What Is a Surety Bond? [Video]
Sometimes, a business may be required to have a surety bond to guarantee that work they are contracted to do will be accomplished. Each surety bond must be uniquely tailored to meet specific needs.
How Surety Bonds Work
There are three parties involved in a surety bond: the principal, the obligee, and the surety.
- The principal purchases the surety bond to guarantee quality and completion of contracted work
- The obligee is the entity who requires the principal to purchase the bond
- The surety is the entity that issues the bond and financially guarantees the principal’s ability to complete the contracted work
If the principal does not complete the work as contracted, the obligee can make a claim for payment from the bond up to but not exceeding the bond amount. The principal is then obligated to pay back the claimed amount to the surety.
Surety Bonds: Understanding the Benefits
Listen to this webinar recording to hear from Travelers experts as they share what you need to know about surety bonds, how they work, and the differences between a surety bond and a letter of credit.
(DESCRIPTION) Travelers logo appears with webinar title that reads: Surety Bonds: Understanding the Benefits
JUSTIN SMULISON: Greetings and welcome to today's RIMS webinar-- Surety Bonds, Understanding The Benefits. This session will be moderated by Tim Gravel and Paul Landry of Travelers. My name is Justin Smulison, the Business Content Manager here at RIMS, the Risk Insurance Management Society.
A few notes before we begin if you have a question for the presenters during today's session, please submit them by writing in the question box. Feel free to ask at any point during the presentation. We will reserve time at the end for Q&A. Following the session, the recording will be available on Opis through rims.org. All downloads and contact information will be accessible to the sponsor.
And on with today's presentation. Today, you will learn a bit about the US surety bond market and the underwriting process performed by most surety companies. The webinar will also explore the advantages of using surety bonds as a replacement to letters of credit and some common situations when surety bonds can be used. RIMS is thrilled to welcome a wonderful global audience. And now, I will hand it off to Paul Landry of Travelers.
In a small video window
PAUL LANDRY: Thank you Justin. And welcome and thank you to everyone else joining us this afternoon for our presentation. As Justin noted our presentation is entitled Surety Bonds, Understanding The Benefits.
Before Tim and I get going into the meat of our presentation, we want to just-- at the top here-- give a quick introduction about ourselves to let you know who you'll be talking to today. But that, I'll pass over to Tim for his quick introduction to start off with.
TIM GRAVEL: Thanks, Paul. So I'm Tim Gravel. I'm part of the Travelers Commercial Surety home office team based out of Hartford, Connecticut. Been with Travelers a little over five years. And then prior to that spent about a decade in the commercial surety industry at two other competitors.
In my role now, my day to day is working with some of our regional offices. You know, that involves a mix of new business underwriting and renewal business underwriting, credit analysis, risk analysis, setting terms and conditions, level of portfolio management. Also lead a team focused on insurance program bonds which is something we'll discuss a little bit later in the presentation. And then also involved in a variety of other projects and initiatives. Paul.
PAUL LANDRY: Thank you, Tim. I am Paul Landry. Like Tim, I am a Commercial Surety Underwriter at Travelers Insurance. I've been in the commercial surety industry for a little over 16 years now. I spent the first 10 years or so of my career as a field office underwriter primarily operating on the East Coast. The last 6 plus years I've spent as a Home Office Underwriter with Travelers.
My roles-- as a Home Office Underwriter-- I support like Tim, a few offices regionally around the country, primarily in the southeast part of the United States. And also within Travelers, I specialize in commercial contract obligations, financial guarantee obligations, or commercial surety rating plan, and our overall compliance actions.
Now as we said at the top, the title of our presentation is Surety Bonds, Understanding The Benefits. Before Tim and I get too deep into the presentation as well, I want to just give you an overview of what we will be covering over the next 45 minutes or so.
To start off with, we're going to give a quick introduction in understanding about the overall surety industry and the surety bond product. I know we have a pretty diverse audience today and didn't want to make the assumption that our audience necessarily knew exactly how surety bonds operated. Or exactly what the industry was all about. It would not be the first time that someone has perhaps confused surety bond with another financial product known as-- bonds with a different purpose. So we wanted to clarify the outset of what we will be covering today.
And of course, after we introduce the concept of suretyship, we will cover into the specific benefit that we want to cover today is the benefit of surety bonds compared to letters of credit. So I will highlight some of the pros and cons of using surety bonds compared to letters of credit when acceptable. Let's review some of the benefits of that. We will provide just a high level overview of what the underwriting process might look like for a surety company for these types of obligations.
Again, this is very high level. It is not meant to be questions you'll necessarily ask or receive from any underwriter. It was meant to just be representative of conversations you may have with the typical surety company or typical underwriters.
After we kind of cover that, we will then dive into a few product-specific explanations. These are specific obligations or liabilities that we think are really good candidates that are currently commonly supported by letters of credit. But a bond is usually also acceptable in these scenarios. We think these are kind of the prime candidates for ways that the audience, such as yourself, could utilize surety bonds to your benefit.
And then after we cover those specific products, we will then hold 10 or 15 minutes at the end for any Q&A that you might have. If there are things that you like tonight to expand on during the course of this presentation here today, we will certainly do that. And if there is anything else that we didn't cover that you'd like to ask but it's still sort of within the confines of our topic today, we will certainly address that as well.
So with that being said, we'll go to the next area here which is, again, just before-- we have two quick housekeeping items at the top here-- before the meet, the presentation. First here is just a quick disclaimer. Obviously, Tim and I as we mentioned at the top-- our employees represent us at Travelers. You will see the brilliant Travelers red logo highlighted in the lower corner of your screen for most of our presentation. But with the exception of the next slide, which I'll get to.
Really, Tim and I are meant to-- are talking about the industry and about these products just as industry representatives. Nothing that we will cover today within the presentation is specific to Travelers in terms of underwriting strategy. None of the products or policies are unique to Travelers. These are all generally available within the surety marketplace. And any strategies that we discuss is, again, more universal surety application. It is not a Travelers-specific thing. So this is all meant to be generally informative about the surety industry in which you might see representative across the industry as a whole.
Travelers: A Bit About Us
Now as I just said that Tim and I were not representing Travelers. We then transition to a slide about Travelers. I have this here-- just want to give you guys a little bit of background about obviously where Tim and I come from-- what travelers is about. Just to level set around the experience that Travelers has within the insurance market and within the surety market. Specifically, as well as, probably lend a little bit of credibility to the experience of professional comments that Tim and I will make over the course of our presentation here today.
Most of you I would expect are probably familiar with Travelers Insurance company. We have been a successful P&C carrier for more than 165 years-- with the foundation that we have always taken care of our customers as our bedrock. Travelers is also traded on the New York Stock Exchange under the symbol TRV. And we have been part of the Dow Jones Industrial average since 2009.
