Presentation to Insurance Regulatory. August 4, 2014

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A Primer on Surety Bonds A Primer on Surety Bonds

Presentation to Insurance Regulatory Examiners Society

Examiners Society

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State Legislative Issues:

Surety Bonds Surety Bonds

Lenore S. Marema

Vice President—Government Affairs Vice President—Government Affairs

The Surety & Fidelity Association of America

Surety and Fidelity Bonds: Protecting consumers, taxpayers, and businesses.

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Background

• A trade association of 450+ insurance companies that plays a leadership role in promoting and

preserving use of surety and fidelity bonds to protect public and private interests

b ll i l i j i

• SFAA members collectively write vast majority of surety and fidelity bonds in United States

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Functions

• SFAA is a state-regulated entity for the following functions:

• Serves as advisory organization for surety &

fidelity

--rate/loss cost and form filing

• Serves as statistical agent for surety & fidelity data

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• Surety Basics:

The Number One Thing You Need to Know

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A Primer on Surety Bonds

Surety bonds are a unique form of insurance

• Surety is a three-party product compared to y p y p p traditional two-party insurance contract

• Sureties prequalify risks rather than spread losses

• A surety incurs a loss only if principal fails to

perform its obligations and cannot reimburse surety

• Surety is generally a mandatory product not a voluntary purchase

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Surety as a 3-Party Contract

Obligee Principal

Suretyy

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Surety as a 3-Party Contract

• Surety is a specialized form of insurance in

which one party guarantees performance of an obligation of another party

obligation of another party

– Principal/obligor is party that undertakes obligation – Surety guarantees that Principal will perform

Obli i t th t i b fit f f

– Obligee is party that receives benefit of performance

• In traditional insurance, risk is transferred to insurer

• In surety, risk remains with Principal (bond is for protection of obligee)

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Prequalification of Risks

• Surety underwriting is based on technical

capability of surety to evaluate risks in order to avoid any losses

• Surety is more like a credit transaction (emphasis

i lifi i d l i )

is on prequalification and selection)

• If there is an appreciable likelihood of loss, t ill t it b d

surety will not write bond

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Claims Under Surety Bonds

• A surety suffers a loss only if principal defaults on its obligation and cannot reimburse surety

• Surety theoretically is written to a zero loss ratio

• In traditional insurance, underwriter takes into consideration that a certain portion of premium will be paid out in losses

• In surety, premiums are charged for use of

surety’s financial backing and guarantee (cost of idi l )

avoiding loss)

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Surety Premium Volume

• Surety and fidelity premium volume is between 2% and 3% of property-casualty p p y y insurance industry

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3 Types of Surety Bonds

Contract surety

• These are bonds that contractors have to provide p under state and federal law to assure that a

construction project will get done on time and

di h d h

according to the contract and that everyone working on the job will be paid

M t f t i i t t t

• Most of surety premium is contract surety

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3 Types of Surety Bonds

Commercial surety

• These are bonds that public entities require of p q

individuals or entities as a condition for a license or a permit to engage in specified activities or to

h i h i li i h l d

otherwise assure their compliance with laws and regulations

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3 Types of Surety Bonds

Fidelity Bonds

• These bonds provide indemnification for insured p from losses caused by dishonest acts of

employees

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Contract Surety

• Bid Bonds

– Guarantee that contractor intends to enter into contract for bid amount and will provide required bonding for job

• Payment Bonds

– Guarantee that contractor will pay subcontractors, suppliers and laborers

• Performance Bonds

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Contract Surety

• Amount of bond is usually 100% of contract price

• Premium is .5% to 2 % of the bond amount

• Public owner usually reimburses the bond

principal for the premium in the first draw on the job so that it is a cost of public construction.

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Prequalification

Character Capital Capacity

• Reputation

• Relationships

• References

• Financial statements

• Working capital

• Resumes

• Contingency plan

• Business plan • References Working capital

• Work-in-progress

• Indemnity

• Business plan (short & long-term)

• Equipment

y q p

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Surety Basics

• Why prequalify contractors on public projects?

