Underwriting

Definition

Underwriting is a financial process commonly used in insurance and securities industries. It involves assessing and assuming risk on behalf of a client, typically for a fee.

What is underwriting?

Here are some key points about underwriting:

1. Risk assessment:
– Underwriting involves evaluating the risk associated with insuring a person, property, or providing financial coverage for a specific event.

2. Insurance industry:
– In the insurance industry, underwriters evaluate insurance applications to determine the level of risk an insurer is willing to take on and the premium that should be charged.

3. Securities industry:
– In the securities industry, underwriters assess the risk of issuing new securities, such as stocks or bonds, and set the terms and conditions for their sale.

4. Due diligence:
– Underwriters conduct thorough due diligence to gather information about the entity or individual seeking coverage. This may include financial records, medical history, or other relevant data.

5. Setting premiums or pricing securities:
– Based on the risk assessment, underwriters determine the appropriate premium for insurance policies or the initial offering price for securities.

6. Risk acceptance or rejection:
– After assessment, underwriters decide whether to accept or reject an application for insurance coverage, or whether to proceed with the underwriting of securities.

7. Risk mitigation:
– Underwriters may also recommend risk mitigation measures, such as higher premiums or specific conditions, to minimise potential losses.

8. Market conditions:
– In the securities industry, underwriters consider market conditions, investor demand, and other factors when pricing and issuing new securities.

9. Legal and regulatory compliance:
– Underwriters must adhere to legal and regulatory requirements that govern their industry, ensuring that all transactions are conducted in accordance with applicable laws.

10. Relationship with clients:
– Underwriters often work closely with brokers, agents, or other intermediaries who bring applications for underwriting. They provide expertise and guidance to these professionals.

11. Risk pooling:
– In insurance, underwriting is a crucial step in the process of risk pooling, where the risks of many individuals or entities are combined to spread the potential financial impact of losses.

12. Adaptability to changing circumstances:
– Underwriters must be able to adapt to changing circumstances, such as shifts in economic conditions or emerging risks.

Overall, underwriting is a vital function in the financial industry that helps manage and distribute risk. Whether in insurance or securities, underwriters play a critical role in ensuring that financial transactions are conducted in a responsible and financially sound manner.

Example of underwriting

XYZ Corporation, a technology company, plans to issue R100 million in corporate bonds to fund its expansion projects. XYZ Corporation approaches an investment bank to underwrite the bond issuance.

1. Assessment of risk: The investment bank conducts thorough due diligence on XYZ Corporation. Based on this assessment, the investment bank determines the risk associated with underwriting the bond issuance.
2. Structuring the offering: The investment bank works with XYZ Corporation to structure the bond offering, determining key terms such as the bond’s interest rate, maturity date, and covenants.
3. Pricing and allocation: After generating investor interest, the investment bank facilitates the pricing of the bonds based on prevailing market conditions and investor demand.
4. Underwriting commitment: As an underwriter, the investment bank agrees to purchase the entire bond issuance from XYZ Corporation at an agreed-upon price, providing assurance that the bond offering will be successfully completed.

In this example, underwriting plays a critical role in facilitating the bond issuance process for XYZ Corporation by assessing risk, structuring the offering, marketing to investors, and providing a commitment to purchase the bonds.