Whether you need a loan, an insurance policy, or are looking to launch your company into the financial stratosphere, you're probably going to encounter the underwriting process. This is a process that helps balance risk for the financial organizations that take it, giving them a chance to get to know you a lot better.
What is underwriting?
Underwriting is a process through which applicants are scrutinized for their risk when it comes to the financial security involved. Many people will encounter underwriting when they buy a home, a process during which their financial soundness and the value of the home are both carefully examined, sometimes repeatedly, until the bank is satisfied that they are likely to repay the loan.
The reason the home is also scrutinized is so that, just in case they're wrong, they know they can recoup a lot of money simply by selling the asset. Underwriting, then, isn't really for the customer, but it enables the customer to get what they need or want from a financial institution through a transparent process that is frequently reproduced for similar financial entanglements.
Types of underwriting
There are three main types of underwriting:
Mortgage: Mortgage underwriting is what's described above, when a bank scrutinizes you and the home you're considering to see whether you meet its criteria.
Insurance: Insurance underwriting works to determine how likely you are to make a claim and uses that information to determine your premium.
Securities: Securities underwriting is most often used before launching an initial public offering (IPO). This type of underwriting is meant to both assess the risk involved with the security and to determine a fair market price that is desirable enough to attract investors. If the bank can't sell the shares, it will be left holding them, which it certainly doesn't need.
In each case, it's about assessing the risk that a bank or insurance company will be left holding the bag after a financial transaction has finished. Whether that's a foreclosure, an insurance claim, or an IPO that falls flat, the process is all about comparing the potential to the reality.
What happens during underwriting?
During underwriting, underwriters gather information about the person or business that wants to be granted the financial product, as well as any collateral they may have, such as houses or stocks from an IPO. The underwriter is like a financial detective, trying to figure out how likely it is that the company will get its money back -- and then more -- from the transaction.
Not every underwriter is perfectly spot on every time, but the goal is to be as accurate as possible using as much information as can be secured. Once that is complete, the underwriter either approves or denies it, although they may also choose to ask for even more information directly from the applicant before making a final decision.
Related investing topics
Why does underwriting matter to investors?
If you invest in banks, insurance companies, or mortgage-backed securities (MBS), knowing that the products driving those assets are secure and reliable is a good feeling. You can depend on that bank being sound, for example, because it practices good underwriting. Underwriting is also really important for MBS products because the grades of the mortgages inside are based on the underwriting.
One other reason that investors care about underwriting is that it's underwriters who help determine the price of an IPO. It's not simply a matter of a company saying, "OK, let's start these new stocks at $5 each," like some kind of high-stakes eBay (EBAY +0.72%) auction. It's the underwriter guiding and directing an initial price that optimizes sales and moves the stocks from the banking firm to the open market without leaving anything behind.
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