CHAPTER OBJECTIVES
When you have finished this chapter, you should be able to
- Identify the three parties to a surety contract and describe their roles
- Distinguish between suretyship and insurance
- Identify and describe the five main categories into which surety bonds may be classified
- Describe the coverage provided by trade credit insurance policies and distinguish between “extraordinary coverage” and “general coverage”
- Describe the purpose of credit enhancement or financial guarantee insurance
Although surety bonds and trade credit insurance might seem unrelated, the two are similar: both are designed to protect against financial losses from default by someone on whom the insured depends.
When a business firm or a government organization hires a contractor to erect a building or perform some other work, it assumes the building will be put up according to plan or the work will be completed. This is not always the case. The contractor may go bankrupt and be unable to complete the job. When a business extends credit to one of its customers, it assumes the customer will pay for the goods, but credit losses do arise. Because these possibilities exist, risk exists, and such failures may produce serious financial loss.
One approach to dealing with these exposures is loss prevention. A business can choose which customers will be given credit or investigate the financial stability of a contractor before hiring it. Another alternative is retention, and the individual or business faced with these risks may elect or have no choice but to retain the risk. The coverages discussed in this chapter represent a third alternative: transferring the risk to a professional risk bearer.
In addition to the treatment of surety bonds and trade credit insurance, this chapter includes a discussion of another area of financial guarantees: credit enhancement insurance. Credit enhancement insurance is a type of financial guarantee in which the insurer guarantees the interest and principal payments on debt instruments. Although the relationship among the parties is somewhat different, credit enhancement insurance is similar to surety bonds and credit insurance.
SURETY BONDS
Technically, all bonds are surety bonds, including the fidelity coverages discussed in Chapter 31, which cover employee theft. However, the term surety is generally reserved for the nonfidelity field. Fidelity bonds are more closely related to insurance coverages than they are to suretyship as discussed here.
As noted in Chapter 4, suretyship is the practice of guaranteeing obligations through a three-party contract. Under the provisions of such a contract, one party (the surety) agrees to be held responsible to a second party (the obligee) for the obligations of a third party (the principal). Under a surety bond, the surety lends its name and credit to guarantee the obligation of the principal. The surety guarantees principal's performance; if the principal fails to perform, the surety is responsible to the obligee for the bond amount, called the “penalty.”
Originally, the surety was a friend or a relative. When there was doubt about the ability of a person to perform some task, the individual to whom the obligation was due required a friend or relative to guarantee the performance.1 Personal suretyship frequently proved to be unsatisfactory, to both the obligee and the surety, and the natural result was corporate suretyship, which developed in England in about 1842.
Surety bonds are used in situations in which one of the parties insists on a guarantee of indemnity if the second party fails to perform a specified act. This situation may arise in connection with construction contracts, court procedures, or other instances when there may be doubt concerning ability to perform.
Suretyship Distinguished from Insurance
Suretyship differs from insurance in several ways. The most frequently stated distinction is that a surety bond is a three-party contract, involving a surety, principal, and obligee, whereas the insurance policy is a two-party contract between the insured and insurer. The most important distinction, however, is in the philosophy regarding losses. In the field of insurance, the insurer expects losses. In the surety field, no losses are expected primarily because the surety will not issue the bond if a loss appears likely. For example, before issuing a bond for the completion of a construction project by a contractor, the surety will examine the contractor's financial resources, operation, and past history. If the contractor appears to have the financial strength and the technical skill required for the project completion, the surety will issue the bond. This bond is a certificate of character, ability, and financial worth of the principal. In essence the surety says, “We have examined the principal's financial statements and the performance record, and we are convinced he or she has the financial resources and skills to complete the project for which he or she intends to contract; if our opinion is wrong, we will be held responsible.” This is an unusually strong guarantee, and a bond will be issued only when the surety has the utmost confidence in the principal's ability to perform. If there is any question about that ability, the bond will not be issued. Sometimes, the surety may require the principal to put up collateral equal to the amount of the maximum possible loss under the bond. Thus, whereas actuarial science is the basis for insurance rates, the fee for a surety bond is primarily a payment for the investigation and certification, with only a small element to cover inevitable losses.
Although the purchaser of the bond is normally the principal, a surety bond is issued for the benefit of the obligee. As proof of this, in the event of a loss under the bond, the surety has a right to collect from the principal any amount the surety must pay the obligee. In other words, when the surety pays for a loss, the surety obtains full rights of recovery against the principal.
