SURETY FOR BANKS
A Perfect Cooperation for Banks and Insurance Companies
Surety is one of the recent cooperation between banks and insurance companies. Insurers discovered that there is a large business potential to which an insurance company has no direct access as certain markets are exclusively covered by banks. Surety for banks seems more sustainable and long-term business.
To create this cooperation, insurers started to cover the bank guarantee business within surety activities by transforming traditional conditional surety to an on-demand guarantee(*). There were a few reasons to do it:
Customer Demands: International companies need and demand more guarantee capacity in different jurisdictions. Banks and insurance companies together can provide more capacity to issue bonds in more jurisdictions.
Operational Convenience: For the sureties, it is very useful to work behind a bank to use their processing power and evaluating risk from a back-seat position.
Underwriting Facilities: Insurers have been dealing with banks for a long time in trade finance. The same people can underwrite the guarantee risks also.
Standardization of Agreements: Surety wordings have adopted to the standard participation agreements which banks are used to. Thus, the increased usage driven by the bank’s familiarity with the product can be achieved.
Speaking the Same Language: A surety provider or a bank also uses the same type of documentation for underwriting.
Increased Capacity: The bank and its surety partner can increase limits for the benefit of the client. Surety is a recognized de-risking tool helps to maximize the credit capacity of the banks. The banks use surety to increase their credit limits – the pricing plays a part as well.
Flexibility: Surety behaves much more like a bank product than an insurance product. It is a very competitive de-risking instrument. Surety underwriters allocate their capacity behind banks, otherwise not necessarily use sureties for direct bonding.
Resolution of Claims: Generally, the bankers solve the problem in many countries where they have issued guarantees by dealing with the client and the surety follows it.
Distribution: In some territories the bank guarantee is the principal instrument. Insurance companies facilitate what they want to do by working with banks and maintaining their relationships with the owners. Insurers in the background take most of the risks, while beneficiaries are happy to receive bank guarantees.
Expansion: Bank and surety cooperation can be expanded for corporate customers in some sectors according to market demand.
(*) Defining the conditional surety and on-demand guarantee:
Bonds and guarantees are related but they are very different legal instruments. Over time, the wording of bonds and guarantees in common circulation has become confused so that they contain a mixture of terms that belong in bonds and terms that apply to guarantees. It has become difficult to tell whether some of them are bonds or guarantees – even for judges. So, the nature of the project security is to be determined clearly.
Under a bond, the bank to pay is required to pay on demand regardless of the underlying contract. An on-demand performance bond is an unconditional obligation that payment is made immediately, so improving cash flow, and without the need to demonstrate the full and proper loss under the primary contract.
The right to claim under a guarantee is linked to non-performance of the underlying contract. A surety bond or performance guarantee can only be called upon if a breach of the primary contract has been demonstrated. Nonetheless, guarantees are economic.
Because the terms "performance bond" and "performance guarantee" are often used synonymously in the construction industry, some contracts as FIDIC Red Book 1999 provide standard forms of security documents to annex.
Which Bonds can be Covered?
All contract and commercial surety bonds can be covered when banks issue them, also issuance of respective standby letters of credit.
All Parties Win
Cooperation in surety is beneficial for all 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. 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.
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 contractor.