Underwriting in insurance
My classmate just got a job as an insurance underwriter, and further to that, I deemed it fit to discuss underwriting to my wonderful visitors. I am quite sure most people have heard the word underwriting at a point in their lifetime, and it is only natural to relate it to investment banks because their underwriting activities are subject to public scrutiny. What most people don’t know is that insurance companies also extend underwriting services to their clients. Today, we would be focusing on underwriting in insurance, but before we begin, let us take a quick look at the differences between underwriting by investment banks and underwriting by insurance companies.
Underwriting as it relates to investment banking
It is the process in which investment banks raise capital on behalf of companies or governments issuing debt or equity securities. In the underwriting process, the investment bank effectively purchases all the new issues of shares or debt (bond) at a discount or negotiated price, and then sells it to the general public, mainly institutional investors such as pension funds or mutual funds. Before an investment bank takes such a huge risk, it will first analyze the value and riskiness of the business in order to price, underwrite and sell the new issues.
The risk being talked about is the risk that the underwriting bank would fail to sell all the shares already purchased from the issuer. In practice, due to the share volume of new issues, no single bank can underwrite all the securities and bear the risk alone. To share the burden of risk, several banks come together to form a syndicate for underwriting the new issue. The banks purchase a portion of the security from the issuer at a negotiated price, and then promote the securities to the investing public, normally through a marketing strategy called a roadshow. A roadshow is a presentation by an issuer of security (in this case the banks) to potential investors. The banks try to market the security, highlighting key benefits of investing in the security. In a roadshow, the investment bank or issuer answers questions from prospective buyers interested in learning more about the offering.
Aside underwriting, some investment banks practice best effort offering. In a best effort offering, the investment bank promises to put in its best effort to sell the issues. The investment bank doesn’t take up the risk of unsold inventory when purchasing the security, it merely acts as an agent to the issuing bank and agrees to do the best it can to sell as many of the issuers shares to the general public as possible. The investment bank I work in offers this type of service to its clients. Due to the market conditions and current recession in Nigeria, it would be highly risky for an investment bank to underwrite the sale of new issues of security in Nigeria.
Underwriting as it relates to insurance
is the process of assessing and classifying the degree of risk represented by proposed insured with respect to a specific insurance product. Unlike investment banks when underwriting occurs mainly in the issue of new securities, underwriting is a core function of insurance companies. An insurance company is a legal entity that provides indemnity to clients for protection from financial impact or uncertainty that can affect the insured negatively. To provide this risky service, insurance companies charge a premium, which is a predetermined amount of money a client pays to avail him access to indemnity against losses or uncertainties. In essence, this process of accepting the risk of the insured is known as underwriting. By pulling similar risks together insurance companies transform the unpredictability of the occurrence of an event of an individual into expected events affecting any one of the insured participants.
Insurance companies employ underwriters whose main purpose is to help the insurance company create homogeneous portfolios by evaluating the risk and accepting them under conditions that make them similar. An underwriter is also tasked with the duty of helping the insurance company protect its book by accepting less risky coverage. If insurance coverage for a client turns out to be highly risky, the client might be denied coverage altogether. The underwriter also helps the insurance company decide how much coverage should be received by the applicant and also the premium that should be paid for a particular amount of coverage.
Objectives of underwriting
- Underwriting enables the proper classification of clients into appropriate risk classes
- It enables the insurance company evaluate risk and price premiums to be paid for insurance coverage.
- The process of Underwriting also helps the insurance companies protect themselves from clients who misrepresent themselves fraudulently.
- Since clients are classified into their appropriate risk classes, insurance companies are able to keep their premiums down and provide a majority of their clients with affordable insurance premiums.
In the next lesson under underwriting, we would be looking at the underwriting process and functions of underwriting. Bye for now and have a lovely day people…cheers!
Eric Briys., Francois de Varenne., Insurance:From Underwriting to Derivatives: Asset Liability Management in Insurance Companies