Underwriting expenses

What Is Underwriting Expenses?

Underwriting expenses are the various costs and expenditures incurred by financial institutions, such as investment banks and insurance companies, during the process of evaluating and assuming financial risk for others. These expenses are a critical component of financial accounting and corporate finance, directly impacting an entity's overall profitability. Whether an investment bank is facilitating an initial public offering (IPO) or an insurance company is assessing applications for insurance policies, the associated operational costs are categorized as underwriting expenses. These costs can range from direct outlays for due diligence and legal fees to indirect expenses like salaries for underwriting staff.

History and Origin

The term "underwriting" traces its origins back to the 17th-century Lloyd's of London insurance market. Individuals who agreed to accept a portion of the risk for a venture, typically a sea voyage and its associated perils, would literally write their names "under" the risk information on a slip of paper in exchange for a premium. This practice of financially backing a venture evolved to encompass the assessment and guarantee of various financial risks. By the 19th century, underwriting became integral to the securities market, with investment banks taking on the risk of selling stocks and bonds on behalf of corporations and governments.¹¹ This historical development laid the foundation for the complex underwriting processes and associated expenses seen today in both the insurance and capital markets.

Key Takeaways

• Underwriting expenses are costs incurred by financial institutions to assess and assume financial risks.
• These expenses are crucial for both insurance companies evaluating policies and investment banks facilitating securities offerings.
• Key components include legal fees, administrative costs, due diligence, and personnel salaries.
• Managing underwriting expenses efficiently is vital for maintaining an institution's profitability.
• Public companies are required to disclose these expenses in their financial filings, particularly for equity offerings.

Formula and Calculation

Underwriting expenses do not typically follow a single, fixed formula but are rather a summation of various direct and indirect costs. For a company undertaking a securities offering, the total underwriting expenses ((UE)) can be broadly calculated as:

Where:

• (UF) = Underwriting Fees (commissions paid to investment banks)
• (LF) = Legal Fees (for counsel, regulatory compliance, and drafting documents)
• (AF) = Accounting Fees (for audits, financial statements, and tax advice)
• (PR) = Printing and Distribution Costs (for prospectuses and other offering materials)
• (MF) = Marketing Fees (for roadshows and promotional activities)
• (RC) = Regulatory Compliance Fees (filing fees with regulatory bodies like the SEC)

For instance, companies issuing new shares are required to report these costs. An example from a past SEC filing (Form S-1) by Realty Income Corporation in 2003 illustrates how various "Expenses of Issuance and Distribution" are itemized, including underwriting discounts and commissions, legal fees, accounting fees, printing, and SEC registration fees.¹⁰

Interpreting Underwriting Expenses

Interpreting underwriting expenses involves understanding their proportion relative to the total value of the underwriting activity or the generated revenue. For insurance companies, these expenses are often analyzed through the "expense ratio," which divides underwriting expenses by earned premiums. A lower expense ratio generally indicates greater efficiency and potentially higher profitability for the insurer.

Similarly, for investment banks involved in debt instruments or equity offerings, underwriting expenses are viewed in relation to the gross proceeds raised. High underwriting expenses can reduce the net funds available to the issuing company, impacting their overall capital structure and financial health. Analysts examine these costs to gauge the efficiency of the underwriting process and the competitiveness of the fees charged by underwriters.

Hypothetical Example

Imagine "Tech Innovations Inc." decides to go public with an initial public offering to raise capital for expansion. They engage an investment bank to underwrite the offering.

The various underwriting expenses incurred might include:

• Underwriting Fees: 6% of the gross proceeds, representing the commission paid to the investment bank for selling the shares.
• Legal Fees: $1,500,000 for drafting the prospectus, ensuring regulatory compliance, and other legal services.
• Accounting Fees: $800,000 for auditing financial statements and preparing all necessary disclosures.
• Printing and Distribution Costs: $200,000 for physical and digital copies of the offering documents.
• SEC Filing Fees: $150,000 to register the securities with the U.S. Securities and Exchange Commission (SEC).
• Roadshow and Marketing Expenses: $500,000 for investor presentations and promotional activities.

If Tech Innovations Inc. aims to raise $100,000,000 in gross proceeds:

• Underwriting Fees = 6% of $100,000,000 = $6,000,000

Total Underwriting Expenses = $6,000,000 (UF) + $1,500,000 (LF) + $800,000 (AF) + $200,000 (PR) + $150,000 (RC) + $500,000 (MF) = $9,150,000.

These expenses are subtracted from the gross proceeds to determine the net proceeds received by Tech Innovations Inc.

