Underwriting: Overview, definition, and example
What is underwriting?
Underwriting is the process by which a party, typically a financial institution, assesses and assumes the risk associated with a financial transaction, such as issuing securities, providing loans, or offering insurance. Underwriting involves evaluating the financial viability of an individual, business, or investment and determining the terms, conditions, and pricing under which the risk will be accepted.
For example, in investment banking, underwriters may assess the risks of a company's initial public offering (IPO) and agree to purchase and distribute the shares to investors.
Why is underwriting important?
Underwriting is important because it facilitates the flow of capital and ensures that financial transactions are based on informed risk assessments. For SMBs, underwriting plays a crucial role in securing loans, insurance coverage, or investment capital by providing a structured process for evaluating risks and setting appropriate terms.
For financial institutions, underwriting minimizes the likelihood of losses by carefully assessing the risk profile of each transaction. A well-defined underwriting process also builds trust and transparency in financial and capital markets.
Understanding underwriting through an example
- Securities underwriting: An SMB plans to raise funds through a public stock offering. An investment bank acts as the underwriter, evaluating the company’s financial position and market potential. The underwriter agrees to purchase all the shares and sell them to investors, taking on the risk of any unsold shares.
- Loan underwriting: A small business applies for a loan to purchase new equipment. The lender conducts underwriting by reviewing the business’s financial statements, credit history, and projected cash flow. Based on the assessment, the lender determines the loan amount, interest rate, and repayment terms.
- Insurance underwriting: An SMB applies for property insurance. The insurer underwrites the policy by assessing the business’s risk factors, such as location, property condition, and claims history, to determine the premium and coverage limits.
An example of an underwriting clause
Here’s how an underwriting clause might appear in a securities agreement:
“The Underwriter agrees to purchase from the Issuer, and the Issuer agrees to sell to the Underwriter, [Insert Number] shares of the Issuer’s common stock at the price of [Insert Price] per share. The Underwriter shall distribute the shares to investors in accordance with applicable securities laws and regulations. In the event that any shares remain unsold, the Underwriter shall bear the risk of such shares unless otherwise agreed in writing.”
Conclusion
Underwriting is a critical process for evaluating and managing risk in financial transactions, including securities issuance, loans, and insurance policies. For SMBs, underwriting provides access to capital, coverage, and financial resources under structured terms. A well-drafted underwriting clause ensures clarity about roles, responsibilities, and risks, fostering trust and efficiency in financial and contractual relationships.
This article contains general legal information and does not contain legal advice. Cobrief is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.