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Toward a New Surety Model for the European Union

Carlos Hoyos, Director-General of MAPFRE Caución y Crédito S.A., Spain, analyzes the developments and changes on the horizon for Surety in the European Union. This, with a few revisions, is the paper he presented at the Pan American Surety Association's 15th International Seminar , held in Capetown, South Africa.

With the possible exception of the United States, surety premiums are at a real low worldwide. And this trend is particularly noteworthy in Europe, as seen in the figures below.


These meager numbers -which, we figure, represent less than 0.5% of total premiums (just 0.1% in Spain, for instance)- are basically attributable to three main factors:
First, surety bonds always emerge from legal, regulatory or contractual obligations. This enhances their marketability, but tends to limit them exclusively to a small number of companies that, due to the nature of their business (mainly public contracting), are required to guarantee the performance of their obligations.
Second is the small percentage covered by performance bonds versus the value of the contract in question. In point of fact, these percentages in Europe range from 4% in Spain or 5% in Portugal to 25% in Ireland. In a considerable number of countries, the figure averages 10%. These European bonds are what is known as penalty bonds: e.g., they do not guarantee the performance of the contract, but the payment of a pre-set amount in the event of non-compliance or non-performance.
These percentages are objectively small, and particularly so when compared with those in effect in the United States, where performance bonds are issued for 100% of the contract price, or in Canada, where coverage is of 50%.
As a result, the amounts bonded are always low, regardless of the sum involved in the contract guaranteed, and so too, therefore, are the premiums we collect. Of still greater concern is the fact that beneficiaries (normally Public Administration) fail to attain what they are actually seeking: i.e., a real performance bond. Instead, they have a penalty bond, which, in the event of contractor non-compliance, guarantees payment of only a specific amount, which, in most cases, is considerably lower than the actual damages. Furthermore, it is becoming increasingly difficult to execute these guarantees, because, in all honesty, many surety companies will use any type of argument they can in order to avoid paying them, and beneficiaries end up collecting them only after protracted lawsuits. Consequently, there is increasing demand for unconditional guarantees that are payable on demand.
The third reason behind reduced premium income among surety companies in Europe is the strong competition they get from banking. In contrast to countries like the USA or Mexico where banks are legally barred from issuing surety bonds, banking institutions in Europe are, on the whole, very tough, aggressive competitors and have the edge on surety companies. They make particularly tough competitors because the surety business is no more than a marginal activity for banks, which thus do not mind reducing the rates they charge to ridiculously low percentages that the insurance sector cannot possibly match. The edge they have on the insurance sector lies in the fact that their customers are usually committed to them on a global basis and are often obliged to request bonds from the bank as compensation for other services rendered.
As mentioned at the beginning, only US surety companies are of relatively large size. In fact, were we to list the fifteen largest surety companies worldwide, we would find that they are all US companies (although, there is a Korean company, Korea Guarantee, that is larger than any US company, but this firm is an exception -in practice, a monopoly that issues a great many financial bonds that are normally excluded from traditional surety companies' business dealings). SIC, the top-ranked company in Europe, would be far from making the list, and practically none of the other "major" European firms would figure anywhere near the 30 largest companies in the United States.


