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Surety Bond Collateral

October 22, 2021

In some circumstances, surety bond underwriters require the Principal to put up collateral in order to receive the surety bond. What exactly does this mean and what are the alternatives, if any? We discuss surety bond collateral in detail below.

 

Types of Surety Bond Collateral

 

There are several different types of collateral that can be taken by surety bond companies. Each has advantages and disadvantages. 

 

Irrevocable Letter of Credit Collateral

 

An Irrevocable Letter of Credit or ILOC is a guarantee from the Principal’s bank. When used as collateral for a surety bond, the ILOC is made out from the bank to the interest of the surety bond company. The bond company can make a demand on the letter at any time and collect money for the entire amount of the ILOC. The Principal has little or no say about the bond company drawing on the ILOC. Therefore, this is the most preferred type of collateral for a bond company because it can be very easily converted to cash in a claims scenario.

 

When a surety bond company takes an ILOC as collateral, they usually require that ILOC to be maintained during the bonded obligation and for a period of at least 6 months after. 

 

ILOCs have two major costs to the Principal. First, the ILOC is a form of credit so the lender will charge a fee for as long as the ILOC remains in force. Secondly, an ILOC has opportunity costs. A Principal cannot use the money or borrowings while the ILOC is in place. Therefore, this decreases the Principal’s potential liquidity. This can be a problem if the Principal is already having financial challenges. For those Principal’s an ILOC is one of the least desirable forms of collateral. 

 

Real Estate Collateral

 

Some surety bond companies will also take real estate as collateral. Often this is land, commercial property or even a Principal’s personal residence. In order for collateral to be an option for most surety bond companies, it must be free and clear of any debts or liens. A Surety Bond Company does not want to be in a second position in a claim situation. 

 

The big advantages to using real estate for collateral are time and costs. Often, a surety bond company can take this type of collateral very quickly without having to get approval from a lender. Secondly, the Principal can use an asset they already have without having to go borrow money and potentially hurt their liquidity. 

 

Unfortunately, these assets are not always easy to value or sell in a claim situation. Therefore, not all surety bond companies will accept real estate for collateral. Additionally, a Principal really needs to consider situations when they are asked to put their personal residence as collateral. By doing so, they may be giving up other protections they have for their residence under the law.

 

Marketable Securities Collateral

 

Some surety bond companies will take collateral on marketable securities such as stocks, bonds, ETFs and mutual funds. This can be a benefit to the Principal as they can continue to get a market return on these assets while they are being tied up as collateral. 

 

However, most surety bond companies that accept this form of collateral will require it to be moved to a brokerage and account of their choosing. They want to make sure they have access to it in a claims situation and that the Principal cannot withdraw it without the surety’s permission. Retirement accounts cannot be used as collateral as surety bond companies cannot usually get access to the funds.

 

Secondly, if this type of collateral is accepted, it must usually be in well established blue chip funds or stocks that are easily liquidated. Finally, it is also common for the surety to require that the account be overcollateralized to protect the surety from any market losses. For these reasons, marketable securities are often not a preferred method by either Principals or Surety Bond Companies. 

 

Cash and Cash Equivalents Collateral

 

Cash and Cash Equivalents such as CDs are rarely taken as collateral. A surety bond company would prefer that a Principal use those funds to obtain an ILOC instead. 

 

Amounts of Surety Bond Collateral

 

A Surety Bond underwriter may ask for collateral in almost any amount depending on the financial strength of the Principal and the risk and duration of the bond. 10%, 20% or even 50% can be common. However, in extreme circumstances, even 100% may be required. It almost never makes sense to provide 100% collateral unless all other options have been exhausted. If a Principal is going to put up 100% collateral, they may need to make a decision on whether it makes more sense to just post an ILOC directly with the obligee. There are reasons that may not make sense though. You can read more about surety bonds versus ILOCs here

 

When is Surety Bond Collateral Required?

 

Surety Bond underwriters may require collateral in many cases. Common situations are below:

 

Principal Financial Difficulties

 

When a Principal’s financial strength is not enough to obtain a bond by itself, a surety may require collateral in order to provide the bond. In these situations, the collateral reduces the risk for the surety bond company. If the Principal’s financial situation gets worse and they cannot fulfill the obligation, the surety bond company has something to reduce the loss.

 

High Risk of Claims

 

Another reason collateral may be required is in instances when a claim on the bond is likely. An example would be in many court bonds such as appeal bonds. The Principal on the bond has already lost in court once and the risk that they will lose again is very high. Therefore, the surety bond company often requires these bonds to be collateralized. 

 

Another example of high risk claims are bonds that are straight financial guarantees or forfeiture bonds. The risk of loss on these bonds is significant and normally require 100% collateral in order to write them. 

 

Private Equity Ownership

 

Surety is written on the Principle of Indemnity meaning that they expect to be reimbursed in a loss scenario. When private equity investors purchase a company, the company often shows negative analyzed net worth from a surety bond perspective. The new company often has lots of debt and goodwill on the balance sheet. In addition, the new ownership is a group of investors and surety bond companies can almost never get the investors to personally indemnify for the new company. Therefore, collateral is often required for these companies to reduce the risk for the surety bond company. 

 

Long Term Obligations

 

Surety Bond companies typically do not like long term obligations. A lot can change over time and the longer the obligation, the more risk to the Principal and the surety. One way to reduce this risk is to require collateral from the Principal. 

 

International Surety Bonds

 

International Surety Bonds often require collateral. These bonds are highly risky to surety bond companies. International laws vary from country to country. Even if a surety bond company can get indemnity from the company, they may have no way to enforce getting reimbursed or it may not be possible to find a replacement Principal if a claim were to happen. Because of this, these international surety bonds usually require collateral. 

 

Alternatives to Surety Bond Collateral

 

There are some alternatives to using collateral for surety bonds. For contract surety bonds, the Principal may prefer using funds control instead of collateral. When possible, this frees up the Principal’s assets to be used for other things. You can read more about funds control here

 

Another tool that can be used for construction bonds, is the use of the SBA’s Surety Bond Guarantee Program. This program reimburses surety bond companies for a percentage of a Principal’s bond claim. This can encourage surety bond companies to write bonds for Principals without the use of collateral or other tools. 

 

It is important to note that in some cases, a surety bond company may want the Principal to use these tools in addition to collateral. Each case is different.

 

Collateral options for surety bonds can be difficult to understand. Axcess Surety tries to avoid using collateral whenever possible. We have lots of options for Principals and seek to avoid collateral requirements. Contact us anytime if you have questions on surety bond collateral or anything else surety bond related. You can also read our Surety Bond FAQ page here.

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