The five categories into which surety bonds may be divided are the following:
A brief discussion of the more important bonds under each of these classifications should serve to illustrate more fully the nature of suretyship.
Contract Bonds
The general purpose of the contract bond is to guarantee the principal, who is normally a contractor or supplier, will fulfill his or her contract commitment. Contract bonds indemnify the obligee if the principal fails to perform on the contract and are used widely in construction.
Performance Bonds This bond is designed for use in connection with contracts to build real property. Under a performance bond, the surety agrees to indemnify the obligee if the principal fails to complete the construction according to contract specifications. If the contractor cannot, for one reason or another, finish the agreed project, it is up to the surety to see that it is done. The performance bond may be written to include the terms of a labor and materials bond, which is discussed next.
Labor and Materials Payment Bond Under the labor and materials bond, the surety guarantees the principal will pay all bills for labor and material in connection with the contract, thus assuring the obligee that the work completed will be free of all mechanics' or other types of liens. It may be written separately or with a performance bond.
Supply Contract Bond This bond guarantees faithful performance under a contract to supply goods or materials. The bond guarantees the principal will furnish the obligee with the goods contracted for according to the specifications in the contract to supply goods.
Completion Bond Here the obligee is normally a lender who has furnished funds to a contractor in connection with construction work. It guarantees the obligee that the principal (who is the borrower) will use the money according to the contract terms and will complete the work undertaken.
Bid Bond In many cases where a contract is being let for public bids, the agency letting the contract requires all bidders to furnish a bid bond. This is necessary to establish that the bid is a bona fide offer by the one required to post the bond. It protects against loss resulting from failure of the bidder to accept the contract. If the bidder who is awarded the contract fails to sign the contract or is unable to provide the required performance bond, the contract may be awarded to the next lowest bidder. The surety on the bid bond becomes liable for the difference between the bid of its principal and the next lowest bidder. A point of frequent misunderstanding has to do with the surety's obligation under a bid bond. The surety on such a bond is not required to furnish its principal with a performance bond if he or she is awarded the contract; however, if the principal cannot obtain a performance bond, the surety on the bid bond becomes liable.
Judicial Bonds
In many court proceedings, some form of bond may be required by the court. There are two basic forms of judicial bonds:
- Fiduciary bonds are required when an individual is appointed by the court to hold, control, or manage the property of others; examples of persons who are required to post fiduciary bonds are executors and administrators of estates, guardians, and receivers.
- Litigation bonds are required of a person who wishes to bring action in a court of law or equity; normally, these bonds are required when the person bringing suit wishes to tie up the other party's assets in the suit or restrain the other party from doing something.
Fiduciary Bonds A fiduciary is a person appointed by the court to hold, control, or manage the property of others. The fiduciary bond guarantees the fiduciary (who is the principal under the bond) will faithfully perform the trust duties. Usually, the court prescribes the form of the bond and sets the bond's face amount (the penalty). To protect itself, the surety frequently asks for joint control of the estate's assets. Under this arrangement, all the estate funds are kept in a joint account, and disbursements are made only with the signature of the principal and the surety. The major subclassifications of fiduciary bonds are described next.
Executor's Bond This is the bond required of the person named in the will of the deceased to administer the estate.
Administrator's Bond When a person dies without a will, the court appoints an administrator, whose duties are similar to those of an executor. The obligee under the executor's bond and the administrator's bond is the state or the court for the benefit of the beneficiaries.
Guardian's Bond This type of fiduciary bond is required when it becomes necessary to appoint someone to administer property belonging to a minor. The court normally appoints a guardian and requires a bond guaranteeing the guardian's faithful performance. The obligee is the state for the minor's benefit.
Bonds in Trust Estates These bonds are called for when the property owner directs that the property be held in trust for his or her heirs for a given period of years or until the death of the heirs. Such a trust may be established by will (testamentary trust) or it may be established during the lifetime of the property owner (inter vivos trust). In either case, when a trust is established, the property must be turned over to a trustee, who is responsible for its administration. The trustee's bond guarantees the trustee's faithful performance.
Committee Bonds These bonds are required when a person is incompetent to handle his or her own affairs and the court appoints someone (known as the committee) to protect the person's property. A committee bond guarantees the committee's faithful performance.
