Surety Bonds

01 December 2014

One of the headaches in tendering for projects is the need to provide guarantees to cover performance and other security requirements. To accommodate cash flow management construction contractors normally need to provide bank guarantees for each project.

However, most banks will require collateral security and tend to restrict the maximum bank guarantee mix available from the contractor’s multi-option banking facility. These conditions can create a delicate balancing act for contractors to ensure they stay within their available limits and retain adequate borrowing capacity for cash flow purposes. 

However, for most contractors with a stable balance sheet and profitable track record, there is a viable alternative available. Surety / insurance bonds can serve the same purpose as bank guarantees to satisfy contract security and performance pledges and, unlike the bank solutions, generally don’t tie up assets as collateral security. 

Here is an example: a contractor with a net worth of say AUD 100 million wins a AUD 10 million project, and is required to lodge a performance bond for 5% of the contract value. A bank guarantee will reduce the contractor’s available bank facility by AUD 500,000 for the term of the contract and a sizeable deposit may also be required, tying up further cash. A surety bond – on the other hand – will not normally require the same security. It will be issued against the surety facility limit, so the contract can be entered into without tying up the contractor’s assets or impeding their cash flow. 

In a shifting regulatory framework requiring banks to maintain higher levels of capital adequacy, the concept of allowing insurers to ‘bond’ projects is becoming more appealing to sensible bankers, this is because bank guarantees, typically issued at much lower interest rates than operational loans, are less profitable for the banks.  

In the past, surety bonds were not as well known, so acceptability was patchy. This was largely due to the internal disconnect between the contractor’s commercial team, the insurance team and the treasury department. Because of the very tight timeframe for settling terms, most contracts included a generic ‘bank-centric’ clause covering the performance guarantee requirements. So without proper collaboration between the parties, we saw very little deviation from the traditional route. 

Now, longer-term strategic bonding solutions are being used. For instance establishing a surety facility with adequate headroom to ‘bond’ upcoming projects, which can be called into play as contracts are agreed. For this the three internal teams need to work together before the tender responses are submitted. 

There are plenty of potential pitfalls, so you will need a skilled broker to arrange your surety facility. For instance you can fall into the trap of dealing directly with an individual insurer only to discover their S&P rating is lower than the minimum acceptable rating required in the contract you subsequently executed. Your broker will also be able to advise you on arranging surety bonds within your broader package of insurances, generating potential to leverage existing relationships to achieve enhanced capacity and pricing outcomes. 

So, with the potential of considerable cost savings and an increasing number of private and public institutions willing to accept surety bonds in lieu of bank guarantees, we can expect to see their use rapidly broadening in the immediate future.

For more information please contact Steve Osborne, Managing Director, JLT Australia & New Zealand 

contact Steve Osbourne
Managing Director