If you are involved with bid and performance bonds for contractors, you may hope to avoid collateral transactions. But if you ever do get into this area, there are things you need to know. Let's take a look at the role collateral plays in surety bonding and go over the important elements.
What Is It? Collateral is a security deposit the bond applicant gives to a surety (bonding company) to gain approve of a bond that is somewhat difficult. The purpose is to lessen the surety's exposure and make supporting the bond more palatable.
Forms of Collateral The most common form of collateral is an Irrevocable Letter of Credit (ILOC) issued by a commercial bank. Also called a Standby Letter of Credit, it is issued based on the credit standing of the bond applicant, with the surety as the beneficiary.
The ILOC states that, upon demand, the bank will make payment to the beneficiary up to the face amount of the letter. Such payments are then recorded as a loan to the bond applicant. If the surety experiences a bond claim or has a loss, they can gain immediate recovery through the ILOC. This protects them from delay or failure of their subrogation (collection) efforts.
Other forms of collateral could be cash, a Certificate of Deposit that is assigned to the surety or even real property if it is professionally appraised and free of encumbrance.
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