Miscellaneous Fiduciary Bonds In addition to those discussed, other similar bonds are required of persons who have custody or control over the property of others. Examples of such bonds are receiver's bonds, which are required of a court-appointed receiver in bankruptcy proceedings; trustee's bonds, which are also appointed in bankruptcy proceedings; and bonds demanded of conservators or liquidators of business firms or partnerships.
Litigation Bonds Litigation bonds are the second major class of judicial bonds. These bonds are required for the purpose of obtaining some restriction on property of others or releasing property from such restrictions. If a person bringing action seeks to attach property and loses the case, the person whose property was attached might argue the action injured him or her and caused damages. The bonds will pay any such damages. In addition, under certain circumstances, the person bringing suit must furnish security to guarantee the payment of court costs. The more common types of litigation bonds are described next.
Attachment Bonds These bonds are required when property is attached before the court decision to prevent its disposal by the person having custody of it. The bond guarantees reimbursement for damages if the attachment is unjustified.
Garnishment Bonds These bonds are necessary when the plaintiff wishes to attach wages or financial assets in the hands of a third party. They are similar to attachment bonds except that the assets attached are in the hands of a third party.
Replevin Bonds These bonds are similar to attachment bonds except that the plaintiff is suing to recover specific property. The replevin bond guarantees the property will be returned to the defendant in proper condition if the plaintiff loses the suit.
Release of Attachment Bond This bond enables the defendant, whose goods have been attached, to recover possession of the goods. It also guarantees the property will be available and turned over to the plaintiff should the defendant lose the suit.
Appeal Bonds These bonds are required of individuals who have lost a suit and wish to appeal and suspend the judgment's execution pending a higher court's decision. The bond guarantees payment of the appeal costs.
Removal Bonds In certain cases when the defendant who is being sued in a state court wishes the suit to be removed to a federal court, or from the court of one state to another state, these bonds are required. The bond guarantees the principal wil pay the court costs if the case was improperly removed to the new court.
Injunction Bonds These bonds are required when the plaintiff alleges he or she is being injured by the defendant's actions and requests the court to restrain the defendant from further action. If an injunction is granted, a bond is required of the plaintiff that guarantees payment of damages if the injunction proves to be unwarranted.
Discharge of Mechanic's Lien Bond The owner of property can obtain removal of a lien before trial by furnishing a bond that promises to indemnify the claimant if the claimant wins the suit.
Bail Bonds Bail bonds are used when a person has been charged with a criminal action. The bond guarantees the payment of the bond amount (i.e., penalty) if the accused person fails to appear in court at the stipulated time.
License and Permit Bonds
Many state and federal licenses are required for manufacturing, tax, and occupational purposes. In many cases, the applicant for a license is required to post a bond guaranteeing faithful performance of duties or payment of taxes collected. These bonds protect the state and the public from damages arising out of the manner in which the business is conducted or they guarantee the payment of taxes collected by the license holder. The four major classes of license and permit bonds and classes of individuals who require the bonds are the following:
- U.S. customs bonds are required for importers; these customs bonds guarantee the payment of duties and taxes on imported goods.
- State tax bonds are required in connection with the sale of gasoline, cigarettes, liquor taxes, sales taxes, and so forth; these guarantee the principal will deliver all taxes collected to the state.
- Occupational bonds are required for securities salespeople, liquor stores, undertakers, collection agencies, warehouse workers, and many other occupational classifications; these guarantee the principal's honest and faithful performance.
- Permit bonds are required to exercise a particular privilege, such as for placing or constructing materials that might cause injury or inconvenience to the public. In many cities, permit bonds are required for billboards or street obstructions; these guarantee indemnity to anyone who is injured because of the construction or materials.
Public Official Bonds
The law requires that certain persons elected to fill positions of trust must furnish bonds that guarantee their faithful performance of duties. The public officials are generally held to be liable for the faithful accounting for all money they receive. If for any reason public officials cannot turn over all the money they have received to the state or if they dissipate assets belonging to the government unit they serve, they are personally liable. Public official bonds are designed to guarantee payment of funds the public official has not turned over or he or she has dissipated. These bonds are designed to protect against dishonesty, negligence, and even lack of ability.
