Contexts: insurance, risk theory, premium
corporate finance

In the financial industry, the word underwriting is used in mainly two contexts:

1. Insurance Underwriting

In insurance, underwriting is the process by which an insurer determines whether to insure a risk, and if so, under what level of premiums and possibly under what conditions.

Underwriting involves firstly finding out as much information as possible about the risk. In life insurance, this would mean finding about the proposer's general health and lifestyle habits. For large sums assured the insurer may insist that the proposer undertake a medical examination. For general insurance, such information may include the geographical location of the insured property, the protection that the property was given, and the owner's habits. For liability insurance, information may include the type of practice that for which insurance is sought.

Once this information is in place, the insurer will decide whether the risk is too great for the insurer to insure. Sometimes reinsurance will help the insurer to take on greater risks than would otherwise be possible. The insurer may also charge a higher premium for particularly high risks, or impose exclusions, circumstances where the insurer will not pay.

2. Financial Underwriting

In corporate finance, underwriting refers to an arrangement between an issuer of a security and an underwriter, usually an investment bank, whereby the underwriter takes on any market risk that the issuer of the security may have. For example, if a company offers a security for $25, but the market can only afford $22, then the company would have excess securities which it could not sell. In an underwriting arrangement, the underwriter would purchase these excess securities at a lower price (say $24), and help sells these securities elsewhere.

The term underwriting originated in the UK, in the coffeehouses of the time when ships of the empire sallied forth and returned with riches from exotic places. Just as now, insurance was provided for those voyages. The insurance contract required the insured (or whoever is paying the premium) to literally write their name and sign underneath the text of the insurance contract. I imagine this was done to enable the insurer weasel out of claims by insisting on the strictest interpretation of the contract.

In relation to issuance of securities, underwriting serves as insurance because it ensures that the issuer of the security will receive some money for its securities. In addition to the underwriting fee paid to the investment bank, there is also a fee if the obligation crystallizes (meaning the contract is called in because the market did not subscribe to the issue), called the crystallization fee. In my experience, it is the largest fee charged by investment banks, sometimes as high as 8% of the amount underwritten. I understood the reasoning behind the steep fees as being a deterrent to issuers from pushing for unrealistic valuations. However, where the investment bank allows such a valuation, and the underwriting obligation crystallizes, the fee it charges might not be enough to cover the costs it would have to bear for holding those securities.

Iron Noder 2020, 17/30

Un"der*writ`ing, n.

The business of an underwriter,

© Webster 1913.