What is Surety?
International Credit Insurance & Surety Association (ICISA) defines the surety as:
"A surety bond is an agreement, issued by an insurance company, which (in most cases) provides for monetary compensation in case the contractor fails to perform. Although many types of surety bonds exist, the two main categories are contract and commercial surety."
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).
The Key Elements of Suretyship
1. Accessory Instrument - A surety agreement should be an accessory to an underlying obligation such as the construction contract or the obligation to deliver under an advanced payment.
2. Joint and Several Liability - Both the surety and contractor are liable.
3. Limited Liability - The surety's liability is limited to the bond amount.
4. Right of Indemnification - The surety is entitled by law to be refunded for any payments made under the bond by the defaulting
contractor for any payments.
5. Non-Cancellable - Unlike other insurance products, a bond cannot be cancelled until the underlying obligations have been fulfilled, even for non-payment of premium.
6. 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.
Underwriting Surety - Analysis of Credit Risk
In traditional insurance business, the insurance companies evaluate the probability, frequency, and severity of risk events, and in case of a claim no recovery is possible. In surety business, insurers analyze the credit risk. So, risk management here is very akin to bank's 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 zero claims underwriting approach; insurer 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 creditworthiness of the contractor.
Transactional - does the project make sense/is the tenor adapted.
Security - what indemnity/collateral is available to protect the surety.
Insurance companies will be very careful before signing a surety, such as if the bonds are issued for a contractor which does not carry out the work itself or if they cover risks beyond the control of the contractor. Further, insurance companies are normally reluctant to write bonds guaranteeing pure financial obligations (financial guarantees) as this is too close to be a funding substitute.
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:
1. Bid Bond: Guarantees the contractor is pre-qualified to undertake the contract and provide a performance bond.
2. Advance Payment Bond: Guarantees proper use of advance payments made to the contractor.
3. Performance/Completion Bond: Guarantees performance of the underlying contract.
4. Payment Bond: Guarantees the contractors' suppliers and subcontractors will be paid.
5. Supply Bond: Guarantees performance of supply contracts.
6. Warranty/Maintenance Bond: Guarantees workmanship and materials after project is completed.
7. Subdivision Bond: Specialized bond for homebuilders, 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:
1. Permit Bonds: Required to obtain licenses/permits from governmental bodies.
2. Judicial Bonds: Bonds used in court systems, such as appeal bonds.
3. Fiduciary Bond: Guarantees faithful performance of court-appointed trustees.
4. Official Bond: Guarantees faithful performance of public officials.
5. Customs and Tax Bonds: Guarantee compliance and payment of tax or custom duties.
6. 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.
7. Miscellaneous Bonds: Bonds of this type include workers compensation self-insurer bonds, lost instrument bonds, utility payment bonds etc.
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 contractor assures the project owner that the contractor it hires has the financial and technical capacity to successfully complete the project.