item that can be received for a small fee when redeeming proofs of purchase that come with or on retail products * Premium segment, high-price brands or services in marketing, ...
, would literally write their names under the risk information that was written on a Lloyd's slip created for this purpose.


Securities underwriting

In the financial
primary market :''"Primary market" may also refer to a market in art valuation.'' The primary market is the part of the capital market that deals with the issuance and sale of securities to purchasers directly by the issuer, with the issuer being paid the proc ...
, securities underwriting is the process by which investment banks raise investment capital from buyers on behalf of corporations and governments by issuing securities (such as stocks or
bond Bond or bonds may refer to: Common meanings * Bond (finance), a type of debt security * Bail bond, a commercial third-party guarantor of surety bonds in the United States * Chemical bond, the attraction of atoms, ions or molecules to form chemical ...
s). As an underwriter, the investment bank guarantees a price for these securities, facilitates the issuance of the securities, and then sells them to the public (or retains them for their own proprietary account). This process is often seen in initial public offerings (IPOs), where investment banks help a corporation raise funds from the public. The underwriter is obligated to purchase the entire issue at a predetermined price before reselling the securities in the market. Should they not be able to find buyers, they will have to hold some securities themselves. In order to reduce the risk, they may form a syndicate with other investment banks. Each bank will buy a portion of the security issue, and typically resell securities from that portion to the public.Mishkin p. 547 Underwriters make their profit from the price difference (called " underwriting spread") between the price they pay the issuer and what they collect from buyers or from
broker-dealer In financial services, a broker-dealer is a natural person, company or other organization that engages in the business of trading securities for its own account or on behalf of its customers. Broker-dealers are at the heart of the securities and ...
s who buy portions of the offering. The services provided in the process of underwriting include: # Giving advice on whether to issue stocks or bonds, the timing of issuance (ideally, corporations should sell securities when they will obtain the highest possible price). Underwriters also have to determine at what price the security should be sold. # Filing documents: assisting companies with making the filings required by financial authorities. Companies issuing new securities to the general public must file a registration statement detailing their financial conditions, management, competition, industry, experience, funding purposes, and securities' risk assessment. A portion of this statement is reproduced in a document called a prospectus, which investors can access to obtain information about new securities. # Underwriting: A company sells the entire issue to the underwriter at an agreed price. The underwriter will then sell it to the public at a higher price to achieve a profit, to the extent that it does not retain part of the issue as a proprietary holding.


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 receives a profit from the markup, plus the possibility of 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 customers by granting them an immediate profit (see flipping), perhaps in a ''
quid pro quo Quid pro quo ('what for what' in Latin) is a Latin phrase used in English to mean an exchange of goods or services, in which one transfer is contingent upon the other; "a favor for a favor". Phrases with similar meanings include: "give and take", ...
''. 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 investment banker Frank Quattrone acted improperly in doling out hot IPO stock during the dot-com bubble. In an attempt to capture more of the value of their securities for themselves, issuing companies are increasingly turning to alternative vehicles for going public, such as direct listings and SPACs.


Bank underwriting

In
banking A bank is a financial institution that accepts deposits from the public and creates a demand deposit while simultaneously making loans. Lending activities can be directly performed by the bank or indirectly through capital markets. Because ...
, 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 :''This article deals with the general concept of the term credit history. For detailed information about the same topic in the United States, see Credit score in the United States.'' A credit history is a record of a borrower's responsible repay ...
; and the lender's evaluation of the borrower's credit needs and ability to pay. Examples include mortgage underwriting. *Commercial (or business) 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 (leverage) and available liquidity (current ratio). Analysis of the income statement typically includes revenue trends, gross margin, profitability, and debt service coverage. Underwriting can also refer to the purchase of
corporate bond A corporate bond is a bond issued by a corporation in order to raise financing for a variety of reasons such as to ongoing operations, M&A, or to expand business. The term is usually applied to longer-term debt instruments, with maturity of ...
s,
commercial paper Commercial paper, in the global financial market, is an unsecured promissory note with a fixed maturity of rarely more than 270 days. In layperson terms, it is like an "IOU" but can be bought and sold because its buyers and sellers have some ...
, 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 affiliate A security is a tradable financial asset. The term commonly refers to any form of financial instrument, but its legal definition varies by jurisdiction. In some countries and languages people commonly use the term "security" to refer to any fo ...
s or Section 20 affiliates. 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

