Alberta Risk Advice by Cielito Villanueva

Often times, a municipal, provincial or federal government, otherwise known as an obligee, may require a contractor to provide a guarantee instrument before hiring them to do a job. The two guarantee instruments usually requested are either a surety bond or an ILOC (Irrevocable Letter of Credit).

Here’s an explanation of the two types:

ILOC (Irrevocable Letter of Credit)

By choosing to obtain an ILOC, you are receiving a letter from the bank that declares that you are “good for” a particular amount of money (this amount varies depending on the project). The ‘irrevocable’ name implies that it cannot be cancelled by anyone but the obligee. This letter of credit is held by the obligee and in the event of a claim, the obligee can draw on these funds at their discretion. It will be up to the contractor to pursue the obligee if they feel a claim is frivolous.

The main drawback of the ILOC is that the bank locks the full amount of the ILOC in cash.  For example, if you are required to have an ILOC for $100,000, then the full $100,000 will be held by the bank and inaccessible to you.

Surety Bonds

A surety bond is a three party agreement involving a principal (the contractor obtaining the bond), an obligee (the party requiring the bond of the principal), and a surety (the surety company who is backing the bond).  In the event of a claim, the surety will investigate a default of the contract, and if a default is confirmed, the surety pays out to the obligee.  In short, you as the principal, are using the financial resources of the surety to cover you, while only having to pay premium on the bond (in some high risk/bad credit cases some collateral may be required).

It should be noted that a surety bond is a form of credit and not insurance. One of the advantages of a surety bond is that it is also considered a default instrument; this will ensure that no payout is made for frivolous claims. Should a payout occur, the principal is obligated to repay the surety company for the entire amount paid out.

Which is More Costly?

It can be assumed that surety bonds are more expensive than ILOC’s, but this may not be completely true. For the sake of simplicity, let’s continue to use the $100,000 amount as an example:

An ILOC generally costs 1% a year or $1,000 for the $100,000 letter.

Generally a surety bond will fall in the 1-3% range or $1,000-3,000 in our example.

On the surface, surety bonds seem more expensive, but let’s dig deeper into the real costs. First and foremost, with the ILOC, the $100,000 is locked up by the bank who is earning interest from this $100,000 and not you. With the 3.5-4.5% money market average, you are leaving $3,500-4,500 on the table. On top of this lost income opportunity, you have no access to this money should another opportunity, or crisis, come you way.

On the other hand, there are no hidden costs attached to a surety bond, and you are free to hold, invest, or use your money as you wish.

If you qualify for a surety bond, it is clearly the better choice, and gives your business more opportunity and flexibility for the future.