Travelers employs more than 30,000 employees. We have operations in every United States state and select international markets as well. To give you a size of our overall company they're at the bottom, we have last year's revenues approximately $32 billion for the fiscal year ending 2020. So just an idea, again, of the size and scale of Travelers.
Within the surety industry specifically, I think it's fair to say Travelers is recognized as one of the industry leaders in the surety marketplace-- in both the construction and commercial lines of business. We have been writing surety bonds for more than 100 years. And we are very much engaged in education and advocacy for the product around the country and internationally as well. We participate [INAUDIBLE] in the Surety and Fidelity Association-- which I will touch on a little bit-- as well as other organizations such as RIMS and bring you these presentations like today.
Before we get into the rest of the presentation I did want to point out one thing. Tim and I just as a quick definition-- Tim and I will use the term-- you may hate the term-- "liquidity," used occasionally throughout the course of our presentation as a benefit to what we are trying to discuss today. For the terms of this conversation, we're really just trying to define liquidity as cash and securities available on hand, versus available borrowing capacity. So I know that there are maybe some different discussions around what liquidity definition would be via an inclusion of operating cash flow or things of that sort. For today's discussion, again, have a limited definition to really keep it simple to make our points. That liquidity-- we're defining it as cash and securities available on hand plus any amounts available under your existing credit facilities.
What Is a Surety Bond? Introduction to Surety Bonds
OK. So let's get into it. What is a surety bond? As I mentioned at the top of the presentation the surety bond industry somewhat of a niche and unknown industry. So the surety bonds are historically and have typically been written by insurance carriers. However, the surety bond itself is not an insurance product.
I'm going to detail for you a little bit the reasons why that is. The chart there on the little picture graphic on the right there is pretty good basic illustration of how the surety bond functions. So really the key point of a surety bond is the presence of the three-party agreement.
So to follow the arrows in the picture on the right there-- the top box there is the principal indemnitor. That's the usually corporate entity that needs a bond to guarantee obligations or promise under a contract. That contract is usually with the promise or the contract is usually guaranteed to the owner or we call them in the surety world, the Obligee.
So the obligee is the beneficiary of the surety bond in the sense that the principal is making a promise in a very, very basic level surety. The principal is making a promise to the owner obligee that they can perform terms of a contract or terms of an obligation be it statutory or within a contract. And if they cannot, that's where the surety comes in. So the surety is that third party that guarantees that promise.
So it's a very basic level that is all a surety is doing in terms of the surety chart there. We are guaranteeing that the principal indemnitor fulfills all their obligations and promises to the owner and the obligee.
Sounds pretty simple enough. What differentiates and also makes this product not insurance, primarily, is that the principal will sign a contract of indemnity with the surety company. So the actual specifics of an indemnity agreement may vary from company to company but that it's really at its foundation.
The purpose of indemnity agreement is that if a surety company is forced to intervene due to a default, or an inability of the principal or indemnitor to fulfill and to fill their guarantees or their promises on a contract to the owner obligee, and the surety is forced to make a payment for that obligation-- the surety would then turn to the principal indemnitor under that contract of indemnity and expect to be held harmless from all losses and expenses that we have had under that arrangement. So there is a reimbursement aspect to the principal and the surety company relationship in the event of a paid claim.
So in practice, a surety underwriter with the aspirational goal of every surety underwriter and surety company is to underwrite to a 0% loss ratio. The idea being that even if we make a surety claim-- a surety payment to the owner or the obligee-- that at the end of that process, we would then get reimbursed by a principal indemnitor and be left with no net loss at the end of the day.
So surety bonds themselves are-- there's a wide range of products-- types of surety bonds. They cover a wide range of industries. And I will cover that in a little bit more detail in subsequent slides. And Tim will talk a little bit more about the underwriting process later on in our presentation.
But just to give you a rough idea of the unique nature of surety bonds is that really-- they can be dictated by a couple of different sources. So surety bonds can come from underlying state statutes, federal regulations, and other legal mechanisms that require a surety bond to be posted as a risk transfer mechanism. They can also be part of private contracts between individual third parties.
So the actual form and product of what a surety bond might look like can vary from project to project, owner to owner, industry to industry. Several of the bonds that we would provide to the industry are not actually Travelers' preferred forms. The forms are more generally dictated either by government regulations or a specific form in terms that are required by the owner or the obligee. So there really is no easy comparison between one surety bond to the next. Each surety bond opportunity presents its own unique set of challenges, risks, terms, and other underwriting considerations.
Industry Information (S F AA Stats) Miscellaneous and Performance Bond pie chart
Again, just want to give you a little bit more of a high level view of the surety industry. Information here you see at the top is courtesy of the Surety and Fidelity Association of America. The Surety and Fidelity Association of America is a nonpartisan trade organization that represents both the surety and the fidelity industries. They are advocates and educators around both of those products. They work with government entities and regulators to ensure that the surety bonds and financial [INAUDIBLE] and fidelity products that they support are used adequately within the legislation.
So anytime there needs to be advice about how a surety bond might function, or new legislation, or changes in legislation, they are usually consulted. It'll offer advice about how to best position that product both for general availability in the marketplace, as well as for success of their member organizations.
The Surety and Fidelity Association of America is comprised of more than 400 members, including most of your major surety carriers, as well as agents and brokers alike. Within that statistical information that we present there on the screen-- give you a view of the surety industry as a whole.
So Tim and I at the top may have referenced our place is a commercial surety underwriter. There are pretty much two very distinct parts of the surety marketplace there is what is called the construction or contract surety market, and there is what is called the commercial surety market.
The 67% red is represented there under the performance bonds is more of a close representation of the construction bond market. So in terms of size, the construction bond market is about 2/3 the industry with the commercial surety industry representing about the remaining one third.
The categorization of bonds there is not exactly accurate in the sense that construction and contract surety does not only write performance bonds though it is the vast majority of the bonds they will support. And commercial surety does not only support bonds considered miscellaneous. We do write in support bonds that are considered performance bonds as well. But for the sake of simplicity it does work out to be fairly accurate without that representation. Just to give you an idea of the size and scale of the construction surety market compared to the commercial surety market. Tim and I in defense of our conversation today are really focusing only on commercial surety type obligations. So while there are a whole host of benefits to surety bonds for the construction industry as well, that is not something that we'll be covering in the context of our presentation today.
The miscellaneous bonds in there include things that I talked about before, such as bonds required by statute or federal regulation. And also include things-- miscellaneous bonds, such as court bonds or bonds to cover customs liabilities and things of that sort.
US Surety Industry At a Glance
Within the figures there you'll see overall-- US surety market-- total about just under $7 billion in written premium in the year 2020. To see the idea of the size and scale of the surety organization. With a loss ratio there you see 22.8% for last year. You kind of rewind a few minutes before to my prior comments that obviously, sureties are targeting a 0% loss ratio with that reimbursement mechanism within the contract of indemnity. Obviously, a 0% loss ratio is not feasible for the industry. If it was easy to obtain a 0% loss ratio there would be no viable need for our product.
