Back in the days, global trade and commerce flourished on the back of shipping voyages. A plethora of ships travelled across the world carrying cargos. However, the risks those commercial voyages implied was also significant, and if actualised, resulted in massive losses.
Naturally, shipowners sought insurance on that front. For that, they would prepare thorough documents listing their ship, cargo, crew, and destination’s details. Business owners willing to assume the latent risk would sign their names under those documents in exchange for a premium. That’s where the term “underwriter” came into being.
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What is an Underwriter?
As can be understood from the above anecdote, an underwriter is someone who assumes the risk of another party. In reciprocation of their services, they receive a fee, called a premium, commission, interest, or spread, depending on the industry.
Similarly, based on the industry, an underwriter also performs an array of job roles. Underwriters usually work for organisations involved in mortgage loans, insurance policies, equities, and debts. The essential point to the underwriter meaning across industries is that they analyse and assume risks of customers against a specific payment.
Underwriters possess specialised knowledge concerning the intricacies of industries they function in. They apply this knowledge to assess and evaluate the risks involved in a transaction or business decision. Based on their understanding, they either accept that risk or deny it, whatever works to the benefit of such organisation which they represent.
What are the Functions of Underwriters?
Per the enumeration above, an underwriter’s job across all industries is to analyse and subsequently assume the risk of another party against a fee or deny it.
For example, suppose Raj applies for a mortgage loan with XYZ Bank. The underwriter in XYZ assesses the risk Raj carries as a borrower by analysing his credit score, repayment history, and also the true value of such mortgaged property, and whether it stands the loan amount.
Next, based on analysis, this underwriting individual first determines whether the company should accept Raj’s application or not. If approved, a borrowing rate justifying findings of such evaluation will be set for Raj. The higher the risk, the higher will be the interest rate.
In the case of equities, an underwriter’s role is primarily felt in the Initial Public Offering (IPO) stage. In this phase, a private company goes public by issuing shares for the first time.
When talking of insurance, one of the underwriter’s chief functions is to determine the likelihood that a policyholder will submit a claim, based on an array of factors. Following that, they will set a premium.
In essence, their primary function is best defined as forging a market with stability and fairness in regards to financial transactions and business decisions.
What are the Different Types of Underwriters?
Based on different industries, underwriters can broadly be classified into four categories:
In general, the job role of an equity underwriter dictates overseeing the issuance and distribution of stocks on behalf of companies. But, perhaps it is most pronounced in the IPO stage.
When companies are going from private to public, they need to determine at what price they will issue such shares. This is where an underwriter comes into play. Companies approach investment banks in regards to the Initial Public Offering.
While investment banks at large ensure regulatory compliance, their underwriters in specific oversee the task of analysing the demand of such stocks. Therein, they contact different institutional investors, like insurance companies and mutual funds, to evaluate a company’s IPO market demand.
Standing on those findings, underwriters determine IPO prices for different organisations. Additionally, they also guarantee the purchase of a specific number of shares. In case they do not sell as per guaranteed, underwriters cover that risk, which is such deviance in estimation.
Insurance underwriters perform two functions. One, they evaluate the risk implied by an applicant to determine whether to accept or reject an application. If assuming the chance favours such an insurer, they accept it. Subsequently, they set a premium reflecting such perceived risk and outline the guidelines for an applicant.
Their primary focus, in this regard, is to spread the risk as widely as possible across different policyholders such that it benefits the company.
Second, they review claims submitted by policyholders. Based on their evaluation, underwriters decide whether a claim is legitimate or not. If consistent, they determine the appropriate coverage amount.
The acceptance or rejection of mortgage loan application hinges on this category of underwriters. Much similar to its insurance counterpart, mortgage underwriters review applications to reckon the risk involved.
They primarily assess an applicant’s repayment history, exposure to credit, debt-to-income ratio, etc. They also evaluate such pledged asset’s value to determine whether it’s sufficient to cover losses in the event of default.
Thus, a mortgage underwriter’s say in the matter of approval is ultimate. Underwriters also play a crucial role in determining interest rates, both for secured and unsecured loans.
Debt security underwriters
These underwriters buy debt instruments, like corporate bonds, municipal bonds, etc. from the issuing body and sell them to other entities at a profit. This profit is called the spread. Such individuals can sell debt securities directly or via dealers. In some cases, a group of underwriters are involved in executing the whole process, called underwriter syndicate.
What is the Difference between Underwriters and Agents/Brokers?
The following table illustrates the distinction between an underwriter and an agent/broker.
|Basis of difference||Underwriter||Brokers/Agents|
|Definition||They assess, evaluate, and assume risk on behalf of other parties.||They act as portals between customers and organisations.|
|Scope of functioning||These individuals solely represent the interests of the company they work for.||These entities represent the interests of both the customer and their employers.|
|Authority||They hold the final say on whether to assume risk or not.||They submit applications from clients but have no significant weight on the matter of approval or rejection.|
An underwriter plays a crucial role in financial markets. They ensure that all transactions and business decisions take place under fair and stable conditions.