- Underwriting is the process of taking on risk in a financial transaction, typically a loan, insurance, or investments.
- Underwriters assess risk, determine how much to assume, and at what price.
- Underwriting helps set rates for loans, premiums for insurance policies, and the cost of risk in securities markets.
For financial institutions, what you don't know can hurt you. When lenders make loans to borrowers or insurance companies write policies for clients, they're taking on a certain amount of risk.
Risk can end up being extremely costly for companies, which is why it's important for them to understand exactly what they're taking on when they extend credit or insurance to an entity. This is where underwriters come in.
How the process of underwriting works
The number one purpose of underwriting is to determine risk. Knowing the amount of risk involved in a financial venture allows for pricing and finally a decision to accept or reject the applicant.
The underwriting process varies somewhat depending on the type of underwriting being done, but in general terms here's how it works:
Step 1: Review and evaluate the application or other paperwork to determine creditworthiness, financial soundness (investment), or other other factors that vary with the type of risk.
Step 2: Obtain an appraisal of property, evaluation of securities, to help further determine risk.
Step 3: Process all gathered information and make a decision to:
- Accept: Approval involves other decisions including loan rates, terms, premium amounts, or price to pay for securities, depending on the type of underwriting decision being made.
- Deny: Denial results when the various factors show unacceptable risk in the eyes of the underwriter.
- Pending: A decision to hold the application typically means the underwriter doesn't have enough or the right information to make a firm decision.
Fun Fact The term 'underwriting' is believed to have originated in the early days of Lloyd's of London when risk takers (underwriters) wrote their names below (under) the total amount of risk they were willing to undertake, such as a voyage of a merchant ship for example, in exchange for a specified premium.
Types of underwriting
Each type of underwriting comes with specific risks. Underwriters generally specialize in one of several risk types.
Loan underwriting
If you've ever applied for a personal, car, or home loan, you've likely heard the term "underwriting" as part of the application process.
Personal and car loans, compared to mortgages, are relatively simple. The risk to the lender is that you will not pay back the loan. These types of loans are often underwritten using a computer and strict modeling algorithms. That is not to say they are "untouched by human hands" just that the process is not as complex as with other types of risk.
Mortgage/real estate loans are more complicated, mostly because the thing you are trying to buy is more expensive and the risk to the lender is greater. As noted above, a home or other real estate loan involves a deep dive into your personal finances including income, assets, debt, and general ability to repay the loan. In addition, the asset (home/real estate) must be appraised, evaluated to make sure you are not overpaying. Other research involves making sure the seller actually owns the property, such as a title search.
"Many people don't realize how tricky underwriting can be for a self-employed person or an entrepreneur who's applying for a loan at a big bank. Sometimes when automated underwriting is used; they will look for a W-2 and when none is found, the system rejects the applicant.
"But there are mortgage lenders who take a more individualized approach to loan qualification, rather than the cookie-cutter approach old-school lenders use. Talk to your lender about the processes they use to qualify you for a loan.
Insurance underwriting
Insurance underwriting involves evaluating an applicant for life or property insurance. It determines the risks of filing large or frequent claims and assessing how much coverage a person can be given, how much they should pay and how much an insurance company is likely to pay to cover the policyholder.
Life insurance underwriting involves assessing the risk of the potential insurer by evaluating age, occupation, health, family medical history, lifestyle, hobbies, and other traits.
Property and casualty insurance underwriting requires inspection of homes and rental properties for deterioration, crumbling foundations, damaged roof or anything that poses a risk to the insurer.
The financial takeaway
Underwriting is all about risk and determining the cost (value) of that risk. With a loan, the risk is whether the borrower will repay or default and the cost is the amount of interest charged. With insurance, the risk is whether too many policyholders will file claims at the same time. To mitigate that risk, the cost is the premium charged to each policyholder.
The role of underwriting and the underwriter cannot be understated. Without some assessment of risk, all financial transactions would be a matter of "guessing." Underwriting removes guesswork and replaces it with a process designed to be fair to both the lender and the borrower; the insurer and the insured; the investor and the investment.
Lenders want to lend, insurers want to insure, and investors want to invest. Conversely, borrowers want to borrow, individuals want insurance, and IPOs want investors. No matter your role in any financial interaction, know that the underwriter is there to ensure fairness.
NOTE: The above information is for informational purposes only. We advise you to speak with your lender regarding your loan and their process.