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There are some excellent bonding companies that help contractors by using collateral to support the underwriting. However, there can be areas of difficulty that pop up. Let’s take a look at the role collateral plays in surety bonding and go over the important elements.
What Is It?
Collateral is a security deposit the bond applicant gives to a surety (bonding company) to gain approval of a bond that is somewhat difficult. The purpose is to lessen the surety’s exposure and make supporting the bond more palatable.
Forms of Collateral
The most common form of collateral is an Irrevocable Letter of Credit (ILOC) issued by a commercial bank. Also called a Standby Letter of Credit, it is based on the credit of the bond applicant, with the surety as the beneficiary.
The ILOC states that, upon demand, the bank will make payment to the beneficiary up to the face amount of the letter. Such payments are then recorded as a loan to the bond applicant. If the surety experiences a bond claim or has a loss, they can gain immediate recovery through the ILOC. This protects them from delay or failure of their subrogation (collection) efforts.
Other forms of collateral could be cash, a Certificate of Deposit that is assigned to the surety or even real property if it is professionally appraised and free of encumbrance.
Typically bonding companies require collateral before the performance bond is issued.
When a bid bond is initially required, usually a promise to give collateral is sufficient. The actual instrument is conveyed prior to the performance and payment bond.
Determine the Amount
Surety underwriters will make a decision regarding the amount of collateral required. It is normally a percentage of the related contract amount. Typical collateral amounts range from 20 to 40% of the contract. In unusual cases, the underwriter may require full collateral (equal to the contract amount) in order to issue a P&P bond.
One collateral instrument can support multiple performance bonds issued in succession, assuming the collateral amount is sufficient. Let’s look at how this works:
Assume 20% collateral is required on a $500,000 contract, therefore $100,000.
When the second bond for $200,000 is needed, the Work In Process schedule reveals that job #1 is now 50% complete. This could mean that half of the original collateral is available to support the new bond. Is the amount of available collateral enough for the second bond? (.2 x 200,000 = ?)
Unless there are problems on the first project, the underwriter may calculate that $50,000 is now available, which is more than 20% of the new contract, and therefore sufficient.
If things are going smoothly, this is the manner in which collateral is rolled forward onto new contracts. The transactions are handled internally by the surety – no action required by the contractor. If the jobs come in rapid succession or a big one is presented, additional collateral may be needed.
Releasing The Collateral
The underwriter will not release the collateral until the surety is exonerated from all bond obligations. How this is determined is often a subject of discussion.
If only one bond was written, it is worth noting that the underwriter will not give partial releases as the work progresses. In other words, when half the job is finished, half of the collateral is not released. The assumption is that it is impossible to predict the amount of a future claim. The underwriter does not know how much collateral they can afford to release. To be conservative, they hold the entire amount until the end.
So when is “the end?” When a performance and payment bond is written, the end is not at the end of the project as would seem logical.
The surety is equally obligated under both the payment and performance bond. Their exposure continues for the duration of the lien period (time allowed for suppliers of labor and material to make claim.) This is often 90 days after completion or delivery of the work.
Contractors should be cautioned that underwriters are in no hurry to give back collateral, particularly if they do not have a continuing relationship with the client. Understandably, their only concern is that they conclude the bond obligation without loss.
It can be difficult to conclude a collateral relationship, especially if a series of bonds has been issued. It may be easier to take a new bond from the old collateral market than to move to a non-collateral surety.
The most beneficial use of the collateral funds is with the old surety. Even if the contractor starts obtaining bonds from a new carrier, the collateral dollars remain tied up until the last bond is exonerated. This can be a disincentive to changing markets, even when more beneficial terms are available.
Solvency Of The Surety
If the surety goes out of business, the collateral funds should be in a separate, protected account. However, there have been cases where collateral markets shut down, causing great anxiety for their bond clients. When additional parties become involved such as the state insurance department and a bankruptcy court, it can only add to the delay in processing a collateral release.
Money Tied Up
Bonding companies realize that completion of the work may be more difficult when they deprive the contractor of a liquid asset. The cash that is given as collateral, or that backs the ILOC, is out of circulation for the contractor. However, they continue to be the owner of the cash. The asset is still shown on their financial statement and to that extent may help in future bonding and banking relationships. Cash that has been pledged or dedicated in his matter is identified as “restricted cash” on the balance sheet.
Collateral may be a necessity in some cases. There are contractors whose business financial statement looks weak, but they have other resources. For them, collateral is not a burden. And it may be the best solution available.
Other companies are distressed and can ill afford to give up liquid assets. They need them to conduct company business. In these cases the underwriters may ask themselves “Will the collateral requirement make it difficult or impossible for the contractor to perform the project?”
- Coming up with the collateral
- Operating without this asset available (if you really need it to survive, the surety will probably not release it!)
- Getting the collateral released promptly
- Graduating to a non-collateral surety
Underwriters must determine the prudence of requiring collateral and the amount.
Contractors must weigh the risk / reward of using this method.