The combination of all of these factors (i.e., legal requirements, small percentages covered by surety bonds and tough banking competition) underlying the limited size of European surety companies is currently preventing the steady and substantial development of the European surety market. And it is likely that this will continue to be the case in the years to come.
Furthermore, changes at a legislative level have eliminated or are threatening to eliminate the need to submit surety bonds in certain cases. RENFE, the Spanish state-owned railway company, is a highly noteworthy case. The company recently resolved that guarantees securing contracts signed for provision of trains and engines for high-speed projects must obligatorily be issued by banking institutions, thus excluding the insurance sector from this major area of business in which bonds are expected to amount to about US$ 1 billion.
Another noteworthy example is the case of legal changes signifying the disappearance of VAT bonds in Italy. These bonds were used to guarantee the VAT reimbursements paid by the Italian Treasury to companies that were not eligible for them. For some of the companies operating on the Italian market, this type of bond represented up to 25% of total surety bond premiums and this piece of business has now disappeared with the stroke of a pen.
Over the years, this situation has led to the periodic search for new types of bonds that would increase turnover. Almost inevitably, the new types of bonds developed have ended up being purely financial issues and history is strewn with the failures, heavy losses and even bankruptcies that this practice has wrought. Nevertheless, European surety companies have not abandoned their legitimate desire to grow. We do not want to simply accept being small forever, regardless of the fact that this has not prevented us from obtaining decades of excellent results and an adequate return on the capital invested by our stockholders (but, obviously, in amounts proportionate to the size of our companies, that is to say, very reduced indeed).
We cannot hide the fact that, in a surety market involving the small amounts described above, the surety company's work is actually quite easy: beneficiaries are seldom tempted to call in the bonds, since this does not solve the problems resulting from non-compliance and, in some cases, may even make matters worse, since the contract must be rescinded, accounts must be settled, a new tender must be organized and a new contract must be awarded. And all of this may entail many, many months of delay. Bearing all of this in mind, beneficiaries tend to prefer to reach an amicable settlement with the contractor rather than to rescind the contract and call in the bond. Clearly, this situation led the British Department of Public Works to propose a couple of years back that surety bonds could be done away with altogether, on the grounds that they had no practical purpose whatsoever. This is where the issue stands at present.
Is there any chance of changing this situation? Is there any orthodox means of promoting surety sector growth? I believe the answer is "yes": Credit bonding is the most natural path to development for our companies. But, are there ways to make Surety grow? We believe there are, and the rest of this paper is devoted to showing how.
Generally speaking, Europe's surety sector -through its representative associations: ICIA, PASA and, especially, the International Surety Association (ISA)- is in the midst of negotiations with the European Union with the aim being to establish a new framework for guarantees requested to secure payment of public works contracts. Adoption of this new framework would bring about radical changes in the surety market as we know it today, and would undoubtedly produce a domino effect in other markets.
The proposal that the ISA will most probably submit to the authorities of the European Union in the coming months consists of a range of surety bonds identical in legal status and purpose to those currently in effect in the countries of the European Union, but with three major differences: adjustment of the bond coverage ratio, the introduction of new options open to the surety company in the event the bonds being called in, and, last but not least, the launching of a new bond model.
We are only mentioning these changes, since other bonds -anticipated payment bonds, maintenance bonds, quality bonds, etc.- are likely to remain just as we know them today. The first bond to be issued under this new system is likely to be the Bid Bond, which would be practically identical to the one issued at present: it would guarantee that tender-winners enter into a proper contract and file a Performance Bond. We believe that this bond should be issued for an amount of between 5% and 10% of the value of the contract tendered -which is a higher than average ratio for the European market at present.
The second type of bond, the Performance Bond, would cover a percentage of no less than 25% to 30%, with the maximum coverage ratio running 50%. This type of bond could not be considered a penalty bond since it would actually be guaranteeing the damages that its beneficiary -i.e., the local or federal administration- might suffer as a result of contractor non-compliance (up to the specified maximum limit of the guarantee). The coverage percentage is not, however, the only change we want to introduce in the field of performance bonds. Here we are contemplating another major change: Just as is currently the case in the United States, the idea would be that, whenever the main contract is breached, the surety, with the beneficiary's express consent, would have the option of fulfilling the contract either per se or through third parties. This alternative involves a radical change in relation to the current situation in Europe and, as far as we know, in most countries where the only thing sureties can do in the event of non-performance is pay the bond, period. Our proposal is for Performance Bonds to honor their name by actually guaranteeing contract fulfillment.
But the greatest innovation with respect to the current system is the suggestion that the insurance sector plans to make for the adoption of a third bond -the so-called "Payment Bond" , by which the surety will guarantee payment of money owed to subcontractors and suppliers by the main contractor for work they have carried out under the contract in question. This type of bond will be of particular importance to small and medium-sized firms that normally act as subcontractors and, as such, are paid three, six or even nine months after carrying out their work and thus run an ever-significant risk that their clients might default on payment. Indeed, such situations can even cause these firms to declare bankruptcy or shut down permanently. Bearing in mind that one of the European Union's major concerns is protection of small and medium-size businesses, this new bond proposal has been very well received by European authorities.
