Business owners are constantly challenged to drive profitability and meet obligations to lenders. Traditionally, irrevocable lines of credit (ILOCs) have been a necessary tool of choice by small and midsize business owners to manage risks and meet obligations. Yet, surety bonds are another available tool – and while similar in some respects to ILOCs, they offer six key advantages for business owners over ILOCs.
Today, more and more businesses are recognizing the value of surety bonds over ILOCs. Why is that? In a May 2, 2018 Insurance Business article, David Hewitt, U.S. Surety Practice Leader, Marsh, stated that great concern has arisen in recent years over interest rates. As more clients sought alternatives to ILOCs, discussions and education surrounding surety bonds have increased, which in turn increased their popularity.
In the article, Hewitt went on to say, “The U.S. commercial surety market is experiencing growth that’s faster than the overall insurance market and faster than North American GDP growth. That’s largely due to increased use of the product as an attractive alternative to ILOCs…”
The article also cites consistently declining pricing of surety bonds for at least the past three years, and it highlights continued expansion of the overall market despite declining rates.
Before highlighting the advantages, let’s take a closer look at what surety bonds and ILOCs are, and how they differ.
Surety Bonds and ILOCs Defined
A surety bond is a three-party agreement among a principal (the party who needs the bond), an obligee (the party who is protected by the bond) and a surety (the party who issues the bond). A surety bond guarantees you will fulfill your tasks and obligations.
While an ILOC also is a three-party agreement, that agreement is among a beneficiary (the party who will be paid), a buyer (the party who buys the goods and/or services) and a bank (the party that issues the ILOC). Essentially, an ILOC is a cash guarantee that a beneficiary will be paid for the goods and/or services provided to buyers.
The differences between ILOCs and surety bonds generally come down to two variables: claims and cost.
When a claim is made on an ILOC, banks need only verify receipt and correctness of documentation required of the ILOC before paying the beneficiary. The bank will pay on an ILOC upon demand, so long as the demand is made prior to the ILOC’s expiration date.
Conversely, when a claim is made against a surety bond, the surety company must investigate the claim to determine if it is valid. The surety company will only pay out on a claim if the investigation deems the claim valid.
In terms of cost, ILOCs normally cost 1 percent of the amount covered in the contract. Also, to obtain an ILOC, it’s not necessary to pay it in its entirety.
For surety bonds, you will normally pay between 1 and 15 percent of the total bond amount. Good credit can help to lessen that percentage; in fact, you may only pay between 1 and 3 percent of the bond amount.
Advantages of Surety Bonds
While surety bond rates may appear to be higher than ILOC rates, surety bonds are, in the long run, less expensive. Six key advantages of surety bonds are as follows:
- Stable rates: Surety rates typically remain stable—and it’s rare to find hidden fees. Oftentimes, ILOCs include hidden fees (e.g., issuance fees, utilization fees, commitment fees). These, in turn, can significantly increase client costs.
- Security: It’s rare that a principal will be required to make a security filing with a surety bond. On the other hand, a bank may opt to take a security interest in its client’s assets.
- Flexibility with covenants: In exchange for an ILOC, a bank can place restrictive covenants on its client. Generally speaking, surety companies offer more flexibility.
- Capacity with respect to credit: An ILOC freezes cash assets for the entire amount, thus tying up a business’ credit capacity and reducing its financial flexibility. Surety bonds offer principals more liquidity, which in turn enables them to invest available capital.
- Efficient claim handling: With ILOCs, clients often must resolve disputes themselves, since banks often do not have a claims staff. Conversely, surety companies maintain claims staffs that assist in the claims process and manage disputes.
- Defense of default: With a surety bond, the surety will request proof of a default and will thoroughly investigate it before deeming it valid. An ILOC may be drawn down at any time, and the company has no defenses at its disposal.
When to Use a Surety Bond Instead of an ILOC
- You seek low rates: Surety rates may be less than what a bank is charging when fees are included in the calculation.
- You want capital and borrowing flexibility: A bond frees up cash, providing a better working capital position as well as creating additional borrowing capacity.
- You desire financial statement flexibility: Surety bonds generally are not noted in financial statements as contingent liabilities. ILOCs, on the other hand, are included.
- You want the assurance of due process in claims handling: An ILOC beneficiary has the option to directly approach the bank and demand payment within 72 hours. Conversely, with a surety bond, a claim must nearly always be made to the surety, after which an investigation ensues to determine if the principal failed to perform its obligation under which the bond was provided.
- You want peace of mind that the project’s end will be finite and well-established: With an ILOC, the ILOC may be held for up to two years before the beneficiary releases it. This is especially true in cases where a warranty exists. Comparatively, with surety bonds, there is a term to which the bond will be held.
Surety Bonds Can Be Complex; Travel the Path With a Trusted Partner
Surety bonds are most often an attractive option for individuals who qualify. They may end up being a cheaper alternative than an ILOC; they often don’t require collateral, and they provide highly desirable asset flexibility. That said, small and midsize business owners can best capitalize on their tremendous potential by leveraging the experience and expertise of a trusted advisor who understands the intricacies of surety bonds and can make optimal recommendations.
If you seek ways to utilize surety bonds for your business, or to learn more about surety bonds in general, please contact Charlie Filisko, Vice President – Property, Casualty & Surety, Marsh & McLennan Agency. Marsh & McLennan partners with privately held businesses, individuals and public companies that seek solutions that go beyond traditional employee benefits services to help them better manage their bottom line. You may contact Charlie by phone at 216-393-1822 or by email at Charlie.Filisko@mma-mw.com.
Disclaimer: This document is not intended to be taken as advice regarding any individual situation and should not be relied upon as such. Marsh & McLennan Agency LLC shall have no obligation to update this publication and shall have no liability to you or any other party arising out of this publication or any matter contained herein. Any statements concerning actuarial, tax, accounting or legal matters are based solely on our experience as consultants and are not to be relied upon as actuarial, accounting, tax or legal advice, for which you should consult your own professional advisors. Any modeling analytics or projections are subject to inherent uncertainty and the analysis could be materially affective if any underlying assumptions, conditions, information or factors are inaccurate or incomplete or should change.