AN ARTICLE BY FRAN MOLLOY IN THE INSURANCE & RISK PROFESSIONAL MAGAZINE – FEBRUARY/MARCH 2013
Surety bonds are specialist products that access insurance capital to provide an alternative ‘capital guarantee’ to contractors bidding on big projects – and since the global financial crisis, they have become a real alternative to bank guarantees.
The GFC left many casualties in its wake, but it also opened opportunities for some savvy operators, such as banker turned surety underwriter, Andrew Calvert, who now heads the surety bonds business for Assetinsure – a market which, he says, continues to grow substantially.
Surety bonds operate much like a bank guarantee, protecting the person or organisation that engages a contractor by paying them an agreed amount if that contractor defaults on the contract’s terms and conditions.
Usually the contractor pays the surety bond premium, and if there’s a default, the bond is to be paid on demand to the principal of the contract.
Whenever a contract states that there must be a form of security for tangible contractual obligations, surety bonds can be used. Examples include bonds for performance, maintenance, retention release, advance payment, bids or off-site material.
Calvert says that he saw there was a big opportunity in the marketplace for a new entrant when international banks started to limit their risk exposure – which flowed on to the big four domestic banks.
“Before the GFC, banks had the capacity to market guarantees more aggressively, but they then made it much harder to get funds and pricing became more realistic”, he says. “I think generally guarantees have doubled in cost in the past three to four years. Banks are now pricing credit correctly.”
“SURETY BONDS OFFER ONE OTHER BIG ATTRACTION: THEY ARE UNSECURED, SO THEY DON’T TIE UP WORKING CAPITAL FOR A CONTRACTOR”
Apart from being more readily available and fairly comparable on price, Calvert adds that surety bonds offer one other big attraction: they are unsecured, so they don’t tie up working capital for a contractor.
“What is driving demand is that construction and mining investment is still plentiful in Australia, and most of it requires bonding,” he explains. “Contractors are looking at more efficient and cost-effective ways to recycle capital in these constrained times.”
Peter Stening, who brokers surety bonds with the Stening Simpson Group, agrees that sureties are booming. “We have seen a huge increase in business since the GFC,” he says, adding that sureties bond sales have increased by more than 100% over the past five years.
Stening says that one of the key reasons that surety bonds have become a more attractive alternative to bank guarantees is that they have become more cost-effective.
“Yes, they free up capital for a contractor, but the premiums are now more competitive, and bank guarantees are just not cost-effective in comparison,” he says.
He warns that the product is complex and requires financial market expertise rather than insurance expertise. “A lot of work goes into administering surety bonds and they are certainly a specialist product.”
Mark Coulson heads Australian Contract Guarantee Services – a Perth based specialist brokerage dealing solely with surety bonding. Coulson is an accountant and says that his finance background has been invaluable in this role.
“Surety bonds are far more like a corporate finance product than an insurance product, so having a finance background is pretty crucial,” he says.
Coulson says that mining services companies are one of the biggest users of surety bonds (these cover a range of work, including civil engineering, construction and engineering). Other key industries using surety bonds include waste management, IT contracting and property development contractors, as well as the traditional commercial construction space.
“Surety bonds will suit any contract that’s performance based and services a large government or corporate client; anywhere there is a performance security component,” Coulson explains.
Vero has offered surety bonds since 2006. But while surety bonds are widely accepted – they secure an estimated 10-12% of commercial construction projects in Australia and are used by all Tier One construction contractors – Darren Beames, Vero’s National Manager, Surety, says the product isn’t well understood by most brokers.
“SURETY BONDS GENERALLY HAVE A VERY LOW CLAIMS FREQUENCY DUE TO THE NICHE MARKETS THEY SUPPORT”
Surety bonds generally have a very low claims frequency due to the niche markets it supports, he says. “Once a bond is paid to a principal, the insurer seeks indemnity under its recourse arrangements (typically unsecured) of the sum from the contractor.”
In terms of increased broker understanding, Beames says there’s room for improvement. “There’s definitely an education process needed, although some larger brokers have a specialist in the product.”
Vero works hand in hand with brokers to help set clients up with a surety bonding facility, Beames says, adding that it is a very ’high-touch’ product.
“We don’t offer one-off bonding, “he explains. “We go through a very thorough underwriting process, so we’ve got a high degree of understanding of the client’s business.”
Getting a surety bonding facility approved is quite an achievement, Beames says, noting that surety bonds won’t be approved unless a client has a solid track record.
“Being a long-term arrangement, we’re looking for the ongoing viability of a company and their ability to perform and deliver on contracts.”
A Group General Manager, Credit & Surety for QBE, Richard Wulff provides surety bonds tailored for large private, ASX-listed and multinational corporations across a diverse range of industries, including engineering (mechanical, civil, electrical), general commercial building, manufacturing, data centre management, waste services, and communication projects. QBE has been in the surety bond market since 2000.
“Market profile, combined with a lack of knowledge, is the only obstacle the surety bond product faces,” says Wulff.
“Bank guarantees have been the default security for many corporates (both issuers and beneficiaries alike) for many years, so changing years of company policy and practice can be challenging – but we are winning”.
Wulff says that the majority of QBE’s surety-related business is via the broker channel.
“It’s fair to say that surety is seen as a specialist or niche product, that many have heard of but only some brokers have actually had experience or have clients with surety bond exposure.”
“However this is changing, with many companies hearing of the benefits of surety bonds and approaching their insurance broker to investigate the suitability of the QBE product for their client.”
Adrian Karle, Head of Credit & Surety, Political Risk, at Swiss Re in Zurich, agrees that there’s a role for brokers, but reiterates the need for financial expertise.
“Surety is often originated direct without a broker because it requires expert know-how to successfully write it,” he says.
“Brokers are a reality of the market. They can play an important role in this line of business but need to have the necessary surety and market know-how to add value.”
“BANK GUARANTEES HAVE BEEN THE DEFAULT SECURITY FOR MANY CORPORATES FOR MANY YEARS, SO CHANGING YEARS OF COMPANY POLICY AND PRACTICE CAN BE CHALLENGING – BUT WE ARE WINNING”