Underwriting: Difference between revisions

{{Short description|Financial practice supporting a contract's value}}{{More citations needed|date=November 2009}}

'''Underwriting''' ('''UW''')<ref>{{Cite web|title=UW {{!}} meaning in the Cambridge English Dictionary|url=https://dictionary.cambridge.org/dictionary/english/uw|access-date=2020-10-23|website=dictionary.cambridge.org|language=en}}</ref> services are provided by some large [[financial institution]]s, such as banks, insurance companies and investment houses, whereby they guarantee payment in case of damage or financial loss and accept the [[financial risk]] for liability arising from such guarantee. An underwriting arrangement may be created in a number of situations including insurance, issues of security in a [[public offering]], and bank lending, among others. The person or institution that agrees to sell a minimum number of securities of the company for commission is called the Underwriterunderwriter.

The nameterm "underwriting" derives from the [[Lloyd's of London]] [[insurance]] market. Financial backers (or risk takers), who would accept some of the risk on a given venture (historically a sea voyage with associated risks of shipwreck) in exchange for a [[insurance premium|premium]], would literally write their names under the risk information that was written on a Lloyd's slip created for this purpose.<ref>[https://books.google.com/books?id=ZCu4ctqn9OsC&pg=PA25 "Underwriting: The Poetics of Insurance in America, 1722-1872"] , by Eric Wertheimer, Stanford University Press, 2006</ref><ref>{{cite news |last1=Probasco |first1=Jim |title=Underwriting: The risk-assessment process used in everything from IPOs to life insurance |url=https://www.businessinsider.com/what-is-underwriting |access-date=6 December 2021 |work=Business Insider |date=2021-11-17}}</ref>

In summary, the securities issuer gets cash up front, access to the contacts and sales channels of the underwriter, and is insulated from the market risk of being unable to sell the securities at a good price. The underwriter getsreceives a profit from the markup, plus the possibility of an exclusive sales agreement.

Also, if the securities are priced significantly below market price (as is often the custom), the underwriter also curries favor with powerful end customers by granting them an immediate profit (see [[flipping]]), perhaps in a ''[[quid pro quo]]''. This practice, which is typically justified as the reward for the underwriter for taking on the market risk, is occasionally criticized as unethical, such as the allegations that investment banker [[Frank Quattrone]] acted improperly in doling out hot [[initial public offering|IPO]] stock during the [[dot-com bubble]].

In an attempt to capture more of the value of their securities for themselves, issuing companies are increasingly turning to alternative vehicles for going public, such as direct listings and [[Special-purpose acquisition company|SPAC]]s.{{Citation needed|date=June 2023}}

*Commercial (or business) underwriting consists of the evaluation of financial information provided by small businesses including analysis of the business balance sheet including tangible net worth, the ratio of debt to worth (leverage) and available liquidity (current ratio). Analysis of the income statement typically includes revenue trends, gross margin, profitability, and [[Debt Service Coverage Ratio|debt service coverage]].

Underwriting can also refer to the purchase of [[corporate bond]]s, [[commercial paper]], government securities, municipal general-obligation bonds by a [[commercial bank]] or dealer bank for its own [[Deposit account|account]] or for resale to investors. Bank underwriting of corporate securities is carried out through separate holding-company affiliates, called [[securities affiliate]]s or Section 20 affiliates.{{Citation needed|date=June 2023}}

Of late, the discourse on underwriting has been dominated by the advent of [[machine learning]] in this space. These profound technological innovations are altering the way traditional underwriting scorecards have been built, and are displacing human underwriters with automation. [[Natural language understanding]] allows the consideration of more sources of information to assess risk than used previously.<ref>{{cite web|url=https://www.businessnewsdaily.com/10203-artificial-intelligence-insurance-industry.html|author=Adam C. Uzialko|title=Artificial Insurance? How Machine Learning is Transforming Underwriting|date=September 11, 2017|access-date=April 28, 2019|publisher=Business News Daily}}</ref> These algorithms typically use modern data sources such as SMS / Email for banking information, location data to verify addresses, and so on. Several firms are trying to build models that can gauge a customer's willingness to pay using social media data by applying natural language understanding algorithms which essentially try to analyse and quantify a person's popularity / likability and so on, with the premise being that people scoring high on these parameters are less likely to default on a loan. However, this area is still vastly subjective.{{Citation needed|date=June 2023}}

[[Insurance]] underwriters evaluate the risk and exposures of potential clients. They decide how much coverage the client should receive, how much they should pay for it, orand whether even to accept the risk and insure them. Underwriting involves measuring risk exposure and determining the [[insurance premium|premium]] that needs to be charged to insure that risk. The function of the underwriter is to protect the company's [[book of business]] from risks that they feel will make a loss and issue [[Insurance contract|insurance policies]] at a premium that is commensurate with the exposure presented by a risk.