So point in fact, there are recognized losses in the surety industry. And that is why the product serves a valuable place in our economy. One of the understated and underspoken benefits of surety bonds which Tim and I don't focus on in this presentation here as well. Is that really, surety bonds can be applicable to virtually all aspects in virtually all industries.
So all the construction industry is focused primarily on the construction and construction trades-- miscellaneous and commercial side. We pretty much cover everything else from transportation to health care, retail to finance, and everything in between.
So really there is the benefit of certain surety bonds that they are able to support companies in our economy across the board and without respect to size or scale as well. There are surety users who need bond programs totaling less than $10,000. And there are companies entities that have surety programs in excess of $1 billion. So there is a need for surety bonds all across our economy from small, to middle market, to your large giant Fortune 500 companies. Everyone has a place for surety there in between.
The loss ratio there as I pointed out-- 22.8%. Loss ratio generally tends to correlate a little bit more with changes in the construction economy as you expect. Obviously, they make up a larger portion of the overall industry and are sort of confined to that one sort of industry-- being construction trades. So any kind of upset within that particular industry will tend to drive the overall industry results a little bit more than the commercial surety does as I said it's kind of a broader diversification of risk across many industries and also representing a smaller piece of the overall premium puzzle.
And so with that being the case, there are just a few points I want to make sure. They're on the lower left in terms of what makes up the market share there. So the top 10 writers, generally, around 60% of the market share. I can share with you Travelers is around 14% or so in terms of the commercial surety-- in terms of the overall market share. The top 50 writers really make up 95%, 96% of the overall market that's really where the majority of the business is written. There are a few writers outside of the top 50 obviously that support meaningful business but by and large as you can see there 95%, 96% of the surety history is written by the top 50 companies.
Surety Bond Vs. Letter of Credit
All right. Surety bonds versus letters of credit. This is really kind of where Tim and I wanted to get into the meat and the importance of our conversation here today. We thought that especially looking at this particular topic in the backdrop of the last 18 months really made sense for this audience.
You rewind back to April 2020. We all realized and I think the economy as a whole realized the severity of the COVID impact and what was happening. We saw from both small companies and large companies alike really, that-- as we realized that this was something that's going to stick around for a little bit a little while-- the concern about liquidity.
So it is, revenues started to dry up depending what industry you're in. Cash flows start to dry up a little bit depending where you're an industry you're in. And just the unknown nature of what the roadmap would be for the next few months-- is it a year, here we are 18, 19 months later, still somewhat in the pandemic. So the unknowns at that point.
A lot of companies felt the need to bolster their liquidity to make sure that they could handle rainy days that can keep operations moving, if needed, as some of those cash flows from other sources dried up.
So I think what happened during that time you think April, May 2020-- what a lot of companies did to look at bolstering that liquidity position-- one option, certainly going to the debt capital markets, issuing some cash-- that way putting some cash in the balance sheet through a through a bond offering, perhaps. Staggering out that maturity as long as you can. Putting that cash in the balance sheet now for rainy day funds, for working capital purposes, for whatever it might be-- certainly one avenue and one viable avenue that many companies took successfully during the pandemic.
Next. One might be just trying to expand your capacity on existing lines of credit. So you had $50 million in February 2020. Maybe you try to bump that to $100 million in May of 2020. Again, just to give yourself that little extra ability to get cash when needed.
So certainly both two viable ways to go about that. But what we're talking about here today is about something that's really not thought of is-- perhaps there's another way to improve your liquidity, maybe not to the same degree-- percentage-wise and dollar-wise as those other two avenues that I mentioned. But in the sense that if you can replace letters of credit that exist on your credit facility, that will increase your available borrowing capacity. So really that's kind of the key point here.
So we talk about other ways you can raise debt to get cash. You can expand your credit facilities-- maybe get more availability of cash. Or you can eliminate debt that's being tied up with letters of credit and then use that than dry powder for any other purpose.
So that's kind of the first key bullet point there versus the benefit of a surety bond, versus the letter of credit. We're not tied to your credit lines. If you get a bond for $10 million that is not reflecting as part of your reduction in the availability under your credit line capacity. So right there you can find a way there's currently a letter of credit posted somewhere that can replace the surety bond-- it frees up that amount of cash that can be used elsewhere at your discretion.
Surety bonds typically-- again, we'll talk in generalizations-- do not include restrictive covenants. So unlike maybe your bank facilities where you're concerned about certain debt to EBITDA ratios, certain fixed coverage charges, things of that sort. Typically, not part of the ongoing surety underwriting process. Obviously, there will be a financial analysis at the front end. But really there's not, generally, typically specific ratios and things that the company or the principal would need to adhere to over time.
And that third benefit there for the surety bond. It's often not always a conditional instrument and that's I think a key differentiator between surety bonds versus the letter of credit. So if you have, go back to that slide the owner of the obligee. If they are holding a letter of credit to guarantee that promise and for whatever reason there's a disagreement in the course of the execution of that contract-- they don't agree that you have fulfilled your side, and they want to make a claim. They go to the bank and make a demand and letter of credit. And the bank has to give them that money.
Over the surety-- if there's a surety bond involved in that letter of credit, the obligee owner makes a claim to the surety company. And the surety then investigates that claim to make sure it's valid. Is the reason for default or the reason for non-compliance with the performance obligation valid? Was the owner obligee holding up their end of the bargain and their promises along the way before the event that might have led to a disputed non-completion of the contract?
So there is an extra layer of-- if there is a dispute, the owner obligee just can't all of a sudden make demand a letter of credit and then your credit facility then reflects that that is in use.
Another key bullet point there-- sureties underwrite with the goal of obligation fulfillment. You think about a bank they look at you purely as a financial credit profile. So how much capacity if I give them in terms of dollars. They get a line of credit of x number of dollars. How you choose to use that line of credit for projects is not really the bank's concern.
But the surety does. So the surety will underwrite each bond obligation that is presented to us. We will analyze the risk, of the [INAUDIBLE] terms. And really what happens is the sureties can be like a risk management arm of your company. We will tell you-- we are obviously, very well-versed as surety underwriters-- underwriting surety obligations. We will tell you along with most companies have legal representation and expertise, as well. Where there are issues in the contract that maybe you want to avoid, we can give you some guidance about just surety, surety terms, or terms within your contract that might reduce your overall liabilities or concerns in ways that are outside of the bond, as well. Really, surety underwriters can serve a risk management arm for a company that might not have the sophistication or the expertise internally. Again, surety-- a niche product.