Most public official bonds are referred to as statutory because the law requires them. The surety cannot reduce its liability by inserting provisions in the bond; the provisions spelled out by statute take precedence. These bonds are normally written for the term of the elected or appointed official and are noncancelable during the term. Usually, the cost of the bond is paid out of public funds.
Public officials bonds are also available to cover employees who are not required by law to post a bond, including most workers in public service other than tax collectors and treasurers. The coverage may be written to cover the public employees' honesty, or it may be written to cover faithful performance. The faithful performance form will pay losses resulting from the bonded person's dishonesty and will pay for losses resulting from negligence or lack of ability.
Miscellaneous Bonds
Many bonds do not fall into any of the previous categories. Some examples are:
Lost Instrument Bonds These bonds, which are also called lost securities bonds, are required of an individual who has lost or accidentally destroyed securities or other valuable papers and wishes to obtain duplicates. The lost instrument bond guarantees the principal will reimburse the issuer of a duplicate instrument if the original security or instrument later turns up and its holder is able to collect on it.
Workers Compensation Bonds In many states, the workers compensation law permits certain employers to self-insure their workers compensation exposure. To ensure the benefits to which an injured worker is entitled will be paid, the self-insurer is required to post a self-insurer bond, which guarantees benefits payment to workers who are injured and entitled to workers compensation benefits under the workers compensation law.
TRADE CREDIT INSURANCE
Accounts receivables can account for a significant proportion of a nonfinancial corporation's assets. Most businesses deal with the credit risk (the risk that customers will fail to pay) through loss-prevention techniques and risk retention. They choose customers carefully to whom credit is to be extended, and they make allowances in the budgeting process for normal bad debt losses. In some cases, these approaches may be inadequate, particularly when the outstanding credit is a large item on the firm's balance sheet. Where the credit risk is great, the firm may prefer to transfer the risk through trade credit insurance, which provides protection against abnormal credit losses. Trade credit insurance, which is sold only to manufacturers and wholesalers and is unavailable to retail establishments, protects against loss resulting from the inability to collect accounts due to insolvency or the unwillingness or inability to pay.2
Trade credit insurance is a specialized field, and the coverage is written only by a few companies. It is divided into two fields: domestic credit insurance and export credit insurance, also called foreign trade credit insurance. Domestic credit insurance is written to cover accounts receivables within the insured's country (or in the case of U.S. insureds, in the United States and Canada). It covers the risk of the customer's bankruptcy and may be written to cover slow payment on undisputed accounts. Policies covering foreign trade credit may also protect against political risk, such as expropriation or confiscation, inability to convert currency or other currency transfer restrictions, embargoes, political violence, and acts of war. Natural disasters may be covered. There is no uniform definition of political risk, so each company's policy must be examined individually.
Over the years, the monoline trade credit insurers have developed large databases that contain company-specific histories on payments for receivables.3 This information, supplemented by information from rating agencies and others, can be used to assess the insured's customers' creditworthiness. Credit insurers use this information advantage for two purposes: first, to determine premiums for trade credit insurance and, second, to assist an insured in its credit risk management practices. This assistance may consist of collecting debts and of helping the insured set appropriate credit limits for a given customer, continuously monitoring accounts for early warning signs of a potential credit risk.
Specific-Account versus Whole-Turnover Coverage
In addition to the distinction between domestic credit risk and export credit risk, credit policies may be subdivided according to the accounts insured. In general, there are two types of contracts. The first type, known as specific-account coverage (or extraordinary coverage) reimburses for losses involving the insured's specific customers and is generally limited to one or a few accounts. It is used when the outstanding balances of a single customer or a few customers represent a serious exposure to the firm, and it is generally purchased by companies that deal with a limited number of buyers. It is issued only after an investigation of the individual debtors and an acceptance of each one by the insurer.
Although individual account coverage is available, most trade credit insurance is written to cover a whole portfolio of short-term receivables. This second type of coverage is known as whole-turnover coverage (or general coverage); it includes protection on all the policyholder's customers that meet the insurer's quality standards, as specified in the policy. Depending on the other policy terms, whole-turnover coverage may require the insurer to assess the quality of most customers in the insured's portfolio, a process made easier by current trends in information technology and the large databases some insurers maintain. Alternatively, the insurer may rely on the insured's own credit assessments.
