Underwriting definition
/What is Underwriting in Insurance?
Underwriting is the exchange of a fee for the acceptance of risk. This is a risk transfer from one party to another, and is most commonly applied to the insurance industry, where clients pay an insurer to take on specific risks. If a covered risk occurs, the underwriter pays the client an amount stated in the related insurance contract. The term comes from the practice of having the person taking on risk sign their name below the amount of risk they agreed to accept.
Example of Insurance Underwriting
A commercial property insurer assesses a manufacturing company's application. The underwriter reviews factors like the building's age, fire safety systems, machinery used, and prior claims history. They also consider the company’s financial stability and risk management practices. Based on this analysis, the underwriter decides to offer coverage with a $1 million limit, a $10,000 deductible, and a premium of $8,500 annually. If risks are high—such as poor safety protocols—they may adjust terms, increase the premium, or decline coverage altogether to manage exposure.
What is Underwriting in Investment Banking?
Underwriting in investment banking is the process by which an investment bank raises capital for an issuer by purchasing securities and reselling them to investors. In a firm commitment underwriting, the bank assumes pricing and market risk by buying the entire offering and bearing the risk of unsold shares. In a best efforts underwriting, the bank acts as an agent and does not guarantee full placement. Underwriters conduct due diligence, structure the offering, prepare registration documents, and coordinate regulatory approvals. They earn compensation through the underwriting spread, which reflects the difference between the purchase price from the issuer and the resale price to investors.
Example of Investment Banking Underwriting
A technology company plans a $200 million initial public offering. An investment bank agrees to a firm commitment underwriting, purchasing all shares from the company at $18 per share and reselling them to investors at $20 per share. The bank conducts due diligence, prepares the registration statement, markets the offering through a roadshow, and builds an order book. If investor demand weakens, the bank bears the risk of unsold shares, earning compensation through the $2 per share underwriting spread.
Related AccountingTools Course
Business Insurance Fundamentals
What is Underwriting in Commercial Banking?
The underwriting concept also arises in commercial banking, where the lender takes on the risk that a borrower is unable to pay back a loan. In exchange, the borrower pays interest and loan initiation fees to the lender. The level of risk undertaken by the lender depends on the financial condition of the borrower, as well as the presence of collateral that can provide a backstop for the lender in case the borrower is unable to pay back a loan.
Underwriting Risk Assessment
A key aspect of the underwriting role is risk assessment. The party taking on the risk examines the financial statements of the other party and the related risk of the proposed transaction. Based on this information and coupled with the underwriter's previous experience in the field, it arrives at a price at which it is willing to engage in the underwriting role. If the risk level appears to be too high, the underwriter may refuse to enter into a transaction at any price.