The claims department there-- the next bullet down there. Again, goes back to the fact that when there is a dispute on a project or an obligation-- there is a claims department with sureties that will help you out. It will give you an extra set of expertise to really go through what rights you might have, what are our options in this point. How do we make the best resolution to this process. Keeping the surety in mind, keeping the principle in mind. Really, the best surety relationships tend to be ones that are collaborative and cooperative between the surety company and the account-- the principal. Where it is a mutually beneficial process, where we are guaranteeing your promises, and we expect you to fulfill them. So really, we want to make sure that you understand the promises and the liabilities that you're taking on under bonded contracts.
And lastly, or almost lastly down to bottom, regulated pricing. So all kind of surety pricing is regulated by state insurance agencies. So there is less volatility within the pricing in the surety bond market compared to, maybe, the banking side which are more driven by interest rates, which, while currently low are a little bit more volatility over time-- over the long run. Surely, as I said there are certain-- within our rate filings-- maximum amounts, minimum amounts that sureties can charge based on any one type of obligation or credit profile.
The last bullet that we have here on the bottom-- really, it's more of a benefit for the owner of the obligees or it's sort of a thing for the industry is we would love for bonds to be accepted by more people and by more entities than they probably are. And one of the key reasons we give for that is several sureties have higher credit ratings than many of the banks. There's concern by an owner obligee that-- I'm concerned-- that maybe this promise from Travelers isn't as good as a letter of credit from Bank Y. Surety companies, especially ones that write a significant amount of sureties have credit ratings in that A plus-- double-A range where certainly in terms of credit capacity ability to make payments in the event of a need does not lag behind it-- does not lag behind any of the banks.
So it's kind of a quick summary of some of the surety bonds advantages versus letter of credit in terms of how it might improve your liquidity. Again, think about back to the different kind of debt offerings that we talked at the top. You can-- in terms of-- there's debt you can raise to go out and make investments. There's debt you can raise to have cash to park for other needs-- working capital. But if there's credit utilization on your facilities, that's really just there to guarantee a promise. We think that a surety bond does that better. We can make that same promise for you with as much financial qualification as the bank. And really give you some extra protections, as well.
Two people review charts. Text, Underwriting the Risk
TIM GRAVEL: All right. Thank you, Paul. So we want to spend a few minutes just walking through the underwriting process and how surety is assessed risk. There's two key components of that analysis. One is the risk assessment of the customer or the indemnitor as Paul described on the diagram. And we'll cover that on this slide. In the second part is the risk assessment of the bond that's being issued and we'll cover that in the next slide.
So for those that may not be as familiar with surety, I want to set the stage a little bit before we get into the underwriting details. As Paul alluded to, this is a product that's written to as close to a 0% loss ratio as possible. And if you contrast that to insurance coverages, charities-- we don't issue bonds with any expectation of receiving a claim. And so you're underwriting to that level. As Paul explained, it's a third-party guarantee. So the primary element of performance exists between our surety customer and the obligee beneficiary. And the surety only becomes involved in the event of a problem.
So if you play it all the way out for the surety to have a loss, two things would need to happen. The customer-- the bond principal would have to fail to perform their obligation, which is supported by the bond. So failure to perform under a contract, failure to comply with the regulations. They're going to make payment under a judgment, et cetera. Then failing to make the obligee a whole is part of that.
Then the second piece says the surety would have had to have incurred a claim and paid that claim. And then the customer would not reimburse the surety company. So if you pair those two things together that's what leads to a loss for a surety company. And really, that's the foundation for the two critical components of the underwriting analysis that's performed.
So part one, let's review the customer's financial and operational capacity and then we'll get into the bottom of that obligation on the next slide.
So surety companies generally are unsecured creditors. As such, the financial review that's performed is on the company. The customer's ability to continue to operate and to comply with the terms of their debt agreements-- that fund's available to address any challenges that might arise. And the financial analysis we're performing is very similar to what's done by a bank or any other lender.
So the financial overview-- the first bullet here is the balance sheet makeup. And every balance sheet line item can be important and is reviewed by the underwriter. But the general focus is on a few things here. And I'm going to give you a kind of a broad-brush example. This certainly varies by customer, by industry, but just for illustrative purposes here.
So part one liquidity. Paul touched on this but cash balances-- more is better. This is obviously relative to the size of the company and their cash needs, working capital. So the difference between their current assets-- things like inventory, and accounts receivable, versus things like accounts payable, which should be a liability. And you net those out. A positive number is good, the bigger the better. And the way we view that is it's money that's available to meet any sort of short term payment needs that come up. And so it's a source of funds for the business.
The second item here is quality of assets. So think about tangible assets, property investments, equipment. Now what is the market value of that relative to the book value that's carried on the balance sheet. Is there a history of impairments or write-downs. Then if you go to the intangible side, so things like intangibles or goodwill-- in a worst case bankruptcy scenario, not a lot of value there-- really looking more at the tangible assets which are much more valuable since they can be liquidated easier in a bankruptcy proceeding.
Third component here-- leverage. So leverage-- this purpose-- any form of debt that's owed to third parties. Be it bank debt, credit facilities, term loans, payables, or really any other liability that could be due in the short or the long term. These are items that can deplete the liquidity profile and they also bring in some other creditors into the mix. General rules here-- more debt is a riskier balance sheet. Again, it's all relative to the individual customer and scenario.
And the final component is the equity base. So who owns the company, how are they compensated. If you look at the net worth of the company is that based on retained earnings, which suggests that the company has a history of making money. Or is it more from equity capital paid in by the owners. And if it's of that variety is that a single time payment, or is that some sort of recurring payment that's taking place. If you put it all together, the strength-- the health of the balance sheet is what we're looking at here. The balance sheet is really the staying power of the company. And so to put it in surety terms-- a stronger, healthier balance sheet is going to lead to better surety terms and a broader appetite to support higher risk type exposures.
Going down the page-- capital structure. So this really homes in on the mix of debt and equity-- how is the company capitalized. By no means a one-size-fits-all answer. We have companies with a wide variety of different capitalization structures. What we're looking at is just the ratio between debt and equity. Certainly dependent on the industry, you think about asset-intensive business like manufacturing, something like mining-- a lot of equipment involved that tends to lead to debt. And the flip side an asset company-- like a service provider-- generally are going to have less debt.
And we also think about where is the company in their life cycle. If they're in the startup phase, they might have a need for more capital. If they're a more mature business, maybe less.
And so understanding that mix is critical for us as underwriters. Too much debt can cripple a company. When that debt comes due, if they can't refinance it, if they can't pay it off, you're in now a distress scenario where bankruptcy is a likely possibility. Bad news for all creditors, surety being one of them.
Equity is a less risky source of capital on the surface but it's also potentially more expensive. And what are the owners desires and plans for the business that starts to matter. Bottom line-- we're looking for a sustainable capital structure here, as we look at the capital structure of the business. And we're looking to avoid is a scenario that results in financial distress or bankruptcy filing for that company.