Proportional versus Excess-of-Loss Coverage
Payment on credit insurance policies may be made on a proportional or excess-of-loss basis. Under proportional coverage, the insurer pays a percentage of losses, with the percentage chosen to give the insured an incentive to efficiently manage its trade credit relationships. It is generally set between 80 and 95 percent but can vary based on the quality of the insured's accounts receivable, with higher-quality accounts receivable eligible for a higher recovery. The policy typically gives the insurer the right to assess the individual buyers' quality in the insured's portfolio and to determine the credit limit insured for each buyer, and the insurer relies on its historical database to make these determinations. Thus, the insured is given little discretion on the credit limits that will be covered by the policy. In addition, the policy is subject to an annual aggregate deductible; the policy will not pay until the insured's share of losses exceeds the aggregate deductible. The large monoline trade credit insurers typically write coverage on a whole-turnover basis with proportional coverage.
An excess-of-loss policy is designed to protect against catastrophic credit losses. Excess-of-loss insurers generally grant insureds a higher level of discretion in approving buyer credit limits. Rather than reviewing each buyer individually, the insurer relies on the insured's own internal credit procedures. Insureds with more sophisticated credit departments may be given greater discretionary authority. Excess-of-loss policies tend to have a relatively high annual aggregate deductible, particularly when compared with the proportional coverages. The insurer relies on the higher deductible to induce the insured to exercise care in the extension of credit.
Credit Insurance in Securitization of Accounts Receivable
Securitization of accounts receivable has become increasingly common over the past decade. In a securitization, the firm effectively sells the future income stream from its accounts to outside investors. New securities, called asset-backed securities, are created, and investors who purchase the asset-backed securities receive a promise of future payments based on revenues from the accounts receivable that back the securities.4
Credit insurance may be used in a securitization to provide credit protection on a subset of the accounts receivable. Often, a firm has a few customers that represent a significant portion of its accounts receivable (e.g., 20 percent or more). This creates a credit risk concentration that may be undesirable to investors in the asset-backed securities. That is, the security's performance is heavily dependent on whether those few customers default. To avoid this risk concentration, the large accounts may be excluded from the securitization agreement. Alternatively, credit insurance may be used to protect against the risk that these particular customers may default, allowing the accounts to be included in the securitization.
Collection Service
Although not all credit policies include provision for the collection of past-due accounts by the insurer, many contracts do, and the collection service is one of the most attractive aspects of credit insurance. Contracts differ in their provisions for collection. In some contracts, the insured is required to turn past-due accounts over to the insurer for collection. In other contracts, it is optional. A third group of contracts makes no provision for collection by the insurer. In those instances in which the insured is required or permitted to turn past-due accounts over to the insurer, accounts overdue by a stated period (say, 60 days) under the original terms of the sale are turned over to the insurer for collection. If the insurer succeeds in collecting the debt, a small service charge is made for the collection. If the insurer is unsuccessful, the account becomes a loss under the policy, and payment is made in the usual manner.
FINANCIAL GUARANTY INSURANCE
Financial guaranty or credit enhancement insurance are terms used to describe a field of coverages that combines elements from suretyship and insurance. Basically, financial guaranty insurance (FGI) is an arrangement by which an insurer guarantees the payment of principal and interest in connection with debt instruments (e.g., bonds) issued by the insurance purchaser. The insurer “insures” the purchaser of bonds and other debt instruments that the debt will be paid and, in a sense, substitutes its financial strength for the financial strength of the bond issuer. Although generally referred to as “insurance,” the coverages are more closely related to suretyship since they guarantee an obligation to third parties, and the insurer retains a right of recovery against the debt issuer that purchased the coverage.
FGI is written on two broad categories of securities in the U.S.—public finance and structured finance. It is written by specialized “monoline” insurers known as financial guarantors (or FGs).
Public Finance Insurance
Municipal bond insurance began in 1971, when the American Municipal Bond Assurance Corporation (AMBAC), a subsidiary of Municipal Guaranty Insurance Company (MGIC), began to offer the product. Until the early 1980s, few other insurers ventured into this field. The $2.2 billion default of the Washington Public Power Supply System (WPPSS), along with the New York City's near default in 1975, raised awareness of the credit risk in municipal financing, and municipal bond insurance grew in the 1980s.
