Sharekhan Blog

Know The Types Of Underwriting

  • Apr 18, 2024

Underwriting plays a crucial role in balancing the interests of issuers and acquirers by evaluating risk and enabling viable marketplace participation sustainably.

In this article, we will learn the important details of underwriting and how it carefully aligns processes with purpose when dealing with various financial instruments. So, keep reading to understand the basics and get a better understanding of the different types of financial mechanisms that are at your disposal.

Understanding of Underwriting

Underwriting refers to the process where a financial institution assesses the eligibility of an individual or organization before offering them products like loans, insurance or investments. The main aim of underwriting is to evaluate if the client poses any risk and whether providing the financial product would be profitable for the institution.

Underwriters are professionals who carry out the task of scrutinizing applications to determine the possibility of clients defaulting on loans or insurance claims. Their core responsibility is calculating risks and setting optimal interest rates, premium amounts, and investment returns. This ensures that both parties benefit from the deal.

Significance of Underwriting

Underwriting is vital in lending and insurance to protect all stakeholders. Here are some benefits:

1. Protects creditors by determining accurate credit risk levels of borrowers

2. Helps set appropriate premium amounts for policyholders

3. Allows insurers to issue policies profitably and sustainably

4. Enables investors to make sound investment choices

5. Maintains stability of financial markets

Underwriting minimizes overall risk exposure while maximizing gains. With stricter evaluation norms in place, the chances of bad loans and unpaid insurance claims have been reduced considerably. This promotes greater accountability among both underwriters and applicants.

Types of Underwriting of Shares

Underwriting is commonly categorized into three main types:

1. Loan Underwriting

The loan underwriting process involves assessing an individual's or business' eligibility for receiving debt financing. Underwriters measure parameters like income levels, credit reports, collateral value and intended use of funds. Based on this review, they approve or reject the application. They also assign suitable interest rates if the loan amount gets sanctioned.

Generally, in mortgages, the loan underwriter verifies the borrower's employment status, savings, existing liabilities, and creditworthiness. This helps verify if they can repay the home loan amount without defaulting. Automated underwriting methods are widely used today which reduces evaluation time. But human underwriters still handle intricate mortgage requests.

Overall, prudent loan underwriting procedures lead to lower non-performing assets for lending institutions. The mutuality of interests between both parties also increases.

2. Insurance Underwriting

Insurance underwriting focuses on examining a customer's insurability to determine appropriate coverage and premium amounts. The main goal is to issue policies profitably so that future claims can be settled.

Underwriters collect data regarding an applicant's age, medical history, family health conditions, lifestyle habits, occupation hazards and current insurance coverage. They use this information to evaluate mortality risk, chances of contracting illnesses and filing accident/disability claims.

Using calculated figures, the underwriter decides whether to provide insurance, reject the application or load the premium. This balanced risk-based pricing safeguards insurer interests without being unfair to policyholders. It compels applicants too to share information honestly.

Modern insurance underwriting methods rely heavily on data analytics to forecast claim likelihood more accurately. However, human expertise is still indispensable for complex cases. Overall, rigorous underwriting is pivotal for insurers to operate viably.

3. Securities Underwriting

Securities underwriting occurs during a company's Initial Public Offering (IPO). Investment banks buy the newly issued shares or bonds from the firm and sell them to investors. The underwriter absorbs the risk of holding these securities until they get sold.

Underwriters evaluate aspects like the issuer's financials, business model, management capability and prevailing market conditions. Based on this assessment, they decide on the offer price scale and timelines. The role of securities underwriting is highest during public issue launches.

Underwriters earn income through underwriting fees paid by issuers. They also gain from the price differential spread between their purchase and sale. Provided rigorous due diligence is conducted, securities underwriting paves the way for profitable investments.

Conclusion

Underwriting is essential for financial institutions to balance risks and returns sustainably. It involves rigorous screening and transparency upfront, building market confidence and setting fair terms. With improving data-based insights, underwriting will become more efficient, but qualified human underwriters will still be needed in complex cases. Overall, underwriting bridges the information gap between issuers and acquirers, lending stability to financial markets.

Team Sharekhan
by Team Sharekhan

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