You're going down the page-- more liquidity. Again, we've defined that pretty well at this point. But what we're looking for there is funds that are available to pay off debt, to grow the business, or in this current environment, to deal with problems that come up. Worst case scenario-- you have liquidity there to either pay a surety claim or if the surety requests collateral, it's there as funds that provide that. And the easiest way to think about it is like your personal finances. Liquidity is there to give you some flexibility and a cushion to deal with any problems that come up.
Cash flow generation. So a business that's able to generate cash flow-- they have the flexibility to repay their debt, to make acquisitions, maybe invest in organic growth, provide returns to their owners. And the ability to generate cash is important. I think most areas would probably agree that you'd prefer to see cash from generations be generated versus a net profit. Reason being, net profits tend to be a little bit more susceptible to some accounting rules and can be a little bit misleading in the positive or negative direction.
And closely related to that is the quality of the earnings. So we're looking for is that earnings are generated from core business operations. And there's enough there to cover any interest that's doing debt. And to pay any taxes that are due. Things like a profit from the gain on the sale of an asset. That could be a positive for one year. But generally, isn't sustainable over a long period of time. So we're looking for consistency, and stability, and profits over a longer time period. And again obviously the higher the profit, the better. Margins do vary by industry and we certainly factor that into the analysis.
Go to the bottom half here on the operational review-- overview side of it. This is just as important as the numbers in the financial statement. The financial analysis is really the objective and numbers based focus. The operational piece is more subjective. It's a SWOT analysis of sorts.
So-- what's the history of the company? How competitive are their products in the marketplace? What markets do they compete in? Are they growing? Is that growth organic or is it via acquisition?
Then we look at the c-suite. This can be a very different analysis if we're talking about a small, closely held company or a very large public company. What are the backgrounds of these people? What are their track records? And then looking forward-- is there stability in the c-suite. And is there succession planning in place for anyone that may-- leave at any time.
Again, in this sort of COVID environment, and supply chain environment-- how does the company mitigate those risks. What's there to protect their supply chains, their labor, the demand for the product if that shifts. What's there for safety-- for their employees? And how do they manage any insurable risks. What industries they compete in-- is it volatile industry, or is it stable? Is it growing, or is it shrinking, or is it stable? What is their market share? And who are they competing with.
So these are all the things that are going into the analysis. And you're trying to gauge the operational strength of the customer and their stability over time. Pair that together with the financial analysis and you're starting to frame out what terms and conditions could look like.
Paul, to the next slide here.
So part two of this analysis is understanding the bond needs and then the risk characteristics of those individual obligations.
So the first bullet here-- financial versus performance. Financial obligations-- these are bonds where the activity that's being secured by the bond is some sort of pain. So paying your utility bill, paying court judgment, remitting tax dollars to the government. The bond is guaranteeing the payment. If the customer doesn't make that payment, the surety will.
And there's the variety of these different types of obligations. Some being riskier than others. But the key underwriting point is trying to understand the timing of the payment-- is it a single one or as recurring. Are there any controls in place? What's the likelihood or potential for a claim? And to protect against that, liquidity becomes the focus making sure the company has the resources to pay that upfront, or to pay the surety to manage the claim.
On the performance side, the activity being performed here is some sort of contract. So building a bridge, manufacture and supply a product, install equipment. What the bond is guaranteeing is that work is performed per the terms of the contract. And if it's not, then the surety would step in at that point to make sure the work gets completed. I think in general, performance bonds are probably viewed as a lower risk than financial obligations. But that's certainly not "we are one-size-fits-all." Some of this goes back to the operational track record of the company. Know what's their ability to perform, to do it successfully, on time, on budget. Are they working in an area that they're familiar with? Are they building a custom product or is it something that's just off the shelf and readily available? Is it some sort of repetitive service like sweeping streets, or mowing the lawn.
Then you think about a contract to supply 100 widgets-- with each one that's successfully supplied that contract value should be declining over time, which is favorable for the surety. Versus some sort of turnkey-like technology contract where they might develop and install this project over three years. You flip the switch and it doesn't work. Well, the outcome there might be completely ripping everything out and starting from scratch. So just a very different risk profile.
Pay on demand, versus conditional. So if you look at the bond form-- are there conditions that the obligee needs to meet in order to make a claim. If yes, that's a conditional obligation. And that's the preference of the surety company is a lower risk profile. Under that scenario for conditional bond, media payment wouldn't be required. There is time to address issues-- the principal and obligee can work out some problems. The surety claim department can certainly get involved and help mitigate that when you don't find a resolution.
On the other hand, we have a pay on demand bonds. Under that structure the obligee can make a demand from the surety at virtually any time for virtually any reason. The surety has very little or no defenses to assert for itself or on behalf of its customer. There really isn't an opportunity to problem-solve. Really can't have the surety claims team get involved to try and mitigate an issue. And that payment is often due in just a matter of days.
And so the underlying obligation itself might be the same. But depending on the conditional versus pay on demand nature of the form, it's a material difference for the underwriting process. And the other pay on demand appetite is certainly more limited than that for a conditional bond.
In the context of replacing letters of credit, pay on demand wording is often required in those bond forms in order for it to be attractive to the obligee and the beneficiary. And so that's something we understand and do factor in. If you're issuing pay on demand forms, there's just an added focus on the financial analysis of the company. And again, the buzzword of the day-- liquidity.
The forfeiture procedure-- can the obligee make a claim for the full amount regardless of the actual loss? Or is the claim proportional? Preference of a surety is certainly not that forfeiture wording. You'd prefer that that claim value be determined on some sort of factual basis. So the presence of forfeiture wording does make for a higher risk obligation.
Duration. So as unsecured creditors, time is your enemy. The economy goes through cycles, risks of all products can become obsolete, the company's credit profile changes, key people leave. There's a myriad of things that happen over the course of time. And from a statistical perspective, the odds of a bankruptcy or default on a debt obligations certainly rise over time, as well. And so where that matters for the surety is managing the duration of the bond [INAUDIBLE] This is done via control of duration as a way to manage the risk profile and sample these approaches.
For performance bond, maybe it's limiting appetite to jobs with a performance period of two, three, four years. Maybe it's trying to use a form or the surety can decide at the end of every year whether they want to continue or not. It could be finding a bond form where the surety has the ability to cancel at a certain point in time. And then for some letter of credit replacement opportunities, something like an evergreen wording could be inserted, as well. Very much case by case analysis, but the general point is durations move in one way and the surety up appetite is negatively correlated.
