If you are involved with bid and performance bonds for contractors, you may hope to avoid collateral transactions. But if you ever do get into this area, there are things you need to know. Let’s take a look at the role collateral plays in surety bonding and go over the important elements.
What Is It?
Collateral is a security deposit the bond applicant gives to a surety (bonding company) to gain approve of a bond that is somewhat difficult. The purpose is to lessen the surety’s exposure and make supporting the bond more palatable.
Forms of Collateral
The most common form of collateral is an Irrevocable Letter of Credit (ILOC) issued by a commercial bank. Also called a Standby Letter of Credit, it is issued based on the credit standing of the bond applicant, with the surety as the beneficiary.
The ILOC states that, upon demand, the bank will make payment to the beneficiary up to the face amount of the letter. Such payments are then recorded as a loan to the bond applicant. If the surety experiences a bond claim or has a loss, they can gain immediate recovery through the ILOC. This protects them from delay or notarizations failure of their subrogation (collection) efforts.
Other forms of collateral could be cash, a Certificate of Deposit that is assigned to the surety or even real property if it is professionally appraised and free of encumbrance.
Typically bonding companies require collateral before the performance bond is issued.
When a bid bond is initially required, usually a promise to give collateral is sufficient. The actual instrument is conveyed prior to the performance and payment bond.
Determine the Amount
Surety underwriters will make a decision regarding the amount of collateral required. It is normally a percentage of the contract amount that requires bonding. Typical collateral amounts range from 20 to 40% of the contract. In unusual cases, the underwriter may require full collateral (100% of the contract amount) in order to issue a P&P bond.
One collateral instrument can support multiple performance bonds issued in succession, assuming the collateral amount is sufficient. Let’s look at an example of how this works:
Assume 20% collateral is required on a $500,000 contract, therefore $100,000.
When the second bond for $200,000 is needed, the Work In Process schedule reveals that job #1 is now 50% complete. This could mean that half of the original collateral is available to support the new bond. Is the amount of available collateral enough to issue the second bond? (.2 x 200,000 =?)
Unless there are problems on the first project, the underwriter may calculate that $50,000 is now available, which is more than 20% of the new contract, and therefore sufficient.