The Mysterious World of Surety Bonding

The Mysterious World of Surety Bonding

The Mysterious World of Surety Bonding Robin Federici, CPCU, AAI, ARM, AINS, AIS, CPIW PO BOX 781 NORTH KINGSTOWN, RI 02852 Phone: 401-294-3557 Fax: 401-294-3557 Robin s Cell-401-529-9617 Fred s Cell-401-524-4567 E-mail: ROBINF@IETA.BIZ EFEDERICI@IETA.BIZ Web site: WWW.IETA.BIZ 1

This material has been designed for use in training programs for insurance industry personnel. It is not intended to be used as a complete reference resource on the programs and coverages outlined herein. The program uses standard policy forms and endorsements for the purposes of discussing the exposures to loss that may exist, some of the coverage options available to treat them, and to provide a framework for discussions with carriers you represent concerning the programs they have available. Coverages, rules and materials presented during this program may differ from those used by individual insurance companies. Contact individual carriers for details about interpretations of their eligibility requirements, particular insurance contracts and rates. Copyright 2014 by Insurance Education & Training Associates, LLC. All rights reserved. This document or any part thereof may not be reproduced or utilized in any form or by any means, electronic or mechanical, including photocopying, recording, or by any information retrieval system, without the express written consent of Insurance Education & Training Associates, LLC. Inquires should be addressed to: PO Box 781, North Kingstown, RI 02852 E-Mail: robinf@ieta.biz. 2

SURETY INTRODUCTION Surety Bond - a written contract where one party guarantees another party s performance for a third party. The two basic types of surety bonds are as follows: Contract surety bond - guarantees the performance of a bonded contractor Commercial surety bond - guarantee performance in situations that arise from other than contracts Parties to the Contract: The principal - the party who will be performing a contractual obligation The obligee - the party to whom the principal owes a duty and who will benefit from the guarantee The surety the party who ensures that the principal s obligation will be performed Through this agreement, the surety agrees to uphold for the benefit of the obligee the contractual promises (obligations) made by the principal if the principal fails to uphold its promises to the obligee. Surety Bond Characteristics: 1. The surety must respond 2. The surety vouches for the principal 3. Terminates when principal completes obligation 4. Bond penalty (limit) 5. A premium is required 6. Must be in writing 3

SURETY CHARACTERISTICS Surety Response: When the principal fails to fulfill their obligation to the obligee the surety must respond. The surety can either fulfill the obligation or pay the loss up to the bond penalty. However, unlike insurance, the principal must indemnify the surety. This right of reimbursement is granted to the surety by common law subrogation. Surety Vouches for the Principal: Character: Reputation Professionalism Capacity- Ability to meet the obligation: Staff Skills Equipment Capital- financial analysis: Economic capital A surety may require the posting of collateral equal to or part of the bond penalty: Acceptable collateral can take many forms: o Letter of credit the underwriter may require certain wording o Investment Securities the underwriter may want a cushion as a hedge against possible market fluctuations o Certificates of Deposit/Savings account necessary assignment forms must be executed & there must be an agreement on whether the interest income will be accrued or paid out to the principal o If the collateral is delivered to the surety the surety will prepare & execute a collateral agreement. The agreement also serves as a receipt and must be returned to the surety when the collateral is no longer need and is returned to the principal. 4

SURETY CHARACTERISTICS Bond Termination: Usually terminate when the obligation has been completed Some bonds may be in effect for an indeterminate time Non-cancelable bonds terminate only when the obligation is fulfilled Bond Penalty: Limit of liability for the bond The maximum the surety is obligated to pay in the event of a loss Some bonds may specify payment of court costs and judgments above the penalty the surety will require collateral equal to 125% of the bond penalty Bond Premium: Premium or service fee represents the price for the surety s guarantee to indemnify the obligee For non-cancelable bonds the surety cannot avoid their obligation if the premium is not paid so the obligee is protected In Writing: Must be in writing to be binding and enforceable Cannot be bound orally 5

BOND TYPES- Commercial (Non-Contract) LICENSE & PERMIT BONDS: Required by federal, state or municipal government guaranteeing the performance of the laws, regulations, or ordinances The Surety Association of America (SAA) has created numerous classifications of license & permit bonds PUBLIC OFFICIAL BONDS (Non-Federal): Guarantee the faithful performance of the public official & for an honest accounting of all public funds handled With few exceptions, they are held personally accountable for losses, shortages, and damages to public property Some are also held accountable for the acts or omissions of those that are their subordinates COURT BONDS: Two main categories: o Judicial arise out of litigation & required by the courts. The bonds are posted by the party seeking or appealing a remedy in court. The obligee on these bonds is the court, for the benefit of the other party. o Fiduciary - arise out the care, custody or control of another party s property by the principal. The bonds remain in force until any applicable proceedings are completed and the principal & surety are released by the court. MISCELLANEOUS SURETY BONDS Bonds that do not clearly fit into one of the other classifications Many contain financial guarantee 6

BOND TYPES- Contract CONTRACT BONDS They serve two broad purposes: 1. Guarantee in the surety s judgment that the principal is qualified to fulfill the terms of the contract 2. Guarantee that, if the principal defaults, either the obligations will be performed, or that the surety will indemnify the obligee up to the amount of the bond penalty CONTRACT BONDS - OVERVIEW: Bid bonds: Obligee: Project owner or party calling for the bids Principal: Bidder Guarantee: If awarded the bid, will enter into the contract & will furnish all required bonds Performance bonds Obligee: Project owner or party having the work done Principal: Contractor Guarantee: Project will be completed on time and as outlined in the contract including within the agreed price Payment bonds Obligee: Project owner or party having the work done Principal: Contractor Guarantee: Bills for labor & material will be paid Maintenance bonds Obligee: Project owner or party having the work done Principal: Contractor Guarantee: Contractor will correct faulty work & replace defective material for a specified period of time 7

BOND PRODUCTION- FINANCIALS Contractors use two common methods of accounting records: 1. Completed contract method: All income and expenses for a particular project are not recognized until the year the contract is completed 2. Percentage of Completion method: Income reported on each project is based on the estimated percentage completed. Sureties prefer this method FINANCIAL STATEMENTS: Audited financial statements, by a CPA, are preferred Review statements may be acceptable. These have fewer tests applied Compilation statements arrange financial information with no tests of accuracy performed. INDEMNITY AGREEMENTS: Personal indemnity agreement (parent indemnity agreement) a contractor may provide these signed agreements to strengthen the financial health of a contracting firm. STATUS REPORTS: When the contractor will not provide financial statements using the Percentage of Completion Method the underwriter will require an alternative report known as Contract Status Report 8

BOND PRODUCTION- BACKGROUND INVESTIGATION Underwriters want to determine how a contractor met past contractual commitments To that end, they are interested in business, credit or professional relationships suppliers, subcontractors, lawyers, CPAs, bankers, etc. Contractors who fail this stage of the underwriting process do not receive further consideration Through credit analysis OTHER: Be prepared to provide a complete picture of the contractor. To that end, the underwriter may require some additional information. 9