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, and whether to accept the risk at all. Underwriting involves measuring risk exposure and determining the
premium Premium may refer to: Marketing * Premium (marketing), a promotional item that can be received for a small fee when redeeming proofs of purchase that come with or on retail products * Premium segment, high-price brands or services in marketing, ...
that needs to be charged to insure that risk. The function of the underwriter is to protect the company's
book of business A book is a medium for recording information in the form of writing or images, typically composed of many pages (made of papyrus, parchment, vellum, or paper) bound together and protected by a cover. The technical term for this physica ...
from risks that they feel will make a loss and issue
insurance policies In insurance, the insurance policy is a contract (generally a standard form contract) between the insurer and the policyholder, which determines the claims which the insurer is legally required to pay. In exchange for an initial payment, known as ...
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 (other factors may be considered as well, such as occupation and risky pursuits) and decide whether the policy can be issued on the standard terms applicable to the customer's age. 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 (including the amount needed to generate a profit, in addition to covering expenses) 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. 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 In economics, a moral hazard is a situation where an economic actor has an incentive to increase its exposure to risk because it does not bear the full costs of that risk. For example, when a corporation is insured, it may take on higher ri ...
and
correlated In statistics, correlation or dependence is any statistical relationship, whether causal or not, between two random variables or bivariate data. Although in the broadest sense, "correlation" may indicate any type of association, in statistic ...
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 in life insurance, death by automobile accident is typically covered, but death by suicide is typically not covered. 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 (usually affecting an individual house), but not floods or earthquakes (which affect many houses at the same time). For all types of insurance underwriting, advice and assistance is often provided by reinsurers, who of course have an interest in accepting risks on appropriate terms.


Other forms


Continuous underwriting

Continuous underwriting is the process in which the risks involved in insuring people or assets are being evaluated and analyzed on a continuous basis. It evolved from the traditional underwriting, in which the risks only get assessed before the policy is signed or renewed. Continuous underwriting was first used in
workers' compensation Workers' compensation or workers' comp is a form of insurance providing wage replacement and medical benefits to employees injured in the course of employment in exchange for mandatory relinquishment of the employee's right to sue his or her emp ...
, where the premium of the insurance was updated monthly, based on the insured’s submitted payroll. It is also used in life insurance and
cyber insurance Cyber-insurance is a specialty insurance product intended to protect businesses from Internet-based risks, and more generally from risks relating to information technology infrastructure and activities. Risks of this nature are typically exclude ...
.


Real estate underwriting

Real estate underwriting is the evaluation of a
real estate Real estate is property consisting of land and the buildings on it, along with its natural resources such as crops, minerals or water; immovable property of this nature; an interest vested in this (also) an item of real property, (more genera ...
investment, either of equity ownership or of a real estate loan. The underwriting process generally involves a detailed analysis of expected cash flows, the local market, supply and demand, and risks such as the physical state of the property, environmental or geotechnical risks, zoning, taxes, and insurance. In the evaluation of a real estate loan, lenders assess both the risk of lending to a specific borrower as well as the risk of the underlying real estate. Loan underwriters use various metrics including debt service coverage ratio, loan-to-value ratio, and
debt yield ratio Debt is an obligation that requires one party, the debtor, to pay money or other agreed-upon value to another party, the creditor. Debt is a deferred payment, or series of payments, which differentiates it from an immediate purchase. The de ...
to assess out whether the property is capable of making debt service payments.


Forensic underwriting

Forensic underwriting is the "after-the-fact" process used by lenders to determine what went wrong with a mortgage. Forensic underwriting is 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 Public broadcasting involves radio, television and other electronic media outlets whose primary mission is public service. Public broadcasters receive funding from diverse sources including license fees, individual contributions, public financing ...
(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 in the
mergers and acquisitions Mergers and acquisitions (M&A) are business transactions in which the ownership of companies, other business organizations, or their operating units are transferred to or consolidated with another company or business organization. As an aspect ...
, equity issuance,
debt Debt is an obligation that requires one party, the debtor, to pay money or other agreed-upon value to another party, the creditor. Debt is a deferred payment, or series of payments, which differentiates it from an immediate purchase. The d ...
issuance, syndicated loans and U.S. municipal bond markets is reported in the
Thomson Financial league tables Refinitiv is an American-British global provider of financial market data and infrastructure. The company was founded in 2018. It is a subsidiary of London Stock Exchange Group after a US$27 billion sale from previous owners Blackstone Group LP ...
.


See also

*
Book building Book building is a systematic process of generating, capturing, and recording investor demand for shares. Usually, the issuer appoints a major investment bank to act as a major securities underwriter or bookrunner. Book building is an alternat ...
* Financial roadshows * Guidewire Software * Predictive analytics * Underwriting contract


References


Bibliography

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External links


Underwriting explained on Investopedia
{{Corporate finance and investment banking Actuarial science Securities (finance)