Meaning of Underwriting
Underwriting is a process of transferring the risk to a person or institution by paying them charges in the form of premium. The person or institutions to whom risk is transferred are known as Underwriters. Underwriters agree to undertake the risk associated with an investment, venture or a loan in exchange for premium.
Underwriting is key function of finance world and is performed in banking, stock market and insurance sector. It is method under which financial businesses assess the creditworthiness and risk of their potential customers before providing them financial services. Underwriters properly analyse the credit history, collateral and capacity of customers before assuming their risk. This process involves conducting several researches for accessing degree of risk of each customer which helps in setting optimum borrowing rate of loan or premium for issuing insurance policy.
Underwriter may also refuse to provide guarantee in case if there is high risk involved. They usually write their name under the total amount of risk they are willing to assume for particular amount of premium. In case of stock market, these underwriters guarantee the sale of minimum amount of financial securities of companies in return for premium. In case if these securities are not sold within 45 days then underwriter will himself subscribe to such unsubscribed securities. He cannot take any other benefit out of underwriting process except his commission that is 5% for shares and 2½% for debentures. Different types of underwriting are discussed as given below:
Types of Underwriting
Firm underwriting is an underwriting agreement in which underwriter takes up a certain number of securities of firm himself. These securities are subscribed by underwriter in addition to his liabilities for securities which remain unsubscribed by public. Under this agreement, underwriter needs to subscribe to agreed number of securities irrespective of public response to company issue that is whether such issue is fully subscribed or oversubscribed.
In case of oversubscription of securities by public, only underwriter will be allotted such agreed number of securities. Whereas in case of under subscription, he will subscribe to both that is to agreed number of shares as ordinary subscriber and to all unsubscribed shares for which he is liable to subscribe as underwriter.
It is an underwriting agreement under which an underwriter appoints several other sub-underwriters to safeguard him. When after underwriting of securities, underwriter feels that it is beyond his capacity to assume the whole risk he appoints other underwriters with him. This is done to diffuse the risk associated with underwriting of securities which is too high for single underwriter to assume.
The sub-underwriter has no connection with customer and is liable only to underwriter for the amount of securities they have underwritten. Relationship between the underwriter and sub-underwriters is same as of agents and sub-agents. Prospectus consists of name of every underwriter along with amount of securities they have agreed to underwrite.
Joint underwriting is one in which there are more than one underwriter appointed by company for underwriting of its securities. This type of underwriting takes place when issue by company is too large and contains large risk. For minimising the burden solely on single underwriter, the firm itself appoints numerous underwriters. All underwriters underwrites to specified amount of securities and in specified ratio.
Syndicate underwriting is an underwriting agreement in which several underwriters join together for underwriting securities. Such agreement takes place when issue is too big that a single underwriter cannot underwrite the whole amount. Under this different underwriters form a syndicate and represent themselves as single underwriter for underwriting securities.
All the underwriters decide in advance the amount and ratio of securities that they will underwrite. It is different from joint underwriting in which company itself appoints several underwriters for underwriting of its securities whereas in syndicate underwriting several underwriters joins together themselves for underwriting.
Complete underwriting is one in which whole issue of securities of company is underwritten. Under such agreement, underwriter underwrites full amount of shares/debentures issued by companies. These securities are underwritten either by single underwriter or by many underwriters who agrees to assume the risk to specified amount.
Partial underwriting is one in which only a certain part of issue of securities of company is underwritten. Under such agreement, underwriter underwrites partial amount of shares/debentures issued by companies. In partial underwriting, securities are underwritten either by single underwriter or by many underwriters who agrees to assume the risk to specified amount.