Each insurance company has its own set of underwriting guidelines to help the underwriter determine whether or not the company should accept the risk. The information used to evaluate the risk of an applicant for insurance will depend on the type of coverage involved. For example, in underwriting automobile coverage, an individual's driving record is critical. However, the type of automobile is actually far more critical.{{Citation needed|date=February 2023}} As part of the underwriting process for [[life insurance|life]] or [[health insurance]], [[medical underwriting]] may be used to examine the applicant's health status (other factors may be considered as well, such as ageoccupation &and occupationrisky pursuits) and decide whether the policy can be issued on the standard terms applicable to the customer's age. The factors that insurers use to classify risks are generally objective, clearly related to the likely cost of providing coverage, practical to administer, consistent with applicable law, and designed to protect the long-term viability of the insurance program.<ref>[http://www.actuarialstandardsboard.org/pdf/asops/asop012_101.pdf "Risk Classification (for All Practice Areas),"] Actuarial Standard of '''Practice No. 12''', Actuarial Standards Board, December 2005</ref>

The underwriters may decline the risk, or may provide a quotation in which the premiums have been [[premium loadings|loaded]] (including the amount needed to generate a profit, in addition to covering expenses<ref>{{cite web|url=http://thelawdictionary.org/premium-loading/|title=What is PREMIUM LOADING? definition of PREMIUM LOADING (Black's Law Dictionary)|date=19 October 2012}}</ref>) or in which various [[exclusions (insurance)|exclusions]] have been stipulated, which restrict the circumstances under which a claim would be paid. Depending on the type of insurance product (line of business), insurance companies use automated underwriting systems to encode these rules, and reduce the amount of manual work in processing quotations and policy issuance. This is especially the case for certain simpler life or personal lines (auto, homeowners) insurance. Some insurance companies, however, rely on agents to underwrite for them. This arrangement allows an insurer to operate in a market closer to its clients without having to establish a physical presence.

Two major categories of exclusion in insurance underwriting are [[moral hazard]] and [[correlated]] losses.<ref name="npr">{{cite webnews|url=https://www.npr.org/blogs/money/2014/10/03/353030214/bedbugs-lava-and-bowling-balls-inside-my-homeowners-insurance-policy|title=Bedbugs, Lava And Bowling Balls: Inside My Homeowners Insurance Policy|newspaper=NPR.org}}</ref> With a moral hazard, the consequences of the customer's actions are insured, making the customer more likely to take costly actions. For example, bedbugs are typically excluded from homeowners' insurance to avoid paying for the consequence of recklessly bringing in a used mattress.<ref name="npr" /> Insured events are generally those outside the control of the customer, for example in life insurance, death by automobile accident is typically covered, but death by suicide is typically not covered. {{Citation needed|date=March 2021}} Correlated losses are those that can affect a large number of customers at the same time, thus potentially bankrupting the insurance company. This is why typical homeowner's policies cover damage from fire or falling trees (usually affecting an individual house), but not floods or earthquakes (which affect many houses at the same time).<ref name="npr" />

Continuous underwriting is the process in which the risks involved in insuring people or assets are being evaluated and analyzed on a continuous basis. It evolved from the traditional underwriting, in which the risks only get assessed before the policy is signed or renewed. Continuous underwriting was first used in [[Workers’ Compensation|workers' compensation]], where the premium of the insurance was updated monthly, based on the insured’sinsured's submitted payroll. It is also used in [[life insurance]]<ref>{{Cite web|url=https://www.sapiens.com/blog/insurers-making-interesting-use-of-continuous-underwriting/|title = Insurers Using Continuous Underwriting|date = 19 December 2017}}</ref> and [[cyber insurance]].<ref>{{Cite web|url=https://content.naic.org/cipr_topics/topic_ondemand_insurance.htm|title = On-demand Insurance}}</ref><ref>{{Cite web |last=McKinsey & Company |date=March 2017 |title=Digital disruption in insurance: Cutting through the noise |url=https://www.mckinsey.com/~/media/mckinsey/industries/financial%20services/our%20insights/time%20for%20insurance%20companies%20to%20face%20digital%20reality/digital-disruption-in-insurance.ashx}}</ref>