Performance GuaranteesShort-term

Surety bond business

Surety bonds are an essential conduit in promoting and sustaining the commercial activities, inter alia, construction, trade and commerce, within the economy. They serve to guarantee fulfilment of contractual obligations of one party to the other.

According to the FSB figures, guarantees (consisting of surety and credit insurance), as a broad line of business in the South African market, generate approx R1,7 bn (2008) in premium income. Although the performance may appear encouraging at around 50%, this class of business is prone to volatility as it is driven by the economic cycle. Thus this business has a direct correlation to the economic trend. The situation interdependency was more evident during the recent years of recession when liquidations were on the increase particularly on the smaller construction companies, whilst major construction groups survived on the strength of their healthy order books.

Surety is a specialised line of business with considerable accumulation of exposure on any one risk, hence the need for prudent and application of best underwriting practice. Adequate risk pricing is therefore a clear requirement.

It has been observed that minimal cognisance is given to the contractual documentation to mitigate unprotected exposure.Considering the wide breadth of forms of guarantees, it is imperative to pay special attention to sections of the wording identifiable as critical focus areas for the management of exposure in Surety business, namely, the scope and period of cover. Such prudence will ensure that cedants don’t lend themselves without cover due to a breach of the terms and conditions.

It is imperative that the class/type of business section outlines, without ambiguity, the type of guarantees that can be automatically written under the treaty. Guarantees may vary according to their risk nature and complexity and are classified into three categories, namely:

· Contract bonds being traditional construction bonds: Bid bond, Performance bond, Maintenance, Advance payment bond, preferably in conjunction with a performance bond, retention bond and materials and labour bond

· Commercial bonds (Customs and Excise bonds)

· Miscellaneous bonds mainly regarded as hazardous in nature: Judicial and fiduciary bonds, payment/credit bonds, supply bonds, concession bonds, environmental types of bonds, rental/lease bonds, and travel bonds, amongst others.

The difference between these categories lies in their different risk intensity. While risk adequate pricing is mandatory to earn equitable margins, prudent risk selection on the basis of risk intensity would complementarily provide sustainable margins. The Miscellaneous Bond types present a higher risk category than the other two on the basis that they are more exposed to moral hazard and dependent on a given liquidity than a performance obligation. Furthermore, alignment of interest on miscellaneous bonds is unpredictable and may suddenly switch, owing to other more favourable conditions. Risk carriers should stay alert, remain cautious and obtain clarity in instances of ambiguity rather than make own assumptions.

In the same vein, surety business requires an efficient and easy to administer reinsurance structure that is amenable to simplicity in terms of cessioning practice. Bonds are issued and ceded to facilities at different inception dates which results in fluctuations in exposures, creating complexity in administering proper cessioning to the obligatory facility. Ideally, a Quota Share is best if not the only suited reinsurance structure to overcome such challenges.

A surety guarantor does not provide insurance, but only assumes a contingent liability. Hence, the underwriting of this line of business should be designed to achieve no claims outflow other than triggered by:

· Claim of the Beneficiary on the surety due to breach of contract by the principal

· Insolvency of the principal (final Loss)

Traditionally surety bonds by law are accessory/conditional to the obligations between the principal and the beneficiary, in terms of the underlying contract. A surety bond should always be linked to the underlying contract, hence, the surety is said to assume a contingent liability.

Empirically, there is a developing trend in the surety market, whereby guarantees are issued for the same purpose as a surety bond; however, one needs to be mindful that a guarantee creates a primary obligation and is payable on demand in the happening of the event and the obligation created is independent of the underlying contract. In the case of a guarantee, the surety is deprived from making any reference to the underlying contract. Hence, this form of guarantee is not acceptable from a reinsurance perspective, particularly on the basis that the performance of the principal or employer is not governed by the underlying contract, and it makes the contract meaningless if either party is unable to refer to it in order to ascertain where and how the breach arose.

Therefore, employers and guarantors need to have a clear understanding of the nature of the obligation they are intending to create when transacting surety business: is it that of a principal or accessory nature to the underlying contract? Ambiguity may result in unfair callings of the bonds and inevitably in complex litigation.

Let’s all embrace a collaborative approach in creating a value-adding product for the benefit of our economy.

Munich Re Group experts, both locally and from the wider Group, are well equipped to provide assistance in our market when needed.

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