GUARANTEEING PERFORMANCE: SURETY EXPLAINED - by Silja Calac - Senior Surety Underwriter, Corporate Solutions at Swiss Re International SE

Surety is a new area of cooperation for banks and insurance companies, says Silja Calac. Note this is an extract from TFR's A Guide To Receivables Finance, 2nd edition.

Insurance has become a more and more important part of international trade finance. There are many different insurance products which support banks in their task to forfait receivables, finance trade, or issue guarantees and letters of credit (LCs).

But bankers as well as brokers and insurers often complain that this cooperation is not always as smooth as it should be: lack of information, misconceptions, regulations, internal barriers etc. often hinder insurance companies from providing efficient protection for transaction banking.

One big issue is the variety of insurance products available (trade credit and political risk insurance being just two examples) and the terminology related to it with which bankers are often not familiar. Thus, it is not always known that besides the traditional credit or political risk insurance, there are other potential areas of cooperation between banks and insurers such as surety, for instance.

Cooperation of banks and insurers in this field has only recently started, when insurance companies active in this field for years discovered that there was a large business potential to which an insurance company has no direct access as certain markets/sectors are exclusively covered by banks.

What is surety?

The ICISA (International Credit Insurance & Surety Association) provides the following definition on its website:

"A surety bond is an agreement, issued by an insurance company, which (in most cases) provides for monetary compensation in case the principal fails to perform. Although many types of surety bonds exist, the two main categories are contract and commercial surety."1

Although guaranteeing performance of third parties has been done nearly for as long as human kind has existed - as a 5,000-year-old Mesopotamian tablet guaranteeing the performance of a farmer proves - and has even been praised in poems (such as Schiller's Bürgschaft), in its modern form, it has its origins in US regulation. In most US states, it is required that a contractor provides a bond issued by an insurance company guaranteeing to the project owner the completion of the construction as per the contractual obligations.

Surety has grown steadily over the last ten years to reach more than €2.5bn in premiums, according to the statistics of ICISA. Suretyship is therefore the obligation in which one party (the insurance company) undertakes to another party (the beneficiary) to guarantee the debts, obligations, or conduct of a third party (the contractor).

A typical transaction would therefore be the following. A construction company enters into a contract with a US state to build a new highway. The insurance company would guarantee that the construction company will complete the project on time and in accordance with the terms and conditions of the underlying contract. The surety bond provided by the insurer (surety) guarantees the performance of contractual or legal obligations entered into by two other parties (contractor and beneficiary). By doing so, the insurance company signals to the benefciary that it is confident about the financial capacity and technical ability of the contractor to complete the project. In case of non-performance or default, it compensates the beneficiary for losses incurred. It is often a mandatory requirement for public construction projects or in connection with payments of tax or customs duties. Both the surety and the contractor/principal are liable under the surety bond; i.e., in case of loss, the surety is entitled to fully recover the amount paid from the contractor/principal.

In a suretyship, each party has specific obligations. The obligations of the principal are:

• performance in accordance with the terms and conditions of the underlying contract;
• payment of the premium for the bond;
• to indemnify the surety for any payments made under the bond or other costs incurred as a surety of the relevant project; and
• to provide all relevant information to the surety.

The owner/beneficiary is obliged to:

• perform in accordance with the terms and conditions of the underlying contract, including payment to contractor;
• inform the surety of all major changes agreed upon in respect of the underlying agreement, progress of work, as well as arising problems; and
• discharge the surety from its liabilities after completion of the contract.

Last but not least, the surety/guarantor has the following obligations:

• to abstain from making any payments under the bond if the contractor/principal has a valid defence; and
• professional claims handling with prompt payments if project owner/beneficiary has sustained a loss.

So, from what has been seen so far, the key elements of suretyship are:

• Accessory instrument - it is accessory to an underlying obligation; namely, the construction contract or the obligation to deliver under an advanced payment.
• Joint and several liability - in a traditional surety, both the surety and principal are liable.
• Limited liability - the surety's liability is limited to the bond amount.
• Right of indemnification - the surety is entitled by law to be refunded for any payments made under the bond by the defaulting principal/contractor for any payments.
• Non-cancellable - unlike other insurance products, a bond cannot be cancelled until the underlying obligations have been fulfilled, even for non-payment of premium.
• Subrogation - as soon as the surety steps in due to failure of the contractor, all obligations and rights of the contractor are automatically inherited by the surety.

Benefits of surety

By reducing the uncertainty of performance, a surety bond benefits the project owner. It also increases the likelihood of a project being completed as initially agreed, as the surety will step in, in case a contractor is not able to perform.

The surety company's expertise in prequalifying the principal assures the project owner that the contractor it hires has the financial and technical capacity to successfully complete the project. Much like a bank line of credit, having sufficient surety capacity available enables the principal/contractor to bid for public projects. The prequalification process eliminates unqualified competition.

Different types of surety

Insurance companies distinguish between two types of surety: contract surety and commercial surety.