Municipal bond insurance is sold to municipalities issuing debt instruments and guarantees the payment of interest and principal on the bonds. Municipal bonds are rated by credit ratings agencies, such as Standard & Poor's and Moody's. The lower the bond rating, the higher the interest the municipality must offer to sell the bonds. When the bonds are covered by bond insurance, the rating is based on the insurer's financial strength rather than the municipality's. The insurance makes the bonds more attractive to potential borrowers because of the lower potential for default, which allows the municipality to issue the bonds at a lower rate. The premium, in effect, is the sharing of a reduced interest cost with the insurance company.
Municipal finance is a highly technical area, and includes a variety of financial instruments. Municipalities may issue bonds backed by general tax revenues (general obligation bonds) or those backed by revenues from specific activities (special revenue bonds). There are also special bonds related to municipal leases and industrial revenue bonds. In addition to offering bond insurance on public projects, many bond insurers will insure private projects with a public interest, such as utilities, health care, higher education, and affordable housing. As the business broadened, the term public finance insurance has begun to replace the term municipal bond insurance.
Structured Finance Insurance
FGs began to insure structured securities such as residential mortgage-backed securities (RMBS) and other asset-backed securities (ABS) in the late 1980s. RMBS are securities created by pooling a group of residential mortgages and selling claims on the pool's revenues. The return to the RMBS investor is derived from the principal and interest payments made on the underlying mortgages. ABS may also be created from other investments, such as student loans, credit card receivables, and automobile loans. When insuring RMBS and other forms of ABS, the insurer would “wrap” the securities, guaranteeing the payments of principal and interest. As with bond insurance, this allowed the securities to have a higher rating. When Wall Street created collateralized debt obligations (CDOs), a more complicated security made up pools of ABS, the financial guarantors began to provide credit protection on CDOs.
Insurance on structured securities was a small part of the business of FGs until about 1995. By 2000, it represented more than half of their U.S. business of FGs, and it grew rapidly between 2000 and 2007 as these securities markets grew.
FGI and the Financial Crisis
The first stage of the recent global financial crisis was evidenced by an increase in defaults in subprime mortgages, mortgages written for individuals who were not eligible for standard mortgages. Many of the CDOs insured by FGs used subprime mortgages as the underlying investments. FGs began to experience losses from their structured finance business in 2007, and they were downgraded by the credit rating agencies in 2008. Because their ability to continue in business depended on having a high rating, many stopped selling insurance. State regulators also ordered companies with impaired financial conditions to cease writing new business. This led to problems with availability of municipal bond insurance. Before 2000, over 50 percent of municipal bonds issued prior to the financial crisis carried bond insurance, but by 2009, it had fallen to less than 10 percent.5
Several companies have been restructured in an attempt to wall-off the problematic structured finance business and enable the firm to continue writing the “good” municipal bond insurance. These restructurings have been accompanied by litigation between the insurers, regulators, and banks that sponsored the ABS and CDOs. In addition, some insurers have sued banks, arguing that they were misinformed on the risks underlying the securities.6 In 2013, only two insurers – Assured Guaranty and Build America Mutual (which was created in 2012) were writing FGI, mostly in the public finance area.
Regulation
Until the late 1980s, there were no specific limitations on writing FGI, and a number of property-liability insurers offered the coverage. In 1986, the NAIC adopted the Financial Guaranty Model Act, making guaranty a separate line of insurance subject to its own requirements and limiting its sale to separate monoline insurers. A main objective of the Act was to separate FG from other lines of insurance, so catastrophic losses would not jeopardize the protection of other insureds. The NAIC model established initial capital requirements of $50 million (substantially above the requirements for traditional insurers), placed limits on the amount of business the company could write, both on an individual risk basis and in aggregate, and established reserve requirements. To address the cyclical nature of credit risk, insurers were required to establish contingency reserves. These were based on the outstanding insured obligations and could only be released over time. The reserve was required to be maintained for 10 or 20 years, depending on the nature of the guarantee. Few states enacted the law, but most FGI is written by a monoline company domiciled in one of those states. In addition, NAIC accounting rules apply the reserve requirements to all states.
In 2007, the NAIC revisited the model act, clarifying the definition of financial guaranty and increasing capital and reserve requirements. Because few states had adopted the model act, the NAIC changed it to a model guideline.
In addition to the efforts of the NAIC, other policymakers are studying the role played by the financial guarantors in the recent financial crisis. Several groups, including the Financial Stability Board and the IAIS, are evaluating whether the activities of financial guarantors pose systemic risk, and, if so, what the regulatory regime should be. Future changes in the regulation of financial guarantors are likely.
