Bank guarantees and insurance bonds
Councils often require security to ensure the performance by third parties of obligations under leases, construction contracts or bonding arrangements under the Development Act 1993.
Bank guarantees have traditionally been favoured as the preferred form of security by councils.
SA Power Networks has recently announced a change to its business rules such that it will now accept insurance bonds in addition to bank guarantees, provided certain mandatory criteria are met, see here. SA Water already accepts bank guarantees or insurance bonds, provided the form of the undertaking and the institution issuing it are approved by SA Water.
It is timely to provide a brief refresher on bank guarantees and insurance bonds.
Bank guarantees
A bank guarantee is, as the name suggests, a guarantee by a financial institution to pay an amount set out in the instrument on receipt of a demand by the holder of that instrument.
A bank guarantee will attract initial and ongoing fees, calculated as a percentage of the guarantee amount (usually around 2.5-3%). It is generally required to be supported by collateral in the form of cash, property or other assets.
To constitute adequate security, a bank guarantee must:
- be in the required amount, including GST if appropriate
- be in the name of the relevant council
- be issued by a reputable bank (i.e. with a high credit rating) with a branch in South Australia
- be unconditional i.e. payable on demand by the council without reference to or approval by the third party
- be irrevocable i.e. not be able to be cancelled by the bank or the third party; and
- have an appropriately lengthy or no expiry date.
Insurance (or surety) bonds
An insurance bond is not an insurance policy. It is a guarantee by a surety provider (confusingly, usually an insurance company) of the performance of contractual obligations.
Unlike a bank guarantee, there is no requirement to provide tangible collateral to support the guarantee, which can free up assets and working capital. Rather, the surety provider makes an assessment of the party’s overall exposure to risk and ability to perform its contractual obligations and “underwrites” its performance on the specific contract the subject of the bond.
There are high turnover and risk thresholds required to be met to establish a surety facility, meaning insurance bonds will not be a practical option for a small business operator, contractor or developer, or a party needing a one-off bond.
While bank guarantees and insurance bonds share similar features, they are not necessarily equivalent. Some additional areas of risk that may apply to insurance bonds (over and above the bank guarantee assessment criteria outlined) include:
- Low or falling credit rating of surety provider (and increased likelihood of financial collapse)
- Lack of clarity around when the liability for payment arises
- Effect on the insurance bond of variations to the underlying contract
- Appropriate timeframe for payment
- Local office in South Australia
- Governing law being South Australian law; and
- Concentration risk of multiple bonds from one insurer.
These risks should be able to be identified and mitigated during review of the terms of the insurance bond and consideration of the status of the surety provider.
Take home message
Whether councils have a policy of allowing insurance bonds or not, every security instrument should be considered on its own terms and assessed carefully to ensure it represents adequate security, before it is accepted.