In this article, we discussed the meaning of underwriting deals, we also talked about the types, function and how underwriting deals work.
Definition
Underwriting is the process of determining and quantifying the financial risk of an individual or institution. Typically, this risk usually involves loans, insurance or investments. Financial institutions, such as banks, insurance agencies, investment firms and loan companies, employ underwriters who conduct risk analysis to determine a potential defaulter’s creditworthiness.
Types of Underwriting
There are three major types of underwriting: loans, insurance, and securities.
Loan Underwriting
All loans undergo some form of underwriting. In many cases, underwriting is automated, it involves evaluating an applicant’s credit history, financial records, and the value of any collateral offered, along with other factors that depend on the size and purpose of the loan. The evaluation process can take a few minutes to a few weeks, depending on whether the appraisal requires a human being to be involved.
Insurance Underwriting
Insurance underwriters receive customer applications and decide whether to offer them a policy on the basis of various criteria. If they do approve the application, the underwriters also set premiums and coverage amounts.
With insurance underwriting, the focus is on the potential policyholder—the person seeking health, home, auto, or life insurance. In the past, medical underwriting for health insurance looked at the applicant’s pre-existing conditions to determine how much to charge an applicant, or whether to offer coverage at all, often based on the applicant’s pre-existing conditions. Beginning in 2014, under the Affordable Care Act, insurers were no longer allowed to deny coverage or impose limitations based on pre-existing conditions.
Securities Underwriting
Investment securities underwriting, which seeks to assess risk and the appropriate price of particular securities—most often related to an IPO—is performed on behalf of a potential investor, often an investment bank. Based on the results of the underwriting process, an investment bank would buy (underwrite) securities issued by the company attempting the IPO and then sell those securities in the open market.
Forensic underwriting
Forensic underwriting typically occurs when a borrower cannot pay back a loan. In this situation, an underwriter performs post-funding analysis to re-evaluate the risk assessment or investigate potential fraud. The underwriter may recommend whether the borrower can receive a new loan or a refinancing agreement. Sometimes, underwriters perform forensic underwriting on closed loans to ensure compliance. This type of underwriting also helps underwriters identify and recommend improvements to the underwriting process.
How underwriting works
During the underwriting process, an underwriter evaluates different factors to determine the estimated risk of approving a loan or policy. An underwriter may choose to recommend approval if a potential borrower scores high in one or several areas. If the borrower scores low in these areas, the underwriter may deny the application. In this case, the underwriter provides the loan candidate with a valid reason for the denial.
There are four basic elements that an underwriter evaluates, which are:
Income
Income refers to both gross and net income. Gross income is the amount a person earns before assumptions, such as duties, while net pay is the amount remaining. Underwriters use income to estimate whether a borrower’s income can cover the monthly payments for a loan. Borrowers typically submit a diversity of documents, such as personal or business tax returns, to help underwriters assess their income.
Appraisal
Appraisals ensure the property or other purpose of the loan is worth the requested amount. In this part of the process, an appraiser visits the property or evaluates the purpose of the loan to collect determining information, such as viability or quality of the investment. An appraisal ensures a borrower can only secure a loan worth the actual amount of the property.
Credit score
Knowing the borrower’s credit score helps an underwriter determine if the borrower is reliable in paying on credit, including loans and credit cards. The credit score also provides a borrower’s debt-to-income (DTI) ratio. Underwriters calculate this ratio to estimate whether the borrower can pay back the loan, along with other existing debts they may have. If a borrower has a good credit score, they may benefit from a lower interest rate.
Assets
Assets are valuable items a borrower owns and can sell if they are unable to pay back their loan. Assets may include buildings, federal treasury notes, corporate bonds, guaranteed investment accounts, mutual funds and land. To evaluate a borrower’s assets, an underwriter may assess their savings accounts, stocks or real estate.
Important Functions of Underwriting
Assesses the potential risk of the person or investment
Establishes fair rates on loans
Sets the correct premiums to cover the actual cost of insuring policyholders
Prices investment risk accurately to establish a market for securities
Ensures proper assessment and coverage
Helps investors make sound investment decisions.
Conclusion
Underwriting is the process of examining the financials of a loan or insurance application to determine how much risk they pose to a lender or guarantor. This usually means checking the applicant’s income.