This type of bond, which we are seeking to impose in Europe, is known by a similar name in the United States, where it is called a Labor & Material Payment Bond. But these bonds are already quite common in the USA and are issued for full 100% contract-price coverage.
Although the name may be similar, however, the US bond's origin, function and characteristics are different. While in the United States the Labor & Material Payment Bond originated as a means of protecting the beneficiary from any preferential rights workers and subcontractors alike might hold on the project contracted, the aim in the European Union is to protect small and medium-size businesses. While, in point of fact, this objective is also achieved in the United States, it is not the real reason behind the US bond.
Another major difference between the Payment Bonds that the European surety sector is seeking to introduce and those issued in the United States is that, in the USA, the Payment Bond is issued jointly with the Performance Bond, each covering 100% of contract value, from the very first day that the agreement comes into effect. The idea in Europe is to issue Payment Bonds for each of the contracts that the main contractor signs with each and every subcontractor or supplier, for the duration of the main contract. Furthermore, European guarantees are to be limited to covering 80% of authorized payments outstanding (although this point is still under discussion and there is a chance that these bonds may end up covering 100% of the sums involved). We figure that the risk undertaken by the surety will never exceed 25%-35% of the full value of the contract, considering that contracts binding the main contractor and his subcontractors are not likely to be entered into all at the same time, and that it is common custom for the main contractor itself to do no less than 30% of the work on a contract and this proportion is not surety bonded.
But, why are we talking about guaranteeing 80% of the value of the contract instead of 100%? The idea is for this new type of bond to replace credit insurance to a certain extent. Until now, credit insurance has been the only coverage subcontractors could resort to, in order to ensure payment owed to them by contractors. As you all know, credit insurance never covers 100% of the sums involved, and we thus thought it advisable to reduce the percentage covered by the payment bond to the traditional 80% credit insurance coverage ratio.
Still another difference between the European Payment Bond and the US Labor & Material Payment Bond is that the European bond only covers contracts between the main contractor and the subcontractor, while excluding any contracts that the subcontractors themselves may sign with other subcontractors, and so on. These other contracts are indeed covered by the US Payment Bond.
But it is our opinion that this European surety bond system will render a great service to beneficiaries and clients alike, and in a broader sense, to society as a whole, since it responds to the needs of Public Administration in terms of proper management of the revenues citizens place in its hands, by guaranteeing proper execution of the works, goods and services supplied.
Another plus for Europe is that, should the bond system described here be adopted by all countries in the European Union, this would facilitate execution of works and provision of supplies from one country to another. The diversity of legal systems in effect at present can turn an apparently inconsequential matter like issuing a guarantee of compliance relative to the terms of a contract into a practically insurmountable obstacle.
There is no denying that the bonding project described above will have to overcome a host of difficulties including, among others, likely opposition from banking institutions and, perhaps, even from our own customers. Moreover, it is by no means a short-term project, since implementing it will call for the amending of a significant number of public contracting laws in every country in the European Union.
Furthermore, should this project be put into practice, surety companies themselves will very likely have to face major changes, ranging from foreseeable increases in the minimum capital levels required for authorization to participate in this type of business to large-scale structural changes emerging from the commitment to complete work in the event of the contractor's failure to comply.
In general, this system appears to be given a more favorable reception by major contractors than by small ones. Small and medium-size contractors seem to think that implementation of this bond model will cause them to have to overcome enormous obstacles in order to be awarded contracts involving average to large sums of money, since no surety company will be eager to grant them the necessary guarantees. But we believe that this system benefits all the parties involved and, in our opinion, small and medium-sized enterprises will, perhaps, be the ones to reap the greatest benefits of all. The fact is that their usual role in public contracts is as subcontractors. Thanks to the system we are proposing, payment of their sales would be guaranteed, whereas nowadays this is only possible if they take out credit insurance.
While this is not the reason why we are proposing this model, the implementation of this system of guarantees would turn the situation in the European Union around completely, and the surety field could thus witness rapid growth. It is not unlikely that, with this type of guarantees in place, the banking system, which today controls 90% of the surety market in the European Union, might adopt a less aggressive stance, permitting a still greater increase in this segment of the insurance business.
What European surety companies are proposing is that the International Chamber of Commerce's Uniform Rules for Contract Bonds be applied as a model. The aim of these Rules is to achieve uniform international criteria for guarantees, as recently approved by the United Nations via the UNCITRAL. This UN approval, in our opinion, constitutes the greatest degree of industry-wide success achieved by surety companies to date. And it serves as tangible proof that, difficult as a project may be, if it makes sense and is designed to improve service to society, it will prevail.

Translation: Dan Newland

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