It is a request many risk professionals dread hearing: “We need a surety bond.” Insurance professionals on the receiving end of this request know the drill: The client is entering into a business arrangement and the negotiations are winding down. Everything is coming together until the end when it comes to the agent’s attention that a surety bond is needed to complete the deal and they are unsure how to proceed.
The problem is that despite being a $16.07 billion market in 2019, surety remains a niche product many are unaware they need. For the uninitiated, a surety bond is a mechanism by which a company (the principal) guarantees to an entity (the oblige) that if the principal cannot perform the obligation for the obligee to which they have committed, a financially stable insurer (the surety) will make the obligee whole. The obligations that are bonded vary widely in amount, complexity and risk. For example, surety bonds are often used by governments to protect taxpayer funds.
While it pales compared to the insurance sector, the surety industry is nonetheless sizable. The global market for surety bonds is expected to grow at a CAGR of 4.4% from 2022 to 2031, with a projected size of $24.4 billion. With such a wide variety of obligations—virtually every city in the United States likely has some sort of unique surety requirement—it is highly likely that at some point, every risk manager will get a request for a surety bond. Therefore, risk professionals should have a basic understanding of what they are, how to obtain them, and when to bring in an expert in the form of a surety agent. The following are five questions one should ask when bonds are involved:
Who needs a surety bond?
If a business works with federal, state or local government, the answer to this question is, at some point, going to be “you.” While there are a multitude of bond needs, they generally come down to the following categories:
- Contracts or project work: In 2019, approximately half of all bonds issued on the global surety market were contract surety bonds. The common wisdom is that sticks-and-bricks contractors need these for traditional construction projects, which is true. However, risk managers must be aware of non-traditional work that may need to be bonded. Is the business contracting with governments or schools to provide goods, services or software? If so, they are likely going to be asked for a bond. A good rule of thumb is to be alert if the company enters into contracts with public or quasi-public entities.
- Licenses, permits, or other specific uses: All businesses typically have a need for these types of bonds that are required to do business. The majority are small license and permit bonds that can be obtained easily and at a low rate. However, other bonds are required for specific activities and can be much more difficult to obtain. It would be impossible to list them all, but if companies are engaging with a governmental agency for a specific business activity, a bond might be required for it.
- Legal or court issues: If a company is involved in any court cases—especially appeals—bonds may be required by the court.
What are the benefits of a surety bond?
The apparent benefit of bonds to a risk professional is that they will allow companies to do whatever activity that requires the bond. This could be the construction of a large project, opening a new business or location, providing guarantees to taxing authorities, or being able to bring or respond to a legal matter. For a company with significant needs, surety bonds can free up liquidity if bank letters of credit are used to secure obligations. Depending on the company's financial wherewithal, bonds are typically more affordable than credit facilities and can save companies’ credit lines to help grow their business in other ways.
Additionally, surety bonds can help in a more intangible way by providing reassurance to obligees (e.g., governmental entities, project owners) of financial security and regulatory compliance. The existence of a bond shows these third parties that the company has been vetted by an established insurance carrier that has determined that the bonded obligation is within the company's abilities. This has the double effect of enhancing the company's credibility in the marketplace while proactively minimizing potential risk and liability for the obligee.
When is the best time to purchase a surety bond?
Bonds are often an afterthought in the process of a commercial exercise. Depending on the complexity of the bond, the process to secure it may not be instantaneous, so it is best practice not to delay it. Small compliance bonds for a license can be acquired quickly. However, a performance bond for a large project is potentially another story. The underwriting process for larger and more complex bonds can be likened to a banking transaction. The business will have to provide financial, organizational and operational information to a surety underwriter, who will use that information to determine the feasibility of providing the bond. This can take some time to develop and review, so the more lead time businesses can provide the surety company, the better.
Risk managers should be proactive in determining whether bonds are required any time a new venture or project is being contemplated. Just as one would not overlook the insurance requirements in these instances, they must also ask whether any bonds are necessary.
Where can surety bonds be purchased?
The traditional outlet for obtaining surety bonds has always been the independent insurance agent. Agents are a great source of knowledge about carrier appetites and capabilities and play a crucial role in the placement of surety bond programs. However, there are now online systems that allow an agent—or even the client themselves—to purchase a bond quickly and with little friction. This channel is increasingly important for small compliance types of surety bonds that do not need much agent interaction, allowing clients to self-service these relatively easy obligations. On the other hand, larger bonds or programs for frequent bond users are best obtained by leveraging the expertise of an agent who is well-versed in surety. Risk professionals should consider the complexity of the need when deciding which mechanism to use to obtain their bonds, as the path of least resistance varies by the obligation and/or size of the bond.
Furthermore, digital surety platforms provide an additional layer of security to reduce the risk of fraudulent or unauthorized actions. Through the employment of multi-factor authentication, data encryption and digital storage, these platforms ensure every step of the bond issuance process can be traced and verified to prevent any loss or unauthorized access of clients’ personally identifiable information.
Why is digitization important for surety bonds?COVID-19 accelerated the acceptance of electronic signatures on surety bonds, which was a welcome advance in the industry. While some obligees insist on paper documents, the number of bonds that can be electronically signed and filed in some cases continues to increase. This reduces costs by eliminating the need for overnight or courier services and cuts the time it takes to issue and deliver a bond. Moreover, electronic bonds are safer to store, so obligees do not have to worry about fires or natural disasters destroying their records. Digitization allows for a seamless and easy process to obtain bonds. The surety industry is also exploring other concepts, such as blockchain, to make it easier to obtain this product.