Practical Applications

Underwriting expenses manifest in several areas of finance and business:

• Investment Banking: These costs are most prominent in capital market transactions such as IPOs, secondary offerings, and corporate bond issuances. Investment banks charge fees for their services, including advisory, book-building, and distribution. The total fees can be substantial, often ranging from 4% to 7% of gross IPO proceeds.⁹
• Insurance Industry: For insurance companies, underwriting expenses encompass the costs associated with risk assessment, policy issuance, and claims management, excluding direct claims payments. This includes salaries of underwriters, actuarial analysis, and administrative overhead.⁸,⁷
• Loan Origination: In lending, particularly mortgages, underwriting expenses cover the costs of evaluating a borrower's creditworthiness, appraising collateral, and processing loan applications. This often involves credit checks and property evaluations.
• Financial Reporting and Analysis: Public companies are required to disclose these expenses in their financial statements, typically on the income statement or within notes to the financial statements. Analysts monitor these figures to assess the efficiency of capital raising efforts and the overall financial health of an enterprise. Regulatory bodies like the SEC have modernized rules for filing fee disclosure and payment methods to improve transparency.⁶

Limitations and Criticisms

While necessary, underwriting expenses can face limitations and criticisms, primarily concerning their magnitude and potential for conflicts of interest.

One major criticism, particularly in initial public offering (IPO) contexts, is the significant percentage of gross proceeds consumed by these costs, especially the underwriting fees. These fees can represent a substantial portion of the funds raised, diminishing the net capital available to the issuing company. Companies often seek to minimize these costs to maximize their proceeds from the offering.⁵ The sheer cost of going public, including underwriting expenses, can be a deterrent for some companies.⁴

Another area of concern revolves around potential conflicts of interest, particularly in investment banking. Underwriters may be incentivized to price an offering in a way that maximizes their fees rather than optimizing the outcome for the issuer or long-term investors. Regulatory bodies like FINRA impose rules to ensure fair and transparent underwriting terms and arrangements, requiring disclosure of all compensation received by participating members.³

Furthermore, in the insurance sector, high underwriting expenses might indicate inefficiencies in the risk assessment or policy administration processes, which could ultimately lead to higher premium costs for policyholders.

Underwriting Expenses vs. Issuance Costs

While closely related and often overlapping, "underwriting expenses" and "issuance costs" refer to distinct aspects of a financial offering.

Underwriting expenses specifically encompass the costs incurred by the underwriter (e.g., investment bank or insurance company) in performing their function of assessing risk and facilitating a securities offering or insurance policy. These are the expenses of the underwriter's business operation tied to the underwriting activity itself. They include items like the underwriter's own legal and due diligence fees, and the compensation or "spread" they earn for taking on the risk of selling the securities.

Issuance costs, on the other hand, are the broader set of direct and incremental costs incurred by the issuer (the company or entity raising capital) to bring new securities to market. This category includes underwriting fees (the compensation paid to the underwriter by the issuer), but also other expenses such as the issuer's own legal fees, accounting fees, printing costs for prospectuses, brokerage fees paid to other parties, and registration fees paid to regulatory bodies like the SEC.²

In essence, underwriting fees are a major component of issuance costs, but issuance costs encompass all the various expenses borne by the company seeking to raise funds, regardless of whether they are paid directly to the underwriter or to other third parties involved in the process.

FAQs

What are common types of underwriting expenses for an IPO?

For an IPO, common underwriting expenses include the underwriting discount or commission paid to the investment bank, legal fees for both the issuer and the underwriter, accounting and audit fees, printing and distribution costs for the prospectus, and regulatory filing fees with bodies like the SEC and FINRA.¹

How do underwriting expenses affect a company's financial statements?

Underwriting expenses reduce the net proceeds a company receives from a securities offering. In financial reporting, particularly for equity issuances, these costs are typically recorded as a reduction to the paid-in capital on the balance sheet, rather than being expensed on the income statement as an operating expense. This reflects their nature as costs of obtaining capital rather than ongoing operational costs.

Are underwriting expenses tax-deductible?

Generally, for securities offerings, underwriting expenses are not directly tax-deductible as ordinary business expenses. Instead, they typically reduce the proceeds from the offering, impacting the cost basis of the securities issued. For insurance companies, underwriting expenses are a cost of doing business and are considered when calculating taxable income.

How are underwriting expenses different in the insurance industry compared to investment banking?

In the insurance industry, underwriting expenses primarily relate to the costs of assessing and accepting risks for insurance policies, such as salaries for underwriters, actuarial reviews, and general administrative overhead related to policy issuance and management. In investment banking, underwriting expenses refer to the costs associated with facilitating the issuance of new securities (like stocks or bonds) for companies or governments, including the fees paid to the investment bank and other direct offering costs.

Why is it important to control underwriting expenses?

Controlling underwriting expenses is crucial for financial institutions to maintain or improve their profitability. For issuers, lower underwriting expenses mean more capital is raised for their intended purpose. For underwriters, efficient management of these costs directly impacts their profit margins and overall competitiveness in the market.