So we just touched on the cancelation provision, but to go a little bit deeper there-- can the surety unilaterally choose to cancel the bond [INAUDIBLE] at the exposure? If they do, can you cancel all of the exposure-- past, present, and future-- or are you just canceling moving forward? What that leaves you with is tail exposure. Preference of the surety would certainly be if you can cancel, you'd like to cancel from everything and be fully released from the exposure.
Maximum penal sum wording. It's a fancy way of saying-- is the bond amount capped? For performance bonds, the answer is probably no. You're guaranteeing the completion of a project. So from the owner's perspective and a worst case scenario you're looking for someone to have the project completed. And so the surety could end up spending more than the bond amount to make sure that that project is completed per the terms of the contract. For most other bonds the answer is probably, yes, where your exposure is kept at the bond amount. And so at least it's a little bit easier to quantify what the risk is under those obligations.
So release procedures. How does surety exit the bond? It could be non-renewal. It could be a cancelation. Trying to understand what is the obligee going to require for documentation. Are there conditions attached to that? It's just better to understand this stuff up front for the customer, for the broker, for the surety. Just so everyone's on the same page.
The bottom line. It's a risk reward analysis. Bonds have been written in the industry with any and all combinations of the items we've talked about above here. It's just a bond analysis, risk analysis. And that's paired with the analysis we're doing or the financial capacity, and the operational capacity that we discussed in the last slide.
And also pointed out there could be some room to negotiate a bond form on a project too. And dial down the risk profile of a job a little bit.
Types of Surety Bonds
Paul, throw it back to you.
PAUL LANDRY: Thank you, Tim. All right. So we've explained to you what surety bonds are. Hopefully outline some of the benefits particularly as they relate to replacement for letters of credit. Tim gave you an idea of what to expect in the underwriting process. So you may be thinking there, OK, I understand all of that. How do I target or identify areas where I can actually recognize someone's benefits that Paul and Tim are talking about. How can I actually increase my liquidity position.
Appeal bonds is one such product. So Tim and I are going to spend the next 10 minutes or so running through again those primary areas where you might find some use for bonds. So appeal bonds-- generally, any company that's been a business for any length of time can expect to see some litigation in the normal course of business. Particularly, we've seen-- we are a litigious society, increasingly so. So no shortage of complaints and lawsuits being filed.
And along with that, we've also seen somewhat of an escalation in the size and amount of awards that have been passed down from certain courts. So one of those-- what an appeal bond does is when a defendant wants to appeal an adverse judgment. So if you want our audience here one of the copies represent-- received a judgment that was adverse to your company. And you wanted to appeal-- you thought that was the wrong decision. In order to secure the appeal and stay the execution of that original judgment, the court will require security to guarantee that original judgment.
So in this sense, the security we're suggesting here would be a surety bond also known here as an appeal bond. What happens is the surety bond will be put in force and it will guarantee the payment of the original judgment plus any interest, expenses, any fees that might accrue over the course of the resolution of that judgment process. So think about this in terms of from your standpoint. The court system and appeals in general-- very unpredictable in terms of how long they last. So assuming a judgment that's sizeable compared to your company's resources-- financially, liquidity-wise. Do you want to provide the court with a letter of credit, with cash, with some sort of escrow arrangement for several thousands, millions, hundreds of millions of dollars. While that process plays out over the next number of years. That money will continue to remain there until the appeal falls its way through to completion.
The other option, as Tim and I have pointed out, is the surety bond. So rather than tie up cash, tie up assets-- that way, the much easier and in many cases much preferred method is to just provide that surety bond. But many courts can and do accept cash, securities, letters of credit-- to guarantee this obligation. Many of them aren't set up to handle that type of funds-- that amount of cash-- and would actually prefer that the surety step in and help guarantee that promise as well.
So you have a few risk considerations down the bottom here to tie back to what Tim was talking on the previous slide. Just to give you an idea of where it might line up with surety appetite. It is a financial payment obligation. Really it is at the end the day, making sure that final judgment is paid, including the expenses and fees. This is one of those bonds that is not canceled for the surety, as well. As I talked about concern for the company having assets tied up long term. For us, our bond will be enforced without our ability to exit for as long as that case remains active. So there is that really long term exposure for us. What we can certainly underwrite-- our principles, and our company, our accounts today. Forecasting their ability to their financial wherewithal-- five, seven, years out can be a difficult task.
So there is no ability for us to get off this bond unilaterally. We will need to approach the courts to get a court order which can also include its own set of difficulties in getting a judge or a clerk to actually sign off on the release of a surety bond. But as appeal bonds and litigation is very prominent, certainly want to point this out is one area where you might look to utilize surety bonds as opposed to cash or letters of credit.
Self-Insured Workers Compensation Bonds
Next. I want to talk about self-insured workers compensation. So workers compensation is a coverage, a liability that every company has to account for. So if you have employees you have to account for the fact that your employees could be injured during the time they were working for you. And self-insured workers compensation is in lieu of a company merely obtaining a worker's compensation insurance policy for that.
Some larger, particularly larger companies may choose to self-insure and to manage those liabilities internally. However, despite that the states are generally ones that regulate workers' compensation insurance. But a handful of exceptions at the federal level but is primarily driven at the state level. They will still require security of any company that is self-insuring. So it can be a combination of cash, funding, putting some kind of trust fund, letter of credit. And again, our preference here is to provide a surety bond.
Surety bonds for workers' compensation are somewhat risky in the sense that workers' compensation has its own kind of unique risk characteristic. And that it is-- we call in the industry tail liability.
So the bond coverage is-- to be issued a bond in the year 2021 through 2022. And any employee was found its future, and found to be later, or currently that they were injured during that time period. There can be a valid claim against this part. So what that means is that fast forward to the year 2050-- if an injury that or a chemical was discovered that caused the problem back in 2020 but it wasn't realized or didn't find the full limit of litigation until 2050, technically the surety could still be responsible for that liability. Rewinding and looking back 30 plus years is possible. So really, an insurance like this type of obligation-- certainly high risk.
But again, it all depends on the states. This is state regulated. We can do different things through the surety market. And do things in different states that they couldn't do in others. And same thing with the federal government. Each kind of obligation is its own unique characteristic. But in the sense that most companies do face-- and all company do face the workers' compensation liability problem. And many choose to self-insure. The bond can certainly be an avenue to help again free up that letter of credit and improve that liquidity.
This slide here is focused specifically on workers compensation. But I will say in general there's also kind of a push recently around the country for there's more products around the self-insurance of automobile liability. So anybody in the audience who has been involved in the transportation industries, or if you just have a lot of vehicles for your company that are on the road and you have to insure all those vehicles. Self-insurance for vehicles is becoming a product that's supported by the industry, as well.
