Underwriting: The risk-assessment process used in everything from IPOs to life insurance
Underwritingis the process of taking on risk in a financial transaction, typically a loan, insurance, or investments.
- Underwriters assess risk, determine how much to assume, and at what price.
- Underwriting helps set rates for loans, premiums for insurance policies, and the cost of risk in securities markets.
Underwriting determines how risky a financial venture such as a loan, insurance policy, or investment is and whether to accept that risk. If the risk is considered worth taking, the underwriting process determines how much to charge.
"Underwriting is basically just verifying all of the information the borrower has provided on their loan application — their income, their tax returns, their bank accounts and other assets," says Mayer Dallal, managing director at
How the process of underwriting works
The main goal of underwriting is to determine risk. Knowing the amount of risk involved in a financial venture allows for pricing and finally a decision to accept or reject the applicant or venture.
The underwriting process varies somewhat depending on the type of underwriting being done, but in general terms here's how it works:
Step 1: Review and evaluate the application or other paperwork to determine creditworthiness, medical history (life insurance), financial soundness (investment), or other other factors that vary with the type of risk.
Step 2: Obtain an appraisal of property, evaluation of securities, or require a medical exam as required to help further determine risk.
Step 3: Process all gathered information and make a decision to:
- Accept: Approval involves other decisions including loan rates, terms, premium amounts, or price to pay for securities, depending on the type of underwriting decision being made.
- Deny: Denial results when the various factors show unacceptable risk in the eyes of the underwriter.
- Pending: A decision to hold the application typically means the underwriter doesn't have enough or the right information to make a firm decision.
Note: The term 'underwriting' is believed to have originated in the early days of Lloyd's of London when risk takers (underwriters) wrote their names below (under) the total amount of risk they were willing to undertake, such as a voyage of a merchant ship for example, in exchange for a specified premium.
What is the role of an underwriter?
The role of an underwriter is to protect the financial interests of the lender, insurer, or investor by assigning appropriate risk and compensation for assuming that risk. Underwriters work in a variety of financial industries including banking, insurance, investing, and more. In fact, anything that involves a combination of risk and money, probably has an underwriter somewhere in the process.
In their role of evaluating financial risk, depending on the type of risk, underwriters investigate all financial aspects of an applicant or investment. Medical history and health come into play when someone applies for life insurance. Appraisal or evaluation is also part of the process when you are buying a house, car, boat, or even investing in real estate or a major project.
Types of underwriting
Each type of underwriting comes with specific risks. Underwriters generally specialize in one of several risk types.
If you've ever applied for a personal, car, or home loan, you've likely heard the term "underwriting" as part of the application process.
Personal and car loans, compared to mortgage loans, are relatively simple. The risk to the lender is that you will not pay back the loan. These types of loans are often underwritten using a computer and strict modeling algorithms. That is not to say they are "untouched by human hands" just that the process is not as complex as with other types of risk.
Mortgage/real estate loans are more complicated, mostly because the thing you are trying to buy is more expensive and the risk to the lender is greater. As noted above, a home or other real estate loan involves a deep dive into your personal finances including income, assets, debt, and general ability to repay the loan. In addition, the asset (home/real estate) must be appraised, evaluated to make sure you are not overpaying. Other research involves making sure the seller actually owns the property, such as a title search.
"Many people don't realize how tricky underwriting can be for a self-employed person or an entrepreneur who's applying for a loan at a big bank," notes Dallal. He blames it on automated underwriting that looks for a W-2 and when none is found, rejects the applicant.
"But there are mortgage lenders who take a more individualized approach to loan qualification, rather than the cookie-cutter approach old-school lenders use," Dallal adds, advising borrowers to seek out those lenders.
Insurance underwriting involves evaluating an applicant for life or property insurance. It determines the risks of filing large or frequent claims and assessing how much coverage a person can be given, how much they should pay and how much an insurance company is likely to pay to cover the policyholder.
Life insurance underwriting involves assessing the risk of the potential insurer by evaluating age, occupation, health, family medical history, lifestyle, hobbies, and other traits.
Property and casualty insurance underwriting requires inspection of homes and rental properties for deterioration, crumbling foundations, damaged roof or anything that poses a risk to the insurer.
Note: Before the Affordable Care Act (ACA) took effect in 2014, health insurance sold in the individual market in most states was medically underwritten to include consideration of pre-existing conditions. Since 2014, however, pre-existing conditions may no longer be considered. Health insurance must now by guaranteed issue, regardless of pre-existing condition status.
In securities underwriting, the process involves the sale of stocks or bonds to investors, often in the form of Initial Public Offerings (IPOs) by an underwriter (bank). In this case the bank relies on a cadre of underwriters who help the bank assess risk, plan for, and execute the agreement to underwrite the IPO and sell securities to fund the IPO.
How long does underwriting take?
It should be no surprise that the amount of time it takes to underwrite a financial transaction depends on the type and complexity of the transaction. Underwriting a personal loan or even a car loan can be completed in minutes using a computer and software. Mortgages and life insurance take longer. Securities underwriting, for example for an IPO, is likely to take the longest.
Personal loans or car loans often take a week or less. In some instances, underwriting and approval can be almost instantaneous, happening in minutes.
Mortgages often take 30 to 45 days for full approval, although the underwriting process is only part of that timeline and is usually complete in about 72 hours after the underwriter has all the information they need.
Life insurance underwriting might be one of the least predictable when it comes to a timeline. Many life insurance policies undergo underwriting and approval in as few as 24 hours. Depending on health and other issues, however, the process can take a month or more.
Property and casualty insurance is typically approved as fast as a personal loan, that is in one to seven days. The effective date of insurance, however, is after your payment is received. Being approved for homeowners insurance doesn't mean you have it.
Securities underwriting as part of the IPO process typically happens within the six to nine months it takes for a company to transition from private to public. Since underwriters are involved at every step in the process on behalf of the bank, their work is not complete until the IPO is complete.
The financial takeaway
Underwriting is all about risk and determining the cost (value) of that risk. With a loan, the risk is whether the borrower will repay or default and the cost is the amount of interest charged. With insurance, the risk is whether too many policyholders will file claims at the same time. To mitigate that risk, the cost is the premium charged to each policyholder. With securities, the risk is that the underwritten investment will not make a profit. The cost is the difference between the amount the underwriter pays for the shares and the amount the public pays when the shares are sold.
The role of underwriting and the underwriter cannot be understated. Without some assessment of risk, all financial transactions would be a matter of "guessing." Underwriting removes guesswork and replaces it with a process designed to be fair to both the lender and the borrower; the insurer and the insured; the investor and the investment.
Lenders want to lend, insurers want to insure, and investors want to invest. Conversely, borrowers want to borrow, individuals want insurance, and IPOs want investors. No matter your role in any financial interaction, know that the underwriter is there to ensure fairness.
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