All financial institutions undergo a crucial process called underwriting before granting loans, mortgages, or funding. Underwriting entails determining a project’s or client’s loan eligibility and financial stability.
This blog post will discuss underwriting in great detail, including its definition, various types, and processes.
What Is Underwriting?
Underwriting refers to the procedure of checking different risks present in any financial deal, contract, or policy to find out if the underwriter can accept that risk and, if so, under what conditions.
Therefore, underwriting is the activity of studying the highest risk and deciding whether to accept it or not. If accepting the risk, then under what conditions or criteria and at what cost?
Underwriting determines pricing for loans and insurance policies. It also involves identifying the insurer’s or lender’s level of risk tolerance. If they accept the risk, they take action to control and minimize it during the term of the loan or insurance. Here are few risk mitigation strategies for startups that one must be aware off.
Types of Underwriting
Now, after knowing the answer to what is underwriting, let us understand its types. There are various types of underwriting depending on the nature of the financial product or service and the risk elements being evaluated. Here are some of the important types of underwriting:
Insurance Underwriting: This includes identifying and measuring the risks involved with insurance policies or applicants for insurance coverage. Factors like age, medical conditions, occupation, and lifestyle habits are considered to determine a person’s insurability and premium amounts.
Loan Underwriting: This is the process of analyzing loan applications to decide whether to issue a loan or not. It aims to mitigate the risk of default by verifying applicant details such as income, existing debts, collateral offered, etc.
Mortgage Underwriting: Focuses on appraising property being offered as collateral for mortgage loans. Here, loan-to-value ratio, borrower’s income/assets, affordability analysis, and property details are assessed with due care.
Financial Underwriting: Done for securities like stocks or bonds offered during public offerings. It evaluates business fundamentals, market conditions, and historical performances to set the right offer price.
Underwriting has also evolved in areas like sustainability underwriting for green projects and social/development underwriting used by impact investors and social enterprises.
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How Does the Process of Underwriting Work?
Below, we have discussed the process for different types of underwriting:
Loan Underwriting Process
Let’s understand the key steps involved in loan underwriting with an example:
- Application: Borrower fills out a loan application form providing details of purpose, amount, and property/collateral details, if any.
- Documentation: Important documents like income, identity, and address proofs are collected based on loan type and amount.
- Verification: Details on applications and documents are verified by creditors to obtain credit reports.
- Assessment: The borrower’s credit history, debt-income ratio, and collateral adequacy are assessed using verified details to identify repayment capacity and risks.
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- Approval: If the assessment shows that the borrower and collateral meet the risk acceptance criteria, the loan is cleared with terms, or additional collateral may be needed.
- Denial: If the assessment shows unacceptably high risks, the loan is declined with the reason provided to the borrower.
- Documentation: The sanction letter and loan/security documents are executed post-approval and before loan disbursal.
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Financial Underwriting Process
The steps involved in the financial underwriting of securities like IPOs are as follows:
- Issuer Presentation: The company mandates the underwriter and provides the underwriting team with a business plan, projected financials, and use of funds.
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- Due Diligence: Due diligence on the firm, industry, and business strategy is carried out by underwriters in the areas of law, finance, and accountancy.
- Roadshow: Company management meets investors to generate interest. Underwriter guides on pricing timing as per market conditions.
- Pricing: The final offer price is determined based on investor demand, company needs, and a risk-adjusted discount.
- Allocation: The underwriter allots shares to investors at the offer price while complying with SEBI guidelines.
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- Stabilization: Post listing, the underwriter may purchase additional shares to provide price support in initial trades.
Mortgage Underwriting Process
The key steps in mortgage underwriting include:
- Loan Application: Borrower submits loan details, property specifics, and income documents.
- Property Appraisal: An independent licensed appraiser assesses property value using comparable properties.
- Lien & Title Search: The title company verifies property ownership and ensures no pending legal issues.
- Credit Evaluation: The borrower’s ability to repay is checked through reports and verifying stated income.
- Documentation: If required, the underwriter collects additional papers, such as HOA/condominium approvals.
- Underwriting Decision: After a comprehensive analysis, the decision is made to clear the loan, request more collateral, or decline the loan request.
- Closing: Cleared loans move to close, wherein final papers and title transfer happen before disbursal.
Benefits of Underwriting
- Underwriting helps mitigate the risks of taking on ineligible clients/proposals by screening them thoroughly. This reduces the likelihood of future losses.
- It helps institutions and individuals figure out how much risk they can handle and spread out their risk across different portfolios. This way, they avoid being overly exposed to any single risky situation.
- The underwriting process leads to improved documentation and stipulated risk mitigation measures, ensuring assets are better protected.
- By declining proposals that are high risk or pricing them appropriately, underwriting ensures the financial stability of organizations over the long run.
- Qualified underwriting decisions backed by data-driven risk analysis bring efficiency and transparency to processes like lending, investing, and insuring, boosting overall confidence in financial systems.
Takeaway
Underwriting lies at the core of all lending and investment decisions by financial institutions. It aids in making thoughtful choices that are necessary for sustainability. Though technology is strengthening underwriting, human judgment will remain vital. As new risks emerge, underwriting practices will continuously evolve by leveraging the best of both automated and traditional approaches to serve customers and mitigate risks.
FAQs
- What are the key steps involved in loan underwriting?
The typical loan underwriting process involves six steps: application screening, verifying applicant details, credit and risk assessment, evaluating repayment ability, analyzing other risk factors, and taking a final approval/rejection call.
- Why is it important to have both automated and human underwriting?
Automated underwriting helps scale operations and standardize processes. However, human underwriters are vital in handling complex cases that are beyond system capabilities and ensuring fair treatment.
- What are some common challenges faced in underwriting?
Common challenges include getting up-to-date applicant information, predicting uncertain economic scenarios, balancing risks with fair treatment, and making quick decisions to keep pace with rising customer expectations.