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China’s surety bond market underwent significant development in 2016 and surety bonds have become one of the most important methods for securing a financial guarantee. However, due to a lack of clear Supreme Court guidance on the matter, the laws that apply to surety bonds issued by insurers in China are still the subject of much debate. This update addresses whether the Guarantee Law’s accessory principle applies to surety bonds issued by insurers in China. Governing laws for interpreting surety bonds A ‘surety bond’ is a written agreement that usually provides for monetary compensation to be paid to the obligee if the principal fails to perform acts as promised. In China, surety bonds can be issued by banks (ie, bank guarantees) and insurers (ie, guarantee insurance). One difference between the two is that bank guarantees are drawn from a company’s credit lines on the bank’s terms, whereas, if an insurer issues a bond to guarantee performance, payments are made in the form of a premium and are not drawn from the company’s credit lines. One of two Chinese laws could apply to the issuance of surety bonds, depending on whether the surety is regarded as: a security instrument governed by the Guarantee Law, which came into force in October 1995; or an insurance product governed by the Insurance Law, the most recent amendment to which came into force in April 2015. Suretyship, guarantee contracts and guarantee insurance Article 6 of the Guarantee Law defines ‘suretyship’ as an agreement between a surety and an obligee that the surety will perform the obligation or bear liability according to the agreement if the obligor fails to perform its obligations to the obligee. Article 5 of the law provides that a ‘guarantee contract’ is “an accessory contract to the principal contract. If the principal contract is null and void, the guarantee contract shall be null and void accordingly. Where it is otherwise agreed in the guarantee contract, such agreement shall prevail.”(1) Under the Guarantee Law, a guarantee contract is an agreement between an obligee and a surety that is different, and yet ancillary, to the principal contract between the obligee and the obligor. The establishment, amendment and termination of a guarantee contract is premised on the principal contract. Where the principal contract is null and void, the guarantee contract shall also be null and void, unless otherwise agreed by the parties or stipulated by law. Conversely, ‘guarantee insurance’ is a type of insurance policy that can be issued only by insurers. Even though guarantee insurance is regarded as being within the scope of ‘property insurance’ under Article 95 of the Insurance Law,(2) Chinese law provides no standardised legal definition of guarantee insurance. The Supreme Court’s decision in a guarantee insurance dispute between two financial institutions held that ‘guarantee insurance’ is a type of insurance through which the insurer provides a guarantee to the insured (obligee) on behalf of the policyholder (obligor), in case the policyholder cannot perform its obligations as agreed in the contract with the insured and causes the insured to suffer an economic loss. In such cases, the insurer will bear the liability to compensate the insured in accordance with the agreement between the insurer and the policyholder. The Supreme Court further held that, even though guarantee insurance is a type of insurance, it is, in effect, a type of suretyship provided by the insurer to the insured. In the China Insurance Regulatory Commission’s (CIRC) decision in the same case, it stated that “guarantee insurance is a type of property insurance”. This classification was later adopted by the Insurance Law. Differing views Although the Supreme Court and the CIRC have each provided definitions, disparity remains among law practitioners and scholars regarding the nature of guarantee insurance. Article 36 of the Draft Interpretations of the Supreme Court on Issues in Trying Insurance Disputes provides that the courts “shall apply the Contract Law and the Insurance Law to ascertain the legal relationship between the parties when trying guarantee insurance contract disputes; the Guarantee Law shall be referenced where the Contract Law and the Insurance Law do not stipulate”. Article 34 of the draft interpretations provides that “guarantee insurance contracts serve to guarantee the performance of the contractual obligations, which has the nature of suretyship”. Article 38 of the draft interpretations provides that: “Guarantee insurance contracts shall be null and void where the principal contract is null and void, and the insurer is not to be held responsible for the insured liability. However, if the insurer knows the principal contract is void and still agrees to issue the guarantee insurance, the insurer shall assume the liability of compensation.” Although the interpretations have yet to come into force and the extent of the official version is unknown, the draft interpretations have substantially influenced the views of some local courts regarding: the nature of guarantee insurance contracts; and the legal relationship between a guarantee insurance contract and its so-called ‘underlying contract’. Specifically, the courts have applied the Guarantee Law in some guarantee insurance cases, holding that: a guarantee insurance contract is an ‘accessory contract’ to the underlying contract; and that guarantee insurance contracts are null and void where the underlying