What is Underwriting in Canada?

Here we break down the definition of underwriting and explain their different applications and complexities.

Underwriting refers to the process financial entities use to assess the risk of lending to a potential borrower or insuring an entity. Originating with Lloyd’s of London in the 17th century, underwriting began with individuals agreeing to take on certain risks in exchange for a specified premium. This practice has changed over time but remains important in sectors such as insurance, lending, and investments.

Underwriting in Finance

In finance, underwriting evaluates an applicant’s creditworthiness. The underwriter’s role involves careful scrutiny of the applicant’s financial background to assess their ability to fulfill the obligations of a loan, insurance policy, or investment. The process includes verifying the information provided and conducting detailed financial research. This helps determine the premiums for insurance, borrowing rates, and prices for investment risks.

The Underwriter’s Responsibilities
An underwriter ensures that applicants are transparent about their financial status and that their representations are factual. Specific roles carried out by underwriters include:

• Creditworthiness Assessment: Underwriters examine the financial stability and credit history of the applicant. They review credit scores from major credit bureaus, employment history, and available financial reserves to assign a rating indicating the borrower’s repayment ability.
• Risk Calculation: The underwriter calculates the level of risk associated with lending or insuring the applicant. Lower risk often leads to lower premiums or favoured borrowing rates, while higher risk might result in increased costs or even denial of terms.
• Fair Market Valuation: For real estate transactions, underwriters ensure that the sale price of a property aligns with its appraised value by ordering appraisals to verify that the property’s value justifies the loan amount.

Underwriting in Real Estate

In real estate, underwriting determines loan eligibility for property transactions. Real estate underwriters differ from securities underwriters as they assess the combined risk of both the borrower and the property.

• Property Appraisal: Real estate underwriters order property appraisals to determine if the loan amount is justified by the property’s sale value. For example, if an appraisal values a property at $200,000 while the requested loan amount is $300,000, the underwriter will likely reject the loan request or adjust it accordingly.
• Title Examination: Underwriters confirm that no other parties have ownership claims on the property, ensuring the title is clear of any encumbrances or conflicting ownership interests.
• Natural Disaster Risks: Underwriters also evaluate potential natural disaster risks, such as floods or earthquakes, that could affect the property’s viability. Properties in high-risk areas might face increased scrutiny or additional requirements for these risks.
  
• Collateral Valuation: Typically, the property itself serves as collateral for the loan. Underwriters use metrics like the debt-service coverage ratio (DSCR), which measures the property’s ability to generate cash flow sufficient to cover debt obligations. A favourable DSCR indicates a lower risk for the underwriter, thereby increasing the likelihood of loan approval. This is typically used to evaluate investment properties.
  
• Verification of Documents: Underwriters meticulously vet all submitted documentation to ensure compliance with legal and financial standards. Any discrepancies must be addressed before final approval.

Complexities in Underwriting Processes

Underwriting involves various steps depending on the sector and type of underwriting. Some core principles remain consistent:

• Financial History Review: A thorough examination of the applicant’s past financial behaviour, including income statements, tax returns, and previous loan repayments, is conducted.
• Future Risk Assessment: Anticipating potential future financial issues based on trends and economic conditions forms a key part of the underwriting process.

Sector-Specific Underwriting Procedures

While the general process of underwriting remains consistent, specific practices vary across sectors.

Insurance Underwriting
In the insurance sector, underwriting determines premiums by assessing the insured party’s level of risk. Elements considered include health, lifestyle, occupational hazards, and prior claims history.

Investment Underwriting
For investment underwriting, mainly in securities, underwriters underwrite the issuance of stock or bonds. Here, they are responsible for setting the offer price and arranging the sale of these securities. The primary goal is to balance the company’s capital needs with investors’ risks to ensure successful issuance.

Lending Underwriting
Lending underwriting mainly involves evaluating credit applications for personal, auto, and mortgage loans. The underwriter assesses an applicant’s creditworthiness to determine loan approval and terms. Factors such as income, credit history, employment status, and debt levels are scrutinized.