Contexts: insurance, risk theory, premium
In the financial industry, the word underwriting is used in mainly two contexts:
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.
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.