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Posted by Scot Albrinck, AFSB
Surety bonds and letters of credit (LOCs) both provide risk management for construction or development projects. To know which is appropriate to use, it helps to understand their differences.
A surety bond is a three-party agreement among:
- The principal, who is the primary party who’ll perform the work (i.e., the obligation).
- The obligee, who is the party responsible for making sure the work gets done, usually by contracting a principal.
- The surety company that guarantees the obligation, which is usually contractual.
For instance, a surety company will issue a performance and payment bond on a construction project. The bond’s function is to ensure the contractor (principal) completes the work according to the contract and provides proper payment to those subcontractors or suppliers covered under the bond. In the event the contractor defaults on any of their obligations that are covered by the bond, the surety company’s bond protects the obligee from loss.
An LOC is similar in that it guarantees payments for goods and services. But in the LOC process, the bank may freeze the contractor’s collateralized assets and set that money aside until the LOC is released or the money is paid out. All parties must follow the stipulations in the credit agreement to ensure proper release of funds.
3 key differences
These three key differences can help determine whether a surety bond or an LOC is the better option:
- Claims and claims handling. Surety bonds and LOCs handle defaults in different ways.
A performance and payment bond protects the obligee from both a job completion standpoint and financial exposure. It can pay out on subcontractors, suppliers, or anyone else with a legal right to be made whole. In addition, the surety company investigates the merits of the claim to protect all parties (including the contractor) to eliminate fraudulent claims, whether from the obligee or subcontractors.
Once a claim is validated, the surety has an obligation to perform. The most common options involve paying the claimed amount, finding another contractor to complete the work, or financing the current contractor to help complete the project all subject to the penal limit of the bond.
On the other hand, an LOC differs in that the issuing bank only needs to verify that the claimant has provided the proper documentation as set forth in the credit agreement. The validity of the claim itself is not verified, leaving the contractor and the bank exposed to fraudulent activity.
- Extension of credit. When a client is approved for a surety bond, it only counts against the total amount of bond credit extended to that client, meaning it doesn’t restrict any assets.
Conversely, when a client tenders an LOC, the assets pledged under that LOC generally become restricted from use. This means that the contractor cannot use those funds elsewhere — which can vastly dampen the contractor’s future credit access. Furthermore, the funds are usually held through the warranty period following project completion, adding perhaps a year or more to the total duration.
- Coverage. There’s a big difference between the amount of coverage a surety bond provides versus an LOC. A surety bond provides full exposure coverage for the penal sum stated in the bond, which is typically 100% of the performance obligation as well as 100% of payment exposure.
An LOC, on the other hand, is usually issued for a certain percentage of the cost of the overall project, not the full amount. In most cases, the coverage is just 5% to 10% of that cost.
Additional surety bond benefits
Overall, the long-term cost of doing business is a lot less with surety bonds, which allows you to make your balance sheet work for you instead of against you. From an upfront-cost standpoint, a surety bond and LOC probably look similar. However, just as with any other financing product, LOCs can come with hidden renewal fees, making surety bonds less expensive in the long term.
It’s also useful to know that a bank issuing an LOC can take a security interest in the business’s assets. A surety bond, on the other hand, is generally unsecured credit.
For help in determining which risk management tool is best for your situation, reach out to an Old Republic Surety branch nearest you.
Scot Albrinck, AFSB
Scot Albrinck is the Bond Manager of Old Republic Surety Company Cincinnati Contract Branch. He has 11 years of surety experience with over 3 of them at Old Republic Surety Company. He is a graduate of The Ohio State University where he earned his Bachelor’s degree in Financial Management. He also has his AFSB certification. Scot enjoys spending time with his family, golfing, and doing anything adventurous and outdoors.