What is the role of underwriters in the stock market?

Introduction 

Every product in the financial market has some level of risk. Some are related to the product itself, while others are related to operational activities such as when a company goes public and faces the risk of not receiving investor response. 

Here comes the role of underwriters. Underwriters assess and take measures to manage risk. This article will explain who underwriters are, their roles, and the difference between underwriters and brokers.

What is an underwriter?

Underwriters are individuals or groups of individuals (companies) who assess and evaluate risks before approving applicants for financial products. Underwriters are necessary for businesses that offer financial products such as insurance, mortgages, and loans. 

Before making any judgment, underwriters consider the applicant’s background such as age, current and previous financial condition, credit score, history on the payback of debt, and more. 

This helps businesses reduce their overall risk by assessing it in advance and taking steps to reduce its impact. Against these services, underwriters charge a commission or fees. 

Different types of underwriters

The role of underwriters depends on their type, which can be classified into the following categories.

1. Insurance underwriters

You can insure your life, health, vehicle, business, or real estate property in India. In the case of a loss to the insured person or property, the insurer pays the sum assured or the full amount of the loss.

However, the insurance company’s goal is to make a profit in addition to providing coverage, and here is where the role of underwriter in insurance comes in. Let us illustrate this with an example of health insurance.

Suppose Mr Ravi, a 75-year-old retiree, wishes to get health insurance. He already has a preexisting illness. Here, the underwriter may rule him ineligible because Mr Ravi’s chronic sickness risk is considerable. This might result in claim initiation right after the policy’s waiting period, resulting in a loss for the insurer. The underwriter may also suggest providing insurance in exchange for a higher premium to be paid by Mr Ravi.

2. Mortgage & loan underwriter

Often people feel that having a solid income is enough to qualify for a mortgage or loan. But this is not the case. When you submit an application, the lending institution will ask for your income proof, bank statement, KYC documents, and employment proof. Once they obtain these documents, they submit them to the underwriter for a credit check.

The underwriter then reviews your financial history to check your suitability. They further review your credit report and compile a list of your debts. If your debt-to-income ratio exceeds the set cut-off, they may reject your loan application due to the difficulty you may encounter in managing a new loan EMI. 

3. Debt securities underwriter

The government and corporations issue debt securities to obtain funds at a fixed interest rate. Debt securities work similarly to loans, except that the bond issuer is the borrower, and the general public is the lender. 

The roles and responsibilities of credit underwriters are to examine whether the issuer can repay the raised funds and pay the interest to investors.

The profit they make from this procedure is called the ‘underwriting spread.’

4. Equity underwriter

When a company raises funds from the general public, it issues an Initial Public Offering (IPO). You may have noticed a price band when the IPO is live for subscriptions, but have you ever considered how this price band is determined? The role of underwriter in IPO comes into action here. 

The underwriter examines the company’s market trend, studies its financial statements, and uses indicators to assess various technical parameters. They then determine the price based on their findings. 

Typically companies going public hire investment bankers as their underwriters and the role of underwriter in IPO is very crucial. Let’s understand how it works. 

How does IPO underwriting work?

To help you understand the role of underwriters in issue management in a better way, let’s take an example.

Suppose a logistics company named XYZ has been in operation for a long time and plans to raise capital via an IPO. The function of underwriters in issue management is as below.

• Step 1: XYZ approaches an investment bank, who becomes an underwriter to buy the entire share lot at a predetermined price. The underwriter assures the company that if the market becomes uncertain and demand for shares falls during IPO, it will still provide the required capital. 

• Step 2: The underwriter conducts the due diligence. They examine the company’s financials, undertake promoter background checks, and comprehend business strategies to determine the risk of investing in XYZ Limited. 

• Step 3: Following their evaluation, the underwriter consults with XYZ’s top management to determine the optimal pricing band. The price is such that it corresponds to the company’s performance and can garner investors’ interest.

• Step 4: After mutual consent on the price band, XYZ drafts an agreement that contains details of the IPO issue and the terms and conditions at which the underwriter will buy the unsold issued shares.

The difference between underwriters and brokers

The key distinctions between the underwriter and the brokers are detailed below, 

Conclusion

Understanding the role of underwriters is crucial for investment or borrowing. Underwriters assess and reduce the overall risks of financial products for businesses issuing them and customers availing them. Overall, underwriters are the dark horse that helps manage risks efficiently.

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