Text, International Bonds;
And international bonds. So international bonds is a very broad category of obligations to cover. Because the fact that it's international is not necessarily a different risk obligation. We can have a performance bond. We can have tax bonds. We can have customs bonds the same that we would in the United States. These are just written to obligees in foreign countries. So guess it's a little bit more challenging to place bonds internationally. Generally, the foreign countries or foreign jurisdictions have local licensing requirements for who may or may not write surety bonds or financial products within that jurisdiction. In some instances, it is possible for a surety company to write bonds in a foreign jurisdiction on a not admitted basis. I will say this is probably considered a fairly rare and be more common approach to place bonds internationally is what's called a fronting relationship. In that sense, there is a local insurance company-- local surety company who will issue the bond on behalf of the principal, the indemnitor of the account. And that bond is then reinsured back through the US surety company. So the US surety company would find a reinsurance guarantee to the foreign surety company that issued the bond, guaranteeing reinsurance on behalf of their domestic client.
These fronting companies-- these third parties in the local jurisdictions to issue surety bonds. They might be wholly owned subsidiaries of a US surety or US insurance company. Or they could be completely separate third parties that the US surety company just has a reinsurance agreement with behind the scenes.
So unique factors of international bonds. Generally, international bonds are lower penalty. So while it's typical for bonds in the US market to be representative 100% of the contract value or 100% of the obligation risk at play. International bonds tend to be more percentage based. 10% can be common and 25% really represents a smaller portion of the risk than the US surety market.
But that being said, obviously Tim's point earlier, where maybe you're working off some of the liability of a contract as you work through it. If you have a 10% bond, really, it'll take a significant amount of time before you actually work through any of the liability that might be subject to the surety. It's really the penalty associated with a percentage bond can be a little bit higher for a surety company.
Because internationally surety bonds aren't as common as they are in the United States-- with some exceptions, but generally United States is the predominant surety market. But internationally, bank guarantees and letters of credit are more the accepted and generally accepted method of financial security.
And with that being the case, as Tim alluded to before, we certainly can make sure your product's more unconditional-- to be more of that handyman feature. And international obligations tend to take on those qualities. So really, the international bonds tend to be considered high risk. They do have some of those forfeiture provisions that Tim alluded to before. Just because there's so many different countries that you're operating with different ways to handle the surety business.
So international bonds are very, very beneficial to a lot of clients in ways to help free up liquidity or bank capacity because there is a lot of obligations worldwide for those of us who operate around the globe.
But then again, the risk reward is the endpoint. That was our last piece there-- is international involves a lot more people. There's usually at least a third party. There's us, there's our account, and there's probably is 1/3 surety company involved. Perhaps a second broker locally that's representing the client in a different jurisdiction. So there's a lot more moving pieces. It can be harder to put the bonds together and the packages together if you don't know what you're doing with that experience in those arenas. So it does take some time. And at the lower bond penalties, doesn't make sense to try to get a bond through with more hoops. But maybe it could be just accomplished by letter of credit. I think there's always a balancing act there. There's certainly benefits to providing letters of credit in certain situations. But as we're reporting today, really, surety bonds can fill all of those bank obligations while also offering you some extra protections, as well.
Text, Insurance Program Bonds
TIM GRAVEL: All right. So I [INAUDIBLE] something typically applies to larger companies with larger insurance exposures-- especially ones that have large deductibles, retrospective rating plans, and lesser extent self-insured retentions. And we're generally talking about auto insurance for large fleets, general liability, or worker's comp coverages.
So the insurance carriers credit management team with using insurance program. And they might determine there's a lot of level collateral that's required. What that collateral does is the carrier's risk. That if the insured fails to repay the deductible, or to make a payment for the retrospectively adjusted premium, there's funds there to make the insurer whole.
So letters of credit are the predominant source of that collateral. Variety reasons for that really beyond the scope of today. But most carriers are often willing to accept surety bonds for at least a portion of that. Maybe something in the 5% to 30% of the overall collateral package. And so then the bond then guarantees some of the deductible repayment or the retrospective premium adjustment. But to be attractive relative to letter of credit, these bonds need to be structured very similar to letters of credit. So they are high risk obligations from a surety's perspective.
They're financial in nature because they really secure payment. They're paying on demand with effectively no defenses, quitclaim notice, quick payment by the surety. The bonds can be canceled or there might be held up and be non-renewed. But if replacement security isn't provided, that's acceptable. That's going to result in a claim and it's likely to be a claim for the full amount of the bond.
So these bonds are written fairly frequently. But I would say the industry's appetite generally does reflect that these are high risk bonds. I'll go next slide.
Bank Fronted Insurance Program Bonds
So a recent development in the surety industry-- bank fronted insurance program bonds. So what I just described in the prior slide largely applies here. The difference is we've just slid a fourth party into the conversation. So if you look at the diagram on the right side of the page instead of the surety issue in the bond direct to the insurance carrier, there's now a bank in the middle. So the surety provides a guarantee to the bank, then the bank provides letter credit to the carrier. So why is this created? What does this accomplish? It's a broader opportunity for the surety and its customers. So rather than that 30% cap on what the surety bond might be for a percentage of the collateral package. That fronted LC could be 100% of the collateral amount.
So there's some untapped opportunity here. For the customer, there's an opportunity to free up liquidity rather than place your own letter of credit through your own bank facility, you can replace that free up that liquidity and then use the surety bond and fronted letter of credit to satisfy the obligation.
That tends to be an off balance sheet item for you. And if you're an insurance carrier, you're getting your preferred form of collateral, which is letter of credit. Caveat I put in this one is it's just more complicated than a traditional surety bond. You've got extra parties at the table, there's more documentation. So it's not right in every scenario but it is something new in the market worth talking about. Paul.
NY Appleton Law
So I'll move through this real quick. So we can get to the Q&A. But underscoring a lot of what we talked about today is some legal principles which define what bonds can and cannot be written. And they're based out of some law in New York, as well as some other states. The reason we mention it is not every letter of credit can be replaced with a bond. There are certain types of obligations which surety companies might deem to be impermissible under this New York law as well as some of the other laws. And so it's just something that we need to be aware of and will be reviewed by your insurance carrier on a case by case basis. On the other hand, for many other obligations replacing an LC with a surety bond is certainly possible. And that is something that you want to discuss with your broker or your agent. And with that, Justin, pass it over to you.
Text, Questions & Answers
JUSTIN SMULISON: All right. We've got a little more than 5 minutes left. We're going to stick around for an extra minute or two to get to as many questions as we can. Thank you, gentlemen. So here's the first question. You're ready?
PAUL LANDRY: Yes.
JUSTIN SMULISON: All right. Where are surety bonds accepted most frequently besides the US?
PAUL LANDRY: Fair question. So it's a most commonly-- certainly very common in Canada and Mexico. Very common throughout Latin America as well down through Brazil. Some of Western Europe is beginning to get more accepted into the surety business-- to accept surety bonds with more frequency. Still a little bit-- it's not quite as consistent throughout Europe as we would hope for. But that is changing to our favor a little bit. On the [INAUDIBLE] in the Asian continent-- South Korea especially, very surety-friendly and they accept surety bonds quite frequently over in South Korea.