Contract surety are bonds that guarantee the performance of a specific contract. They are generally issued under construction and service/supply contracts. Bond types include:

• bid bond - guarantees the contractor is pre-qualified to undertake the contract and provide a performance bond;
• advance payment bond - guarantees proper use of advance payments made to the contractor;
• performance/completion bond - guarantees performance of the underlying contract;
• payment bond - guarantees the contractors' suppliers and subcontractors will be paid;
• supply bond - guarantees performance of supply contracts;
• warranty/maintenance bond - guarantees workmanship and materials after project is completed; and
• subdivision bond - specialised bond for home builders, which guarantees that civil infrastructure (streets, curbs, utilities) for housing tract is completed.

Commercial surety comprises a broad spectrum of bonds written for a variety of industries, including:

• permit bonds - required to obtain licences/permits from governmental bodies;
• judicial bonds - bonds used in court systems, such as appeal bonds;
• fiduciary bond - guarantees faithful performance of court-appointed trustees;
• official bond - guarantees faithful performance of public officials;
• customs and tax bonds - guarantee compliance and payment of tax or custom duties;
• reclamation/post-closure bond - guarantees mines and landfills will be properly closed and land restored at the end of the mine/landfill's useful life; and
• miscellaneous bonds - bonds of this type include workers self-insurer bonds, lost instrument bonds, utility payment bonds, etc.

Underwriting surety - analysis of credit risk

Unlike traditional insurance business, such as life or property insurance, where the insurance companies evaluate the probability, frequency, and severity of risk events, and where in case of a claim no recovery is possible, surety analyses a credit risk. So risk management here is very akin to what banks do when assessing risk.

When underwriting surety, insurance companies will proceed in a very similar way as banks do when assessing a credit. It is a risk selection process with a zero claims underwriting approach; insurance will not underwrite a surety where there is a true risk that the contractor will default. Thus the main aspects of risk analysis are:

• financial - what is the credit-worthiness of the principal;
• transactional - does the project make sense/is the tenor adapted; and
• security - what indemnity/collateral is available to protect the surety.

In particular situations, insurance companies will be very careful before signing a surety, such as if the bonds are issued for a principal which does not carry out the work itself or if they cover risks beyond the control of the principal. Further, insurance companies are normally reluctant to write bonds guaranteeing pure financial obligations (financial guarantees) as this is too close to being a funding substitute.

Surety for banks

Following the financial crisis, regulators have become even tougher with regard to banks' risk management, mainly through the introduction of strict requirements for banks to get a better grip on their use of capital (Basel III/CRD IV).

New regulatory requirements have obliged banks to allocate more risk-weighted assets at higher costs for each transaction. Historically, banks would have come to insurance companies to get rid of country or credit risks they could not accommodate.

With these new regulatory requirements, this has slightly changed to using insurance to get capital relief. It is the perfect cooperation: banks have the origination network, the proximity to the transaction parties, and the liquidity. Insurance companies provide the balance sheet to accommodate the growing needs for capital and the expertise to deal with risk. As a result, cooperation between banks and insurance companies in the field of credit risk insurance has been growing continuously.

Surety is especially adapted to such cooperation, as surety providers are already used to issuing cover under policies with a wording very close to that of bank guarantees. Also, if traditional surety often has a certain conditionality (the insurer would not pay if the principal has a valid objection and the insurer would subrogate itself to the contractor in case of a claim) this is of course not the case when insurers cover banks.

The participation agreements used here are on demand guarantees. Thus, surety cover for banks is mostly CRR compliant, therefore saving up to 80% of capital usage of a bank.

Which bonds can be covered?

All above-mentioned contract and commercial surety bonds can be covered when banks issue them. Of course, above-mentioned guarantees bonds also include the issuance of respective standby letters of credit.

A win-win situation

Cooperation in surety is beneficial for both parties. Banks resolve credit limit and capital constraints; capacities can thus be used for better priced business instead of blocking lines with low priced guarantee/bond facilities. Thanks to insurance cover, banks can get access to positions as key banker or lead arranger; the insurer enables banks to achieve their customers' capacity requirements and improve their relationship with their customers. Banks can thus win market share, improve strategic positioning, or even get access to new customer segments/markets.

This type of risk mitigation is often confidential/silent; the insurer is not a competitor of the bank but a partner, as insurance companies cannot handle cash and clearing needs of corporate customers. Using insurance cover allows the bank to diversify distribution channels for a more cost-efficient portfolio management. The insurer's credit capacity is not as correlated to those of a bank as is the case for other secondary market players. Last but not least, the insurance cover improves key performance indicators (KPIs) of the bank's retained share thanks to commission on covered part.

For the insurance company too, cooperation with the bank is beneficial in that it provides access to markets and products otherwise out of reach for an insurer. The insurer can rely on the product know-how and market access of its bank partners, and it can leverage on its existing product know-how and credit capacities.

Documentation

The documentation is quite straightforward: the bank and the insurer will normally sign a bilateral framework agreement (the Master Risk Participation Agreement or MRPA) at the beginning of the business relationship. This MRPA defines the general terms and conditions which apply to all single transactions which will be concluded between the two parties (e.g. process of issuing guarantees, conditions for claiming, representations and warranties, applicable law in case of dispute, etc.).

For each single transaction, a short document (two to three pages) specifying the details of each individual transaction such as the amounts, tenors, pricing, etc. will be signed. The underlying documentation such as the bond facility or the credit agreement is signed with the principal.

Reference:

1. See also 'Great client expectations' by Robert Nijhout, executive director of ICISA at www.tfreview.com/node/11957