MORTGAGE GUARANTY INSURANCE
Mortgage guaranty insurance protects a mortgage lender from the borrower's default. Government-sponsored entities (GSEs) write much of the U.S. mortgage insurance, but they are limited to mortgages up to 80 percent of the property value. Private mortgage insurance in the U.S. serves as a supplement to insurance offered by the Government Sponsored Entities (GSEs) and enables home-owners to borrow more than 80 percent of the value of the home. During the recent financial crisis, private mortgage insurers were also stressed, and some ceased operation.
As with financial guaranty insurers, mortgage insurers are required to carry contingency reserves for an economic downturn. These have been an important cushion for private mortgage insurers, but have diminished considerably since the onset of the financial crisis. Between 2007 and 2011, aggregate contingency reserves for the U.S. mortgage insurance industry shrank more than 95 percent. Two insurers (PMI mortgage Insurance Company and Republic Mortgage Insurance Company) were placed under state supervision. The NAIC is currently evaluating the solvency requirements for mortgage insurers to determine whether they need to be strengthened.
Mortgage insurance volumes have fallen during the financial crisis, but there is evidence the sector will continue to be important. The financial difficulties of the GSEs, which required a federal bailout in 2008, have increased policymaker interest in private mortgage insurance.7 In Feb. 2011, the U.S. Treasury issued a report to Congress on reforming America's housing finance market. Among other recommendations, the report called for winding down the GSEs to pave the way for a robust private insurance market.
IMPORTANT CONCEPTS TO REMEMBER
surety
obligee
principal
contract bonds
performance bonds
labor and materials bond
supply contract bond
completion bond
bid bond
judicial bonds
fiduciary bonds
litigation bonds
license and permit bonds
public official bonds
lost-instrument bonds
extraordinary (or specific) coverage
general coverage
credit enhancement insurance
trade credit insurance
financial guaranty
municipal bond insurance
asset-backed securities
mortgage insurance
QUESTIONS FOR REVIEW
1. Briefly distinguish between an insurance contract and a surety bond.
2. In what way is the underwriting process different for surety bonding and fire insurance?
3. Who is the obligee under a labor and materials bond? Who, in addition to the obligee, benefits from the existence of a labor and materials bond?
4. For which type of bond would the underwriting standards be more severe: a bid bond or a construction contract bond?
5. There are five bidders on a construction job. The average bid on the job is $2.5 million, and the bids of four bidders range from $2.4 to $2.6 million. The fifth bidder submits a bid of $2 million and is awarded the contract and is applying for a bond. What will the underwriter's reaction be?
6. Explain the purpose of a joint-control provision used in connection with surety bonds. With what types of bonds is this provision required?
7. Describe the difference between the dishonesty form and the faithful performance form of the public official bond.
8. Describe the ways in which trade credit insurers assist their customers with credit risk management.
9. Describe the two broad categories of financial guaranty insurance.
10. Describe the business activities of financial guarantors that created their financial difficulty in 2007 and 2008.
QUESTIONS FOR DISCUSSION
1. A property and liability insurance agent is generally authorized to bind coverage. This is not true with respect to surety coverages. Why not?
2. Joe Schwartz is the principal stockholder in a small construction company specializing in concrete work. He needs a performance bond to obtain a contract to build a city swimming pool. However, the surety company has refused to issue the bond unless Schwartz personally signs a co-indemnity agreement under whose terms he will personally be responsible for the obligation assumed by his corporation. He feels this defeats the whole purpose of a corporation and maintains the surety company is being unreasonable. What do you think?
3. Is the treatment of suretyship and trade credit insurance in the same chapter a logical combination? What is the similarity or dissimilarity in their natures on which you base your answer?
4. Some experts believe the business of financial guarantors is more like banking than insurance, and the guarantors should be regulated like banks. Do you agree or disagree?
5. In most states certified public accountants licensed by the State Board of Accountancy are required to post a surety bond or show evidence of an accountant's professional liability policy. Based on your understanding of surety bonds, what do you think is the basic difference between the protection provided by the professional liability policy and the accountant's bond?
SUGGESTIONS FOR ADDITIONAL READING
Drake, Pamela Peterson and Faith Roberts Neal. “Financial Guarantee Insurance and Failures in Risk Management.” Journal of Insurance Regulation, vol. 30 (Dec. 2011).