contract is null and void. However, some courts have maintained the opposite view that: a guarantee insurance contract is independent from the principal contract; and its validity does not depend on the principal contract. The ultimate reason behind this disparity is the absence of legislation and legally binding guidance in the guarantee insurance field. Are guarantee insurance contracts insurance contracts? Notwithstanding the above disparity, a guarantee insurance contract should arguably be regarded as an insurance contract governed by the Insurance Law, rather than a guarantee contract governed by the Guarantee Law. The reasons for this view, which is held by the majority of law practitioners and scholars in China, are as follows: The parties to a guarantee insurance contract are the insurer (surety) and the policyholder (obligor). The obligee to the principal contract, which is normally

Risks in the construction industry and commercial markets highlight the growing importance of surety bonds The evolving complexities of risks in the construction industry and commercial markets highlight the growing importance of surety bonds, a joint study by the Associated General Contractors of America (AGC) and consulting firm FMI found. The survey, entitled “Surety Bonding and Risk Management Forum,” polled 83 of the best-in-class construction companies with an aggregate annual volume nearing $50 billion. The poll found a majority of contractors believe the current construction risk environment is drastically different than it was five years ago. The finding is a complete turnaround from previous experiences of the construction industry, which for several decades has not seen a sudden shift in the pace of change and productivity gains like other industries. Industry players have noticed a rapidly changing landscape in the construction sector from Public Private Partnerships (PPP) to alternative delivery methods, including Integrated Project Delivery (IDP). As new technologies are introduced into the sector, construction projects are becoming more complicated, posing new challenges that are forcing the industry to adapt. But the industry as a whole is not in sync in adapting to the changing times, with some still clinging to what they have been used to, while others have embraced the change. According to the survey, contractors consider the risk for subcontractor default one of the top three risks facing the industry, together with a shortage of skilled craft labor and one-sided contract language. Other risk factors identified by those surveyed include: construction firms are managing risk differently today, risk management effectiveness varies and mitigating and managing risk has become a strategic priority. To mitigate hazards and to allow contractors to transfer some of the performance or payment guarantee risks, surety bonds play a more crucial role than ever, the survey suggested. Contractors are guaranteeing their investors and clients they can complete their projects within the terms of the contract by buying a surety bond or construction bond. A surety bond also provides additional protection to owners and an increased level of guarantee because sureties are expected to carefully scrutinize a contractor’s capacity to finish the project as specified in the contract, as well as conduct due diligence on its financial capability. Failing to do so means sureties would assume the claims against the bonds posted by the contractor. Greg Rynerson, CEO and founder of full-service surety bond company Surety Authority, commented on the issue, “To be sure, no contractor can afford to use the same business model he was using five years ago. The market environment has changed and is still changing. You have to adapt your strategy and accept an entirely new playing field, from rebuilding, retooling and refitting.” Luckily for clients, the surety industry has been at the forefront in recognizing the evolving risk landscape of the construction sector. In response, surety firms, including brokers and insurance firms, have expanded their teams of experts over the past several years. Their years of experience have allowed them to gain more in-depth knowledge of the complex construction risks. In turn, contractors are getting the necessary tools from surety experts that allows them to mitigate the performance and payment risk posed by their projects. The FMI and AGC study said, “Still, we can cautiously point to a number of positive trends that are taking place. For example, the industry did not witness nearly as many surety losses or large contractor failures as expected during the downturn—a sign that contractors, sureties and banks are more conservative in their underwriting approaches. Contractors are exercising more self-discipline and both sureties and banks are resisting the temptation to let contractors overextend themselves. Recent experience also indicates that the industry is getting more sophisticated. Leaders are better-educated, think more strategically and, thus, are apt to run their organizations more effectively. However, with the risk of contractor default higher in a recovering economy compared to other economic phases, the industry needs to keep a close eye on the potential for an increase in default claims going forward.” Rynerson added that looking at surety bonds from a pricing perspective, the surety industry is still a buyer’s market. Since 2007, the price for surety premiums is on a downward spiral, mimicing the downturn experienced by the construction space. He