JUSTIN SMULISON: All right. And as a reminder, we will follow up individually on questions that remain unanswered. Do you require any collateral to back up the surety bond?
TIM GRAVEL: Let me take that, Paul.
PAUL LANDRY: Sure.
TIM GRAVEL: I would say, for the most part surety terms are unsecured. But it is a deal by deal analysis and consideration. So there are some accounts out there that have either partial or full collateral. And that really just depends on the mix of financial analysis, as well as the nature of the bonds that are issued.
JUSTIN SMULISON: OK. I think this question is for Tim. Do all insurance carriers accept surety bonds?
TIM GRAVEL: Sure. So I would say most or at least many, but not all. And even the ones that do it doesn't necessarily mean that they're accepted for all of the insurance, but it is an option. And then the insurance carrier-- their credit team is going to take a look at the deal and they'll make a decision on whether they'll accept surety. And if so, in what amount.
JUSTIN SMULISON: All right. Tim one more for you as a quick follow up. Have sureties had to pay claims or losses on insurance program bonds?
TIM GRAVEL: So yes, there have been claims. There have been claims paid. So that's actually good for the reputation of the product. But we're generally talking about a loss ratio that's under 10% over the last decade. For of the SFA data that Paul was walking through earlier.
JUSTIN SMULISON: OK. Hey Paul, a question for you. How can the health care industry utilize surety bonds?
PAUL LANDRY: Sure. So fair point. So I guess I would say begin with health care has utilized surety bonds for quite a long time. One of the most frequent uses of surety bonds in the health care industry is meant to be more consumer protection. They are kind of tied to state statutes around things such as patient trust obligations for nursing homes, third party administrator bonds, license requirements for that, and many hospital systems might actually need self-insured workers compensation obligations. That's certainly a product that hospitals might see a need for surety bonds, as well. And within the last few years, I would say I mentioned the SFA earlier. The SFA has worked closely with the federal government in the last-- maybe going back a decade or so now at this point. Spent a lot of new products for surety that are related to the health care industry. Be a durable medical suppliers is one area where there's been an increase in surety activity with requirements for them. As well as other emerging kind of health care trends such as managed care organizations and entities of that sort. So there is a lot of movement within the acceptability of surety for the health care industry.
JUSTIN SMULISON: OK. And I think we'll close out on this question right here. In the presentation you compared surety bonds and bank letters of credit. Tim, what are the drivers for a surety to enter into a bank fronted IP bond?
TIM GRAVEL: Sure. So from the surety's perspective, if you've got a customer that you like and you want to do more for-- this affords that opportunity. You can use that fronted letter of credit to secure the entire insurance agreement collateral requirement as opposed to just that capped amount for the surety collateral. And from the client's perspective, this is a way to free up liquidity. So reduce the usage on your letter of credit facility. Utilize surety instead and put that liquidity use for something else.
JUSTIN SMULISON: Excellent. Thank you, gentlemen. As I said, we will follow up individually on questions that remain unanswered. I would like to thank Tim Gravel and Paul Landry of Travelers for their time and expertise.
A copy of this webinar will be archived on rims.org within a few business days. Visit rims.org/webinars to register for upcoming sessions. Be sure to check out RIMScast. That is the society's official free and weekly podcast that is hosted by yours truly. Visit rims.org/rimscast to subscribe and download. I'm very excited to be collaborating with Travelers for a new sponsored episode of RIMScast that will be live on October 18th. So visit Risk Knowledge on rims.org for that episode.
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Types of Surety Bonds:
Surety bonds can be required for different types of contracts. The two most common types of surety bonds are contract surety bonds and commercial surety bonds.
Contract Surety Bonds
Contract surety bonds are bonds the government or an owner of a construction project may require a contractor to obtain. There are three types of contract surety bonds:
- Bid bond – this bond protects a project owner (obligee) in the event a successful bidder will not enter a contract and will not provide the required surety bonds or other security
- Performance bond – this bond protects the obligee if the contractor defaults on its obligations under the bonded contract
- Payment bond – this bond guarantees that the contractor will pay subcontractor labor and material bills associated with the construction project
Commercial Surety Bonds
Commercial Surety Bonds are required of individuals or businesses by the government, legislation or by other entities. Travelers Bond & Specialty Insurance provides the following types of commercial surety bonds:
- License and permit bonds - required by state, municipal or federal ordinance or regulation. These bonds may be required as a condition for engaging in a particular business or exercising a particular privilege. Examples include performance and payment bonds, customs bonds, tax bonds and warehouse bonds.
- Court bonds, including:
- Judicial bonds, required of either a plaintiff or defendant in judicial proceedings, to reserve the rights of the opposing litigant or other interested parties
- Fiduciary bonds - required of those who administer a trust under court supervision
- Public official bonds - required by statute for certain holders of public office, to protect the public from malfeasance by an official or from an official's failure to faithfully perform duties
- Notary Bonds – surety bond required by statute for a notary public and guarantees a notary will protect the public from financial harm as a result of the notary failing to perform required notarial procedures
- Miscellaneous bonds - bonds that do not fit into any of the other categories
How to Apply for a Surety Bond
Your city, county and state have different requirements for how to get a surety bond. It is important for you to understand what type of bond a particular obligee requires and in what amount, in order to get a surety bond. You should then contact your independent insurance agent to understand how to apply for a surety bond. They will guide you through that process, which will include:
- Evaluation and qualification – you will be required to provide financial documents to demonstrate your creditworthiness and that you have the resources to fulfill the terms of the surety bond. You will also be required to provide details about the project that will be covered by the bond.
- Underwriting – Travelers will assess the risk to bond you and may offer a formal agreement requiring your indemnification in the event of a loss along with other required responsibilities
- Bond issuance – the surety bond will be issued for you to sign and deliver to the other party (Obligee)
How Much do Surety Bonds Cost?
The cost (known as the premium) of a surety bond depends on a number of things, including the bond type, length of time for coverage, risk, the principal’s credit score and past claims history, financial wherewithal, and other factors. Depending on that information, the surety bond premium can vary.
Each state and their governing agencies set their own surety bond requirements. The obligee will inform you if they require a bond, the bond type and the amount of coverage.
Find an independent agent near you to learn more about surety bonds and to get a quote for a surety bond program that is right for your business or project.
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For more than 100 years, Travelers has been a leader in the surety industry. We consistently earn high marks for financial strength including an A++ rating from A.M. Best*.
Insights & Expertise
Learn more about how Travelers can help you with your commercial surety needs.
While international letters of credit and surety bonds are similar, there are important considerations that can make international surety bonds a more attractive alternative to letters of credit.