How Can Insurers, Reinsurers and Brokers in the CIMA Region Issue Surety Bonds?
This blog is a summary of a recent book in french by the author (firstname.lastname@example.org) about the theoretical and practical aspects of the surety branch and its reinsurance.
The question may sound puzzling given that surety bonds fall within the broader portfolio of traditional insurance products. Yet, it is a crucial question nonetheless as surety is a highly specialized niche within the insurance world. The issue is equally important if one is to take into consideration the growing interest from mainstream insurance sector players particularly in the CIMA (Conférence Interafricaine des Marchés d’Assurances) region, which includes 13 African francophone countries. However, despite surety bonds being a new phenomenon in the franc zone, a number of specialized companies have already had their licences withdrawn.
More importantly, the issuance of surety bonds is a crucial topic especially with regard to emerging development prospects and synergies between the banking and insurance sectors. This is thanks to financial insurances and bank guarantees. Take for instance the housing finance sector, mortgage guarantee is a case in point with regard to synergies between the housing and insurance sectors.
What is a surety bond and what exactly do insurers understand by the term?
A surety bond is a regulated product that is governed by an agreement that protects against financial loss. As such, there is not one specific definition of the term. If anything, a definition per se does not quite exist. The only explicit reference of the concept in the CIMA insurance code, is in article 328 on the classification of insurance classes. The term surety bond is listed under class 15 and split into two subsectors; direct bond 15A, and indirect bond 15B.
There is no further direct reference of the concept in the CIMA code, hence the recourse to doctrine, jurisprudence, legal references from other countries and professional practice.
What is a direct bond?
A direct bond or surety bond is an ordinary legal guarantee granted by an insurance company.
Stricto sensu, a guarantor is a person committing to guarantee the payment of a liability contracted by a person or company (the principal) with a third person (the obligee), in the event that the principal defaults. On a broader note, a surety bond is a security for the main contract agreement. The surety can be implemented free of charge or paid at a fee of between 0.1% and 3.5% of the contract amount. When the surety is issued by a professional credit and financial institution, a collective credit guarantee entity, or an insurance company, it is referred to as a professional or financial guarantee. A surety allows for the fulfilment of numerous conventional or legal operations. Whenever there is need for a guarantee, a surety is a definite way of securing the operation.
The business of guaranteeing, also known as « surety » is a financial service. The French Association of Specialised Financial Companies (ASF) defines the concept as: « a commitment made by a surety company (guarantor/surety) on behalf of a person or a company (principal), enabling the principal to offer a guarantee to its financial or economic partners (the surety beneficiaries). If the principal defaults, the guarantor shall replace the former to execute their legal duty. The guarantor may later seek financial redress from the principal.»
Surety bonds apply to a wide variety of cases, for example market sureties, which is necessary for public and private sector procurement. There is also a regulated profession guarantee fund, to protect clients of such professionals, when the latter handle funds belonging to third parties e.g. travel agents, notaries, lawyers, insurance brokers, etc.
As defined above, a surety bond, generally involves three parties, resulting in a dual relationship; between the guarantor and the principal, and between the guarantor and the obligee; which by nature is a personal guarantee or surety (a concept that protects the obligee against financial loss, thanks to a third party commitment). As such, a surety, which is actually a financial service, is not limited to a guarantee. It also covers the independent guarantee, which in itself is a commitment separate from the main contract. The legal nature of a surety bond is similar to a bank loan rather than to an insurance contract. A good rule of thumb is that not all guarantees issued by an insurance company constitute an insurance policy.
To non-specialists, this difference between a surety bond and an insurance policy may not be obvious, and especially because service insurance companies that issue sureties use the same risk management techniques as those in mainstream insurance business. For instance, the risk pooling which includes spreading the risk across a large number of policy holders for risk mitigation, risk selection, premiums, risk reinsurance, provisioning collecting premium tax etc.
In actual sense, the difference between the two concepts is rather obvious. Unlike in insurance where the risk is linked to the occurrence of an unforeseeable/unavoidable event, such as a fire or an accident, surety applies when the damage is as a result of a person’s or a company’s inability to honour their commitment.
Yet, a principal’s failure to honour his engagement is seldom an accident. It is usually the result of either financial, technical, judicial, economic or political situations, which in some cases could have been avoided. The damage does not result from unforeseeable circumstances as would be the case with traditional insurance. Additionally, unlike an insurance contract, a surety bond gives an obligee, subrogatory or personal recourse in the event that a payment is made out on his behalf. Unlike bankers who control financial flows of the clients they guarantee, which enables them obtain a reimbursement for payments made out on their behalf, a guarantor does not have direct access to their clients’ bank accounts. It is for this reason that a surety has to build his business model around a sound risk management mechanism and a clear and innovative re-insurance structure.
In a nutshell, a bond is not an insurance product but rather a financial service. If an insurer were to issue such a product, he would be forced to adopt a banker's attitude, while managing the constraints of the insurance world.
What about suretyship (indirect), the second subsector of sureties?
Suretyship (indirect), also known as surety insurance by legal advisors is a type of insurance that provides a cover to sureties such as banks and financial institutions or entities other than surety companies. Surety insurers mainly target banks, financial institutions, surety funds, or even individuals. It is crucial to note that indirect bonds have the same judicial connotation as insurance contracts. As such, they can only be issued by insurance companies. That is the particularity of such bonds.
What is the purpose of this book and more precisely, who does it target?
Success in any given insurance sector can only happen if one fully understands and masters the parameters that govern the sector. The book "La branche caution et sa reassurance: Théorie et Pratique" (Surety and Reinsurance: Theory and Practice) allows the reader to have a better understanding of the reinsurance sector. It is a contribution to the sector as it scientifically examines the business of surety bonds in a neutral and practical manner. The book covers topics such as; risk and claims management, the financial selection of risks, information systems etc. It is a guide book to be used as a strategic tool for decision-makers in the industry.
About the Author
Jean Olivier Anet is currently the Technical Operations Manager at the Continental Re-insurance in the Abidjan Regional Office. Prior to joining the organization, he worked for ten years as a Senior Underwriting Assistant in charge of claims management and underwriting of surety and credit insurances. In 2012, Jean Olivier received the FANAF’s Jean CODJOVI Award in recognition of his work in surety. The Jean CODJOVI award aims to promote research in the Insurance and Reinsurance field. Jean Olivier holds a Master’s degree (Msc) in Management and another in Insurance.