Jaffee, Dwight M. “The Application of Monoline Insurance Principles to the Reregulation of Investment Banks and GSEs.” Risk Management and Insurance Review 12(1), 2009.
Joint Forum. Mortgage Insurance: Market Structure, Underwriting Cycle, and Policy Implications. Consultative Paper, Feb. 2013.
Promontory Financial Group. The Role of Private Mortgage Insurance in the U.S. January 2011.
Subcommittee on Financial Guaranty Instrumentation of the Committee on Developments in Business Financing “NAIC Model Act on Financial Guaranty Insurance: A Commentary.” The Business Lawyer 43(2), American Bar Association, February 1988.
Schich, Sebastian “Challenges Related to Financial Guarantee Insurance,” Financial Market Trends, No. 94, Organization for Economic Cooperation and Development (OECD), 2008.
Swiss Re. Trade Credit Insurance: Globalization and E-Commerce at the Key Business Opportunities. Sigma No. 7/2000.
WEB SITES TO EXPLORE
| Association of Financial Guaranty Insurance Insurers | www.afgi.org |
| Risk and Insurance Managers Society | www.rims.org |
| Surety Information Office | www.suretyinfo.org |
1One of the earliest forms of suretyship was the hostage. A debtor might offer as security for a debt a hostage, who was usually a close relative. When the debt was paid, the hostage was released. If the debt was not paid, the hostage was likely to be in for a hard time.
2We must distinguish trade credit insurance from accounts receivable insurance discussed in Chapter 31. As the reader will recall, the accounts receivable coverage indemnifies the insured in the event of a loss resulting from the destruction of accounts receivable records as a result of an insured peril. In the case of trade credit insurance, the peril insured against is insolvency or default of a debtor to whom credit has been extended. Trade credit insurance is also called credit insurance, but we will use the term “trade credit” to distinguish this coverage from those policies sold to individuals to pay a loan balance in the case of death, disability, or unemployment Credit life, credit disability, and credit unemployment insurance were discussed in Chapter 12.
3In 2007, the bulk of trade-credit insurance was written by three insurers: Euler Hermes ACI, Atradius, and Coface. These insurers, which developed through a series of mergers of European credit insurers, are estimated to account for 85 percent of the global credit insurance market. The dominance of European insurers in this market likely reflects the distribution of the insureds. It is estimated that 80 precent of global credit insurance premiums are written in Western Europe. Swiss Re has speculated that trade credit insurance has historically been less common in the United States than in Europe for three reasons: Exports are a smaller percentage of the United States economy, domestic credit insurance is less important in the United States because information on companies is more accessible and transparent; and the operations of credit departments, including debt collection, are more developed in the United States. Trade Credit Insurance: Globalization and E-Business Are the Key Opportunities (Swiss Re, Sigma No. 7/2000).
4Technically, this is accomplished through a special-purpose, vehicle (SPV), created to protect the asset-backed securities from the risk of the firm's bankruptcy. The firm sells the accounts receivable to the SPV, giving the SPV the right to the future payments by the firm's customers. The SPV uses the accounts receivable to collateralize newly created asset-backed securities, which are then sold to investors. As the firm's customers make payments, the SPV uses the funds to make distributions to the investors in the asset-backed securities.
5Moody Investor Service, “Financial Guaranty Insurance Industry: 2009 Review and 2010 Outlook.” Available at: www.nationalpfg.com/pdf/RatingAgencyReports/Moodys_02_2010.pdf.
6The NY Insurance Department restructured Municipal Bond Insurance Association (MBIA), the world's largest bond insurer, in 2008. The transaction separated the public finance and structured finance businesses, with the goal of enabling the company to continue writing municipal bond insurance. The Wisconsin Insurance Department restructured AMBAC, the second largest bond insurer in a transaction also designed to separate the structured finance problems from public finance business. Both arrangement have been challenged by banks and others. Meanwhile, AMBAC has sued Countrywide Home Loans, Inc, claiming Countrywide fraudulently induced AMBAC to insure bad loans.
7In Sept. 2009, The Federal National Mortgage Association (FannieMae) and Federal Home Loan Mortgage Corporation (Freddie Mac) were placed into conservatorship by their regulator, the Federal Housing Finance Authority, and given financial support by the US Treasury, amounting to over $120 billion by 2013.