Underwriting is the exchange of a fee for the acceptance of risk. This is a risk transfer from one party to another. The concept most commonly applies 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 concept also applies to investment banking, where an underwriter assists a client in selling its securities to the investment community. The underwriter takes on risk by guaranteeing that the securities will be sold for a minimum price; the underwriter will make up the difference if this does not happen. The underwriter can also earn a substantial profit by selling the securities at a higher price and pocketing the difference.
Underwriters may offload a portion of the risk associated with a transaction by forming a syndicate of several underwriting entities. If a risk occurs, the related payment obligation is spread among the members of the syndicate, so that no one entity will bear the burden of the entire payment.
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.
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.