UNDERWRITING

Definition

Underwriting is the process by which a financial institution or underwriter evaluates and assumes risk in exchange for a fee or premium. It is used in securities issuance, insurance contracts, and loan approvals to determine pricing, eligibility, and terms.

In essence, underwriting involves assessing risk and determining the terms under which it is acceptable to take on that risk.

Origins

The term “underwriting” originates from Lloyd’s of London in the 17th century, where risk-takers would write their name under insurance contracts in exchange for a premium. Over time, the term evolved across insurance, capital markets, and banking, becoming a cornerstone of modern financial risk management.

Usage

Industry Applications:

• Investment Banking – Underwriting IPOs, bond issues, or secondary offerings.

• Insurance – Assessing applicants to price risk and determine coverage.

• Lending – Credit risk assessment in personal, corporate, and mortgage loans.

• Reinsurance – Transferring portions of risk between insurers.

• Private Placements – Underwriting private securities for institutional investors.

How Underwriting Works

Key Roles in Underwriting:

1. Risk Assessment – Evaluate the applicant’s or issuer’s risk profile.

2. Pricing – Set the premium, interest rate, or offer price to compensate for risk.

3. Approval / Rejection – Decide whether to accept, decline, or modify the application.

4. Documentation & Disclosure – Ensure regulatory compliance and full transparency.

Key Takeaway

• Underwriting ensures fair risk-pricing and protects institutions from excessive exposure.

• In capital markets, it provides liquidity and confidence to the issuance process.

• Underwriters can retain or distribute the risk (e.g., via syndicates or reinsurers).

• Involves quantitative and qualitative analysis, often aided by models and credit scoring tools.

Types of Asset

Context in Financial Modeling

Underwriting affects:

• Deal Pricing – In IPO or bond offerings, underwriters set initial price based on valuation, risk, and market demand.

• Revenue Forecasting – For banks and insurers, underwriting income and loss ratios affect top-line and profit metrics.

• Credit Models – Underwriters use models to determine loan eligibility, expected losses (PD, LGD, EAD).

• Risk Adjustments – DCF and valuation models adjust discount rates for underwriting and risk assumptions.

Nuances & Complexities

• Firm Commitment vs. Best Efforts (Securities):

  • Firm Commitment: Underwriter buys the entire issue, assumes full risk.

  • Best Efforts: Underwriter sells as much as possible, issuer bears the risk.

• Syndicated Underwriting: Risk is shared among multiple institutions to reduce concentration.

• Moral Hazard: Poor underwriting can lead to adverse selection and financial losses.

• Underwriting Standards: Governed by internal policy and regulatory guidelines (e.g., Basel III for credit risk, Solvency II for insurers).

Mathematical Formulas

1. Underwriting Spread (Securities):

$$\text{Underwriting Spread} = \text{Public Offering Price} - \text{Price Paid to Issuer}$$

2. Loss Ratio (Insurance):

$$\text{Loss Ratio} = \frac{\text{Claims Paid}}{\text{Premiums Earned}} \times 100$$

3. Debt Service Coverage Ratio (Loan Underwriting):

$$\text{DSCR} = \frac{\text{Net Operating Income}}{\text{Debt Service}}$$

4. Expected Credit Loss (IFRS 9 / CECL):

$$\text{ECL} = \text{PD} \times \text{LGD} \times \text{EAD}$$

Related Terms

• IPO

• Bond Issuance

• Credit Risk

• Premium

• Risk Appetite

• Due Diligence

• Syndicate

• Loan Origination

Real-World Applications

1. IPO Underwriting

Goldman Sachs underwrites a $1B IPO, committing to purchase shares and resell them to the public, earning an underwriting spread.

2. Mortgage Loan Approval

A bank uses automated and manual underwriting to approve a $500,000 mortgage based on credit score, income, and property appraisal.

3. Auto Insurance Underwriting

An insurer evaluates driving history, vehicle type, and geographic location to price an auto policy premium.

4. Bond Issuance

A municipal government hires underwriters to sell $250M in general obligation bonds, which are rated and priced based on creditworthiness.

References & Sources

• SEC.gov – Securities Offering and Underwriting Disclosure Rules

• NAIC & FINRA – Underwriting Standards for Insurers and Broker-Dealers