Like most other financial products, there is a wide range of insurance products, which need clarity for the comprehension of the insuring public.

This will clarify the possible ambiguities often associated with some types of insurance thereby emphasising the cardinal principle of ‘Utmost Good Faith’ (i.e. upholding the truth at all times).

For instance, underwriting Guarantee Bond policy can be really challenging, as consequential claims can literally ‘kill’ any organization. 

Instructively, Credit Guarantee Bond insurance policy is often confused with advance mobilization policy. Technically, one could easily qualify as a sub-set of the other, but the two are different. The scenario below will summarize it all.

The Scenario

Gastoro Contractors, a reputable construction firm operating in Western and Central Africa, with over US$23billion in assets, won a bid to construct a Government of Ghana (GoG) funded footbridge.

As per the agreement, they are required to pre-finance the project; hence they sought funding from the bankers, who requested a credit guarantee bond valued at USS$10million (which is the contract value). Q insurance company has agreed to underwrite the risk.

However, Q insurance has inadequate capacity to underwrite the policy all alone; hence they got two other insurers, P and D, to share the risk, known in insurance parlance as co-insurance. The insurance premium collected was then shared between the team of insurers, who also paid the appropriate re-insurance premiums.

In both cases, the accruing commissions were earned. After a successful contract execution while meeting specifications and timelines, the GoG was enjoined to pay the contractor through the funding bank. (Co-insurance and re-insurance would be discussed in subsequent write-ups for a clearer insight).

Purpose of Credit Guarantee
The purpose of having this bond is to protect the financing institution against the contractor’s default in repaying the facility. The underlying risk is the possible inability of the contractor to pay his bankers for pre-financing the project. In this regard, the bankers will fall on the insurer to execute the guarantee bond. This would, therefore, exonerate the bank from any financial losses arising out of non-payment of the facility by the contractor.

Other Businesses That Require Credit Guarantee

Aside from civil contractors, credit guarantee bonds are also sought after by foreign suppliers of goods on credit to local customers. This type of insurance underwriting requires a lot of full proof measures including warehousing of the goods and the establishment of escrow accounts to ensure that the goods are received, sold and the supplier(s) paid. 

Nature of Credit Guarantee

Credit guarantee bond is normally issued taking into consideration stringent underwriting assessment as well as the application of the rule book to include business decisions by the insurer. Most underwriters, in addition to the premium, will require additional collateral before issuing the bond.

This will enable the contractor to bid for a contract having in mind the fact that the existing credit arrangements with his or her bankers do not suffer.  This implies that borrowing from the banks are safeguarded making it possible for the contractor to adequately plan, with the confidence and capability of execution.

This, therefore, gives the contractor a competitive advantage in the bidding process. Meanwhile, bonding can also be likened to “surety” in legal terms. Giving the high risk associated with guarantee bonds therefore, many underwriters shy away from them as they have the potential to cause bankruptcy.

Types of Guarantee Bonds

There are different types of bonds taken for specific projects including tendering/bidding processes as follows:

1. Performance Bonds: It is a written guarantee obtained from either an insurer or other financial institutions for the purpose of executing a contract. In the scenario above, the GoG, being the principal/employer, may have requested a performance bond on or before the bid. The purpose of this bond is to indemnify the principal/employer against losses that may arise from the non-performance of the contract by the contractor.

2. Tender or Bid Bonds: These are issued as part of a tendering process by the guarantor to the employer, to guarantee that the one who secures the tender will undertake the contract under the terms clearly outlined.

3. Retention Bonds: It is a performance bond that protects the employer after a project has been duly completed, guaranteeing that the contractor will still carry out corrective structural and defective observations moments upon completion of the project.

4. Advance Mobilization (or payment) Bonds: This is also known in accounting as prepaid expenses. It involves paying a part of the contract sum paid in advance for goods and services. The description of the policy is often a source of confusion in this case. The bond is issued by the employer in order to advance money to the contractor, as start-up capital to commence the project or, at least, mobilize equipment to site. Typically, the contractor refunds the advance if he fails to mobilize the necessary equipment to site or commence the project by a defined time. The specification and scope of the mobilization are often well defined, and the extent of liability decreases in value, as and when the contractor submits certificates endorsed by the Project Owner (GoG ), stating the completion of important milestones.

Premium

The premium is normally a percentage of the amount involved and can run into thousands or millions of cedis depending on the amount to be secured. From the scenario above, Gastoro Contractors delivered the contract to specification. Until that was done, the insurers were on the tenterhooks, hoping that the contractor would execute the project in order that they may make a gain in the absence of a claim.

The Dilemma and Way Forward

Is it really a ‘gamble’ to underwrite Credit Guarantee Bonds?  If so, isn’t it about time it was reviewed or expunged from our insurance business modules?

 

Until next week, “This is Insurance from the eyes of my mind”