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Why is Collateral Needed on Surety Bonds?

By J. Mark Strange, Surety Advisors, LLC, Bonding Agents

Collateral is rarely popular with applicants but may be needed to reduce the risk of a bond loss. Technically collateral is used to support the applicant's indemnity or agreement to repay the surety if it has to pay a claim. Surety bonds are not insurance. While losses do occur, premiums are mostly used to pay the sales and analysis costs of writing the bond.

A common misconception is that collateral is appropriate for financially distressed individuals and firms. If the applicant files bankruptcy the surety could lose its rights to the collateral. The most appropriate use of collateral is on bonds that traditionally have high claims frequency like defendants court bonds or appellate bonds, tax lien bonds, or release of lien bonds. If there is a high percentage chance (80% on appeal bonds) of receiving a demand to pay and the bond principal will have to repay the bonding company, it makes good business sense to request the money in advance. (Refer to our report on "Cash vs. Collateral" for information on the benefits of posting bonds).

Another justifiable but sometimes self -defeating use of collateral is for applicants with good credit and experience but who may not have the financial strength in relation to the size of the bond. In the case of a contract bond it seems counterproductive to tie up cash that could be used to fund a job or for emergencies.

When collateral is accepted the applicant/bond principal must sign a collateral security agreement which describes the terms under which collateral will be held and distributed either as a payment for a claim, applied to unpaid renewal premiums or returned when the bond is released. All collateral must be received before a bond will be issued.

Collateral is often held past the cancellation or release date of the bond. In some cases the obligee (bond beneficiary) can make a claim on the bond for a year or more (as long as 18 months) after it has cancelled.

The amount of collateral held by a surety can fluctuate with the bond amount. For instance some judges may order appeal bond amounts to increase or decrease as evidence warrants. Performance and payment bond amounts can increase due to large change orders.

Generally Unacceptable Collateral:

Certificates of Deposit (CDs)- Fewer sureties are accepting CDs because the maturity dates of CDs rarely coincide with the bond term. This mismatch causes collateral to be either held longer than needed or prematurely liquidate and incur penalties.

Government securities, blue chip stocks and bonds, gold and silver bullion- In the past have been considered acceptable collateral. Over time market fluctuations have proven them unreliable security for most bonding companies.

Physical assets like cars and boats are not acceptable due to a lack of liquidity and cost of storage.

Acceptable Collateral:

Cash- Held by the bonding company in an FDIC insured bank account on behalf of the bond principal, some sureties offer interest which can be used by the bond principal to defray the cost of the bond. The surety is not allowed to invest the money in other financial vehicles having greater yield and risk.

Irrevocable letters of Credit (ILOCs)- The preferred collateral because of their durability in bankruptcy proceedings, liquidity, term flexibility and conditions, ILOCs must be on the surety's form and only in rare instances is the wording modified. Most sureties only accept ILOCs from financially approved FDIC banks.

For more information on collateral issues contact an insurance agency specializing in surety bonding. Surety Advisors, LLC, www.suretybondservices.com, is a bonding agency in Houston, Texas whose specialty is contract, license, permit, probate, court and fidelity bonds.