Dear readers, how are you? I hope your business is doing well this year and wish you a better next year.
Let’s continue our discussion regarding risk management and insurance. This time Surety is about Bonds as a kind of financial risk concerning the contract requirement.
In line with the rapid development in Indonesia, a lot of infrastructure construction build by the government and private sectors.
To ensure that the projects are built and completed in line with the project schedule in then every contract there is always a requirement from the project owners (oblige) to the contractor (principal) to provide a financial guarantee in the form of a Surety Bond or Bank Guarantee.
What is Surety Bond/Bank Guarantee?
Surety Bond is usually issued by an insurance company and Bank Guarantee is issued by a bank, but now there is a new type of bank guarantee which is issued by a bank and backed up by insurance known as Contra Bank Guarantee. From insurance cost and premium, the latter type is more efficient. Let’s discuss this later.
The needs for surety bonds make sense when a contract requires performance because they help compensate obligees when (contractors) principals fail to meet their contractual obligations. In the construction industry, some lenders may require the project to be bonded before they extend financing.
A surety bond requires the Surety to pay a set amount of money to the obligee if a principal fails to perform a contractual obligation.
Obligees are frequently government agencies, but commercial and professional parties can also use surety bonds. Surety bonds help principals, typically small contractors, compete for contracts by reassuring customers that they will receive the product or service promised.
A surety bond is a legally binding contract that ensures obligations are met — or in the case of failure, that compensation will be paid to cover the missed obligations.
Surety bonds can be used to ensure that government contracts are completed, cover losses arising from a court case, or protect a company from employee dishonesty.
Surety bonds are a promise by a surety company to pay the first party if a second party fails to meet its obligations. Three parties are involved:
- The principal is the person who must make good on an obligation.
- The obligee person who needs a guarantee that the principal will perform.
- The Surety, the issuer of the surety bond guarantees that the principal will meet its obligation.
How does a surety bond work?
To obtain a surety bond, the principal pays a premium to the Surety, typically an insurance company. The surety bond requires the principal to sign an indemnity agreement that pledges company and personal assets to reimburse the Surety if a claim occurs. If these assets are insufficient or uncollectable, the Surety pays its own money to satisfy the claim.
What is the process of the issuance of a surety bond?
Surety bond underwriting is the pre-approval evaluation by the Surety of both the bond performance requirements determined by the obligee and the principal’s current financial situation to assess the risk related to the performance criteria and the principal’s ability to reimburse the Surety should a claim occur.
As explained, Bonds are financial guarantees of the principal’s performance to established criteria by the obligee. Bonds transfer the risk of the principal’s performance from the obligee to the Surety.
If the principal does what they say they will do, nothing happens with the bond. Unlike insurance, if a claim is made on a surety bond, the principal must pay back the Surety.
An underwriter may be an employee of the surety carrier or an employee of your surety bond broker if that broker has in-house authority.
Either way, they are licensed individuals trained to assess risk for a surety carrier. Second, being regular people, they all have their insights, opinions, and risk tolerances. Therefore, some underwriters will approve a bond while others will not. But there are basic guidelines they follow.
What is The Basics Consideration of Surety Bond Underwriting?
The riskier the bond type or principal, the more in-depth the underwriting. A bond type with numerous and complicated performance criteria is more dangerous than a bond with simple, manageable conditions.
A bond for a new industry is riskier than a well-established industry that’s existed for many years. A more significant bond amount is more dangerous than a smaller one. A principal with limited financial resources is riskier than one with lots of cash, assets & profits.
A risky bond type with a principal having enormous financial resources could be less dangerous for the Surety than a simple bond type for a principal with minimal financial capabilities and vice versa.
Not all bonds require the same amount of underwriting or information. The underwriter’s job is to determine if any situation is a reasonable risk for the Surety. The primary question underwriting is trying to answer the likelihood that this principal will have a claim on this bond. If that happens, will they be able to indemnify the Surety?
What is the bond amount?
- Are the performance criteria clearly stated and defined
- How long will the Surety need to stay on the bond
- What is the bond claim history with this type of bond
- When, or if, the Surety can cancel the bond
- Regarding the principal’s financial condition, this may include items such as:
- Are they profitable
- How long have they been in business
- How much liquid assets do the business and/or owner(s) have (cash, investments, etc)
- The credit score of the owner(s)
- What is the business’ total sales
- What is the business’ working capital (current assets fewer current liabilities)
- What is their experience in this industry
- Who will indemnify the bond (the business, the owners, spouses, etc.)
Good underwriters look for a reason to say yes. They look at the overall picture instead of a complex “go, no go” with the above items.
But in general, they are looking for a proven track record of the principal doing what they said they would, and if there’s a claim, is there enough liquidity to indemnify the Surety?
For example, good credit is a sign that someone does what they say they’ll do. If someone extends another person’s credit, that person pays them back.
Bankruptcies, past due bills, etc., are opposite signs. Cash in the bank, positive working capital, and profitability show a principal is responsibly running the business.
They are being overly leveraged and taking every dollar out of the business signals something else. In the end, the underwriter typically doesn’t know the principal personally, so they must use the financial information available to ascertain if they are a reasonable risk.
There are also different ways an underwriter can minimize the Surety’s risk on a riskier bond and still approve it. For example, if the situation is riskier then they may require collateral to approve it.
Collateral can be in cash, an irrevocable letter of credit from a bank, or in some cases, real property. The collateral amount depends on the situation and can range from a small percentage of the bond amount up to 100%.
The collateral minimizes the Surety’s risk since if a bond claim cannot be repaid, then the Surety has something to cover or reduce their loss.
After the underwriting is done, the bond is either approved or not, and the premium rate is set. A bond must be authorized to ensure the Surety will agree to issue the requested bond.
If a bond is approved, then the Surety agrees to take on the risk of the bond in exchange for a premium. This premium is based on the risk identified by the underwriting.
How to get the best Surety Bond and Contra Bank Guarantee in Indonesia?
Frankly, arranging a Surety Bond in Indonesia is not easy because there are not many insurance companies that provide this guarantee. Therefore, you need the help of an insurance broker company that is experienced in the field of Surety Bonds.
Insurance brokers are certified insurance experts from credible insurance education institutions in Indonesia and abroad. They are registered with the Financial Services Authority (OJK).
An insurance broker will help you review the contracts, company documents, and other required information. Then place your risk into several insurance companies and banks to get the appropriate guarantees at competitive costs.
One of the official insurance brokerage companies registered with the OJK is L&G Insurance Broker.
For all your Surety Bond and Bank Guarantee needs, contact L&G right now!
Sources:
- https://www.valuepenguin.com/small-business/what-is-a-surety-bond#:~:text=To%20obtain%20a%20surety%20bond,surety%20if%20a%20claim%20occurs.
- https://alphasurety.com/surety-bond-info/what-is-a-surety-bond-underwriter/#:~:text=Surety%20bond%20underwriting%20is%20the,surety%20should%20a%20claim%20occur.
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