Underwriting is the process of assessing risk and the cost of that risk for a lender or investor for a particular financial transaction.
Underwriters evaluate the financial profile of the applicant to make the right decision about investing money or approving an insurance plan.
What is Underwriting?
Underwriting refers to evaluating and quantifying the financial risk of an individual or an entity. It determines the magnitude of the risk associated with a financial transaction.
The underwriting process helps to set the right price for taking on the financial risk. It helps lenders and investors make the right decisions with loans, insurance plans, IPOs, and other types of financial transactions.
Banks, insurance companies, and other financial institutes use a cadre of underwriters to perform risk assessments on various investment and insurance proposals.
The main objectives of underwriting are:
- Vetting financial risks coming from a loan, insurance, or IPO.
- Assessing the financial profile of the applicant.
- Conducting research and analyzing the applicant’s documents.
- Assessing the cost of risk for the investors.
- Making a clear decision on the application.
How Does Underwriting Work?
The underwriting process means assessing the risk of the applicant and determining the true cost of undertaking that risk.
Underwriters will first determine the income potential of the applicant. It includes both the gross and net income of an individual or a business.
The next important aspect is to evaluate assets owned by the applicant. Underwriters will look at the financial strength of the applicant by evaluating the fair market value of the assets.
Then, an underwriter will typically evaluate the potential investment option. It means appraising the project for which the loan or insurance is required.
Assessing factors like income, collateral, investment appraisals, and credit scores help underwriters to evaluate the financial profile of the applicant.
Then, they recommend based on their research whether the investor (the lender) should undertake the risk of investing (lending) money and at what cost.
When applying for a loan, the bank or lender may use the process of underwriting to assess your creditworthiness (ie. the risk you present), to decide whether to approve your loan request.
Types of Underwriting
Underwriting is used in several types of financial transactions. Broadly, we can categorize it into three categories.
This process involves assessing the risk of lending to a particular borrower. The underwriter will evaluate the creditworthiness of the borrower and present recommendations for lending. This may include using alternative data (such as cash flow information using bank statements).
This is the process to assess the magnitude of the risk and how much coverage should a potential insured party should get. It includes insurance risk assessments of life, health, property, rental, and financial insurance plans.
It is the process of evaluating the correct price and risks of financial security like a bond or stock. Securities underwriting is common with initial public offerings (IPOs). It helps banks and financial institutions to determine the right IPO price for a stock.
The Underwriting Decisions
The underwriting process begins when an applicant applies for a loan or insurance plan. It covers every aspect of the transaction from preapproval to the final stage of lending money.
However, underwriting decisions can vary after evaluating the applicant’s credit profile.
It means the underwriters concluded the risk is unworthy or unacceptable for the lenders. The applicant’s loan or insurance application will be denied.
Suspension or pending means underwriters require more information to make the right decision. They’ll ask the applicant to provide more documents and conduct further research.
Approval means the application is approved. However, it may come with certain conditions.