Underwriting
The process by which an institution evaluates and assumes financial risk on behalf of a client, used in securities issuance, insurance, and lending.
What is Underwriting?
Underwriting is the process of evaluating, pricing, and assuming financial risk. In securities underwriting, investment banks underwrite stock and bond offerings by committing to purchase the securities from the issuer and reselling them to investors — taking on the risk that they can sell all shares. Firm commitment underwriting requires the bank to buy all unsold shares; best efforts underwriting requires only good-faith selling efforts. In insurance, underwriters assess an applicant's risk profile to determine whether to issue coverage and at what premium. In mortgage lending, underwriters review the borrower's credit, income, and the property value to approve or deny the loan.
Example
For a $500 million IPO, Goldman Sachs agrees to firm commitment underwriting: it buys all shares from the company at $18/share and offers them to investors at $20/share, earning a 10% spread ($50 million). If the offering is poorly received and the stock drops to $16 before Goldman sells all shares, Goldman absorbs the loss. This commitment gives the issuing company certainty of raising the capital.
Source: SEC — Underwriters