In recent years new and expanded uses for surety bonds have emerged, beyond the traditional use within the construction sector. They can provide clients with a number of advantages and, for businesses that have traditionally used bank guarantees, are a viable alternative which also enable such businesses to diversify their capital sources and release debt capacity within existing banking facilities.
Surety bonds are a form of guarantee issued by a surety, rather than a bank. There are three parties to a surety bond:
- The Surety (as guarantor).
- The party who is required to perform the subject matter of the bond, i.e. the contractor or service provider.
- The party in whose favour the bond is issued – and who has typically requested the guarantee to be provided, i.e. the beneficiary.
Under the surety bond, the surety agrees to hold itself responsible to the beneficiary up to the specified amount of the bond and subject to its terms for the non-performance of an express obligation, i.e. the obligation of the contractor to the beneficiary.
If the contractor fails to perform the obligations for which it was required to provide a bond or guarantee, the beneficiary of the bond can present the bond to the surety and receive up to the bond amount. Beneficiaries can include corporations, utilities, government authorities and councils.
Key points covered:
- Benefits of using surety bonds
- Establishing a surety bond facility
- Common misconceptions
- Potential uses for surety bonds
- New applications for surety bonds
- Future developments
- Case studies
Benefits
There can be substantial benefits to using surety bonds in place of bank guarantees. For example, they can help to preserve bank limits for other purposes such as working capital and hedging or to fund expansion plans, acquisitions and investments.
They are typically subordinated to senior security holders and in many circumstances they can be unsecured. Facilities can be committed or uncommitted or a combination of both. In our experience, they are typically more cost-effective than a bank guarantee and rates have shown less volatility than bank guarantees.
Surety bonds can be provided on a direct basis, where the surety bond is accepted by the beneficiary, or via a bank fronted structure, where a bank issues a guarantee on behalf of the contractor but the bank’s recourse is to the surety.
Establishing a Surety Bond Facility
It usually takes between four and six weeks for a surety to process an application to establish a new surety facility. The surety will focus on the applicant’s financial strength, their ability to undertake the contractual obligations, and the broader macroeconomic factors influencing the sector in which the applicant operates.
The surety will review the applicant’s audited historical financial statements in order to undertake a credit assessment. The minimum eligibility criteria typically includes the contractor having an annual turnover of approximately $50 million, that its operations are profitable and net tangible assets should not be less than approximately one-and-a-half times the bond amount, although this may be less for large clients with annual turnovers of more than approximately $500 million.
In its due diligence, the surety will also review the applicant’s historical execution of similar projects and their pipeline of projects. Once the facility is established, the surety can issue bonds on behalf of contractors within 24-48 hours of an application being received.
In our experience, surety bonds are typically more cost-effective than a bank guarantee and rates have shown less volatility than bank guarantees.
Common Misconceptions
While usage and acceptance of surety bonds has increased significantly and is now widespread, occasionally there are some misconceptions which are worth addressing.
Comparison to bank guarantees
Myth: That bank guarantees are a superior guarantee instrument than surety bonds.
Reality: Surety bonds typically contain identical key wording to bank guarantees and have the same obligations. However, unlike bank guarantees, which can be used to guarantee a financial obligation, surety bonds cannot be used to guarantee the repayment of principal and interest.
It’s also worth noting that surety companies operating in Australia are highly rated, (typically between A and AA- by S&P) and they are regulated by APRA.
Comparisons to insurance policies
A surety bond is not an insurance policy; it is a contract of guarantee from the surety to the beneficiary that guarantees the contractor will meet its obligations as described in the contract between the contractor and beneficiary.
A surety bond protects the beneficiary, not the contractor. While there is an upfront premium, there is no deductible, no excess, and for unconditional bonds there is no requirement to prove a loss.
Importantly, once issued, unconditional bonds are paid on demand just like a bank guarantee. That is to be distinguished to an insurer’s response and evaluation to a claim made under an insurance policy.
Willingness to pay
Being unconditional instruments, when a bond is presented to a surety they must pay the bond amount. In the recent past, sureties in the Australian market have paid out in excess of $400 million. In our experience, most payments were made within 24 hours of the bond being presented.
Potential Uses for Surety Bonds
- Performance bonds
- Advance payment bonds
- Retention release bonds
- Rehabilitation obligations
- Petroleum bonds
- Bid/tender bonds
- Maintenance bonds
- AEMO credit support
- Workers compensation liabilities
- Rental bonds
New Applications For Surety Bonds
Recently a number of new uses for surety bonds have emerged.
Rehabilitation obligations
State and federal governments require mining, oil and gas companies (among other industries) to provide financial assurance in favour of the state or federal government as security for their obligation to rehabilitate their sites on cessation of activities. Typically this has taken the form of a bank guarantee or, if the corporate is highly rated, a corporate guarantee may be accepted.
In response to the often significant liability and the negative effect that bank guarantees impose on corporate lending limits, Marsh is working with the various counterparties in the mining, oil and gas industries, state governments and sureties to develop acceptance of surety rehabilitation bonds for the Australian market. In the interim, bank fronted surety bonds may be a viable alternative.
Bonds for self-insured workers compensation liabilities
Workers’ compensation program management can be complex, with premiums often representing the next highest cost to the business after employee salaries.
For employers with an appetite and capacity to bear risk, obtaining a self-insurer license can be an important workers’ compensation cost management tool. Hybrid schemes, such as the retro paid-loss premium schemes, are also an option for qualifying employers.
Participation in these schemes will typically require the employer to post security to the state regulator.
Participants have traditionally used bank guarantees to support their self-insured status and retro-paid loss workers compensation programs. More recently, Marsh has developed structures to enable surety bonds to be a viable and attractive option to bank guarantees.
Future Developments
Marsh is working with leading sureties and key industry players to expand surety bonds into other areas:
- Replacing bank guarantees with surety bonds during the bid stage for infrastructure projects.
- Using surety bonds to guarantee sponsor equity contributions.
- Security for ‘take or pay’ obligations.
