One of the hottest trends in the surety marketplace in 2023 and 2024 is the emergence of Surety Backed Letters of Credit (SBLCs). Gallagher is seeing this market grow rapidly as both sureties and our clients are seeing the tremendous benefits of this product.
SBLCs can be tailored for either commercial surety or contract surety obligations (primarily internationally on the contract side). It can be a solution when placing a traditional surety bond isn't possible due to onerous bond forms, capacity considerations, letter of credit "only" requirements or a lack of fronting ability.
What: Surety Backed Letters of Credit (SBLCs)
Benefits: Use the existing surety facility to front Letters of Credit (LCs) outside existing credit facility
How: The surety company uses their financial relationships to place LCs on the client's behalf
Cost: Typical Surety program rate, plus 25-40 basis points (bps) fronting fee
Target market: Medium to large companies that utilize LCs as a course of business
Some of the many industries in which SBLCs are gaining traction are:
- Insurance and finance: Insurance program collateral, lease guarantees and pay on demand
- Renewable energy: Power Purchase Agreement (PPA), interconnection and decommissioning
- Oil and gas: Financial assurances, plugging and abandonment
- Environmental: Mining and reclamation
How Surety Backed Letters of Credit work
The first step is that a surety must identify banking partners to support them. Typically, these banks are international banks, as the current US regulatory environment regarding capital requirements doesn't support this product well.
Once the surety establishes their banking partners, the surety set up a revolving facility with the partners for issuing LCs. The bank will use the surety's (insurance company) financial condition as the underwriting for the facility, which produces very favorable terms.
Once up and running, the surety decides which clients meet their internally developed underwriting criteria for SBLC issuance. The sweet spot for this product is low- to mid-investment grade (or equivalent) credits that would be paying ~150 bps+ on their standalone facility, and/or clients who use extensive LCs as a course of business and who could benefit from additional credit support.
In the LC structure, the bank would be the issuer, the surety is the guarantor and our client would be the applicant — hence the name Surety Backed (Guarantor) Letter of Credit. Any counterparty draws (claims) on a SBLC would first go to the issuing bank and then to the surety. Then, via the existing indemnity agreement with the client, the surety would look to the client for remuneration. The client and bank don't maintain a working relationship in the structure; this product doesn't disrupt the client's existing bank facilities.
For use of this facility, the client is charged their predetermined account rate, plus the average 25-40bps bank fee from the surety (the cost is passed through the client). Often, we see this "all-in" pricing lower than what our clients could secure a LC for on their own because the surety — and their big balance sheet — is the Guarantor. Any SBLC issuances are deducted from an account's aggregate surety facility, and we often establish a SBLC sublimit in the bond program as well.
The benefits of Surety Backed Letters of Credit
This facility is truly a win-win for the surety and the client.
The surety:
- Can respond to otherwise unwritable requests
- Shows flexibility in their support
- Develops a deeper account relationship
The client:
- Can tap into Surety Program capacity for LC needs
- Saves capacity under the client's bank facility for working capital needs vs LC issuance
- Can be a cost savings to the client by using the surety's credit strength for pricing/fees
- Improved liquidity, cash isn't being used to backstop LC issuances or for collateral
- Offloads the LC process on the surety, thereby streamlining treasury operations
Things to be aware of
As this is a new product, there are still some growing pains in the industry, with the largest two being surety reinsurance considerations and capacity/aggregation constraints. We should relay these risks to our clients.
Many participating sureties are seeing price increases at their reinsurance treaty renewals because of this program and the perceived higher financial risk associated with it. This product could become cost prohibitive should reinsurers continue to hike rates and/or increase retentions. These considerations also drive the selective nature of the client the surety will consider for this product.
On the capacity side, because US banks do not participate at this time, it does limit the product to acceptable foreign banks. In addition, there are less than 10 sureties actively supporting this product, although that list has been trending upward. The mid-to-long-term concern is that we could conceivably reach a point where we have capacity constraints and aggregation issues at all parties: the banks, the sureties, and counter-parties accepting the SBLCs.
Own the idea
If you have a client who could benefit from this product, why not own the idea? Gallagher's Commercial Surety team would be happy to facilitate a discovery call to see if your client is a fit for this alternative surety product.
