Specific industry risk can play a major role in how much capital an insurer is willing to put forward for commercial surety bonds, a speaker said during a recent webinar.
Industry risk is a “unique” underwriting consideration, Rob Dempsey, senior vice president of commercial insurance with Gallagher, said during the Sept. 15 webinar Using Surety Products to Improve your Balance Sheet. The webinar explored key underwriting considerations for commercial surety bonds, and how companies can protect their balance sheet with creative solutions to free up cash and improve liquidity.
As little as three or four years ago, cannabis was the “hot thing” for investment, and banking facilities were happy to invest, Dempsey said. “Today, unfortunately, it did not go quite as projected. The financing relationship is a little different for cannabis, but it also applied to bond. Unless you are investment-grade, it’s difficult to get a cannabis bond.”
By “investment grade,” Dempsey was referring to bonds that are believed to have a lower risk of default and therefore receive higher ratings by credit rating agencies.
Contrast the cannabis example with the situation in the mining sector today. Ten-plus years ago, it was “very, very difficult” to get a reclamation bond unless it was investment-grade, especially outside of Canada, Dempsey said. Nowadays, most sureties, or insurers, are “quite interested in doing reclamation,” he said. “In fact, some specialize in junior mines, not even an operating mine, but just for that future reclamation obligation. The industry can be a big factor on what sort of capital the surety is willing to put forth.”
During the webinar, Dempsey specifically discussed commercial surety, a newer on-demand payment bond structure that is meant to replace restricted cash or letters of credit (LOC), and that is different from traditional contract bonds. He also briefly outlined the three parties to the surety agreement:
The obligee: The party requiring the bond (such as the owner of the construction project)
The principal: the bond purchaser
The surety: The insurer backing the bond.
“With these financial times [and] economic uncertainty, use of bonds is critical,” Dempsey said. “I would strongly encourage it to de-risk your organization.”
Besides mining, other industries are learning how they can use bonds to spread out risks. For example, Dempsey said he is seeing a “growing trend” where more municipalities are willing to accept a bond as a different form of collateral. “That has changed the world dramatically for developers in those areas.”
Commercial surety bonds can also provide a competitive advantage to an owner or supplier. “If you are able to expand your interests beyond an LOC and use a bond, that helps your clients, or it helps your competitive advantage by making you a more appealing supplier to work with,” Dempsey said.
Other key underwriting considerations discussed during the webinar include:
Amendments: Sometimes the contract itself will need an amendment to accept a bond instead of an LOC as a form of collateral
Size of the bond: Bonds can go into hundreds of millions of dollars, and Gallagher even encountered one situation where the bond was up to $1 billion. “We’ve looked at some large obligations on behalf of our clients and come up with some pretty unique situations,” Dempsey said
Duration of the bond: The contract could be for several years, with reclamation or mining bonds tending to have the longest tail (i.e. the life of the mine can extend out to 25 years). In that case, the surety would have to project the cash flow of the organization for a long period of time
Credit rating of the organization: Includes the strength of the balance sheet
Political environment: In other countries around the world, political turmoil may affect bonding situations. Sureties have to underwrite that, as well as the potential environmental risks associated with different countries
Bonding wording required: Understanding the obligation the bond will create for principals or owners. “We go into a lot of detail understanding not only the contract, but the wording we are willing to provide,” Dempsey said.