As Business Booms, Surety Bonds Offer a Better Way to Hedge Risk
Global growth is back, with the US economy expanding nearly 3% in the last three months of 2017. But with boom times come added risk as well. Deals, projects, and litigation are all becoming more costly and complex.
Enter the surety market, which grew 6% in 2017, according to the Surety & Fidelity Association of America. The growing interest in surety bonds shows that companies not only want to mitigate financial risk, but are looking for the most efficient and cost-effective ways to do it.
What is a Surety Bond?
A surety bond is a contract involving three parties:
- A principal: The party that needs the financial support provided by the bond.
- An obligee: The party requiring that there be a bond.
- A surety: An insurance company guaranteeing that the principal will be able to meet its obligations to the obligee.
Companies are turning to surety bonds as an alternative to bank letters of credit when they need security to meet financial obligations. And they are doing so to meet a range of commitments. For example:
- To post collateral needed for large leases.
- In response to court demands for collateral when a company has been hit with an adverse ruling and wants to appeal.
- To satisfy collateral requirements for various insurance coverages, including employer-funded, self-insured workers’ compensation programs.
A major driver of the growing demand for surety bonds is borrowing capacity. Unlike a letter of credit, a surety bond does not count against a company’s overall borrowing capacity, which means it can free up capital and credit for more productive uses. Surety bonds also enjoy a cost advantage because their pricing is not tied to interest rate fluctuations. Letters of credit are, so their cost is rising as the Federal Reserve raises rates.
But a surety bond is about more than just cost. It generally provides better protection for the company that posts the bond, whether it’s a contractor working on a major project or a large corporation appealing a court judgement. And a surety bond helps you avoid being overly reliant on one or two large financial institutions.
Using surety bonds is not terribly difficult, and should be considered by any company with financial obligations to meet. To get started, look inside your organization to see where letters of credit are being used and for what purpose. You should then talk to your risk advisor, who can help you work with underwriters to determine your capacity for surety bonds. You’ll need to provide underwriters with detailed financial information and an overview of the financial obligations you intend to guarantee through a surety bond.
By using surety bonds, companies can expand their network of financial partners beyond the handful of banks that dominate the market for letters of credit. With the economy in growth mode, this is a good time to consider new options.