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Contract Surety

• The cost of surety bonds

– Bid Bond (No charge)

– Performance Bond (0.5% to 2% of contract price) – Payment Bond (Price included with performance

b d) bond)

• In contract surety, obligee ultimately pays for bond

bond

• Amount of bond is usually 100% of contract price

price

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Example Surety Bond Rates

Project Amount

• $1 million

Bond Premium

• $7,700-$13,500

• $5 million

• $10 million

, ,

• $33,200-$47,250

• $56,950-$81,000

$

• $20 million

$ , $ ,

• $101,950-$146,000

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Commercial Surety

• License and permit bonds

– Guarantee compliance with laws and regulations

• Judicial bonds

– Appeals; attachments; injunctions

• Fiduciary bonds

– Probate; bankruptcy trustee; executor; guardian

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Commercial Surety

• Public official bonds

– Sometimes are fidelity bonds

• Miscellaneous bonds

– Endless garden variety—workers comp self-insurance;

income tax bond; lost securities

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Commercial Surety Underwriting

• Statutory obligation being bonded

• Bond form—terms and conditions

• Evaluation of principal

• Role of bond amount

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Commercial Surety Underwriting

• Bond premium generally is a fixed percentage of bond amount

• For many commercial bonds, there is an annual premium

• Bond principal pays the premium for most bonds

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Fidelity Bonds

• These bonds protect against loss from employee dishonesty

• There are few, if any, state legislative or other issues related to fidelity bonds because most of

i b i fid li b d f d l

requirements to obtain fidelity bonds are federal for federally regulated entities

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• Why prequalify those applying for state licenses?

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• Availability: I cannot get a bond

• Not everyone is supposed to get a bond—

prequalification prequalification

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• Cancellation of Bonds

• Contract surety bonds cannot be cancelledContract surety bonds cannot be cancelled

• Cancellation of a commercial surety bond often is a good thing

often is a good thing

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• Form Filing Compliance

• The public entity that requires the bondThe public entity that requires the bond promulgates the form

• Form filing requirements would result in

• Form filing requirements would result in multiple filings of the same bond form

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• Claims Issues

• Surety bonds are exempt from the unfairSurety bonds are exempt from the unfair claims settlement practices laws and

regulations in most states just like other regulations in most states just like other three-party coverages—health; workers comp

comp

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• Rates

• All SFAA’s loss cost filings areAll SFAA s loss cost filings are countrywide data

• Companies file deviations

• SFAA as an advisory organization is

i d fi

examined once every five years

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Market Conduct Issues

• Fraud

--Individual suretiesIndividual sureties --fraudulent bonds

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• A Unique Surety Bond

• Contract between surety and bail bondContract between surety and bail bond agent requires the agent to indemnify the surety for all losses paid

surety for all losses paid

• The surety underwrites the bail bond agent not the criminal defendants agent—not the criminal defendants

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• The relationship between the surety and agent is the guarantyg g y

• The risk of loss primarily is on the bail bond agent

agent

• The bail bond agent retains a large part of the premium

the premium

• The surety is left with a premium minus

i i h fl i l i k

commission that reflects its actual risk

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• Rates generally are statutory

• The claim is made on the bail bond agentThe claim is made on the bail bond agent who has taken collateral

• The agent looks to the criminal defendant

• The agent looks to the criminal defendant and third party indemnitors to recover if the defendant fails to comply with terms of bail defendant fails to comply with terms of bail

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• Agency Agreements are the Key --How bail bonds are UnderwrittenHow bail bonds are Underwritten -- Reporting of bail bonds

H h b d S d

--How the bonds are Secured

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• Indemnity Agreement requires a Build Up Fund

• Surety holds 1% or more of the premiums of each bond to assure that the agent will be of each bond to assure that the agent will be able to pay all losses

• Sureties have segregated accounts for each

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• Power of Attorney(POA) grants the agents the authority to execute a bondy

• Sureties commonly control the highest penal sum and create a fixed aggregate penal sum and create a fixed aggregate authority

• A POA must be attached to each bail bond

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• Sureties placed identifying numbers on each POA given to an agent and give agents g g g g

POAs in different denominations

• When the POAs are attached to the bondsWhen the POAs are attached to the bonds and reported to the surety, the surety can assess its overall liability by calculating the assess its overall liability by calculating the

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• Sureties can calculate and control the stock of unused POAs

• Sureties require an accounting when the agent asks for a new stock of POAs

agent asks for a new stock of POAs.

• The agent must remit premium to the Back Up Fund when issuing a double another Up Fund when issuing a double—another double check for the surety

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• Other Controls Sureties Put in Place

--How agents takes and holds collateral andHow agents takes and holds collateral and when it must be returned

Sureties require periodic reporting of --Sureties require periodic reporting of

bonds executed and payment of premiums to the surety and the Build Up Fund

to the surety and the Build Up Fund

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• Missing POA—in a numbered sequence- assumed attached to a bond

• Courts send notices of default to the surety

• Failure to report a bond issued is a warning

• Failure to report a bond issued is a warning sign

Th ’ i f f

• The surety’s experience of percentage of defaults vs the agents’ records

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• Based on SFAA’s experience:

– Examinations of sureties largely are financialExaminations of sureties largely are financial exams to determine the controls in place with the agents

– Market conduct exams most often are of agents/agencies

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Parting Shots and Questions

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