Underwriting and deal analysis

What is underwriting? In short, underwriting is the process by which an institution determines if they want to take a financial risk in exchange for a premium. Examples of transactions that require underwriting are:

• Issuing an insurance policy
  • Health
  • Life
  • Home
  • Driving
• Loans
  • Installment loans
  • Credit cards
  • Mortgages
  • Commercial lines of credit
• Securities underwriting and Initial Public Offerings (IPOs)

As can be expected, determining whether an insurance policy or a loan should be issued and at what price can be very costly if the wrong decision is made. For example, if a bank issues a loan and the loan defaults, it would require dozens of other performing loans to make up for that loss. Inversely, if the bank passes up on a loan where the borrower was going to make all their payments is also detrimental to the bank finances. For this reason, the bank spends considerable time analyzing or "underwriting" the loan to determine the credit worthiness of the borrower as well as the value of the collateral securing the loan.

Even with all these checks, underwriters still get it wrong and issue loans that default or bypass deserving borrowers. The current underwriting process follows a set of criteria that must be met but specially for smaller banks there is still a degree of human subjectivity in the process. This is not necessarily a bad thing. Let's visit a scenario to explore this further:

A high net worth individual recently came back from a tour around the world. Three months ago, they got a job at a prestigious medical institution and their credit score is above 800.

Would you lend money to this individual? With the characteristics given, they seem to be a good credit risk. However, normal underwriting rules might disqualify them because they haven't been employed for the last two years. Manual underwriting would look at the whole picture and probably approve them.

Similarly, a machine learning model would probably be able to flag this as a worthy account and issue the loan. Machine learning models don't have hard and fast rules but rather "learn by example."

Many lenders are already using machine learning in their underwriting. An interesting example of a company that specializes in this space is Zest Finance. Zest Finance uses AI techniques to assist lenders with their underwriting. AI can help to increase revenue and reduce risk. Most importantly well applied AI in general and Zest Finance in particular can help companies to ensure that the AI models used are compliant with a country's regulations. Some AI models can be a "black box" where it is difficult to explain why one borrower was rejected and another one was accepted. Zest Finance can fully explain data modeling results, measure business impact, and comply with regulatory requirements. One of Zest Finance's secret weapons is the use of non-traditional data, including data that a lender might have in-house, such as:

• Customer support data
• Payment histories
• Purchase transactions

They might also consider nontraditional credit variables such as:

• The way a customer fills out a form
• The method a customer uses to arrive at the site or how they navigate the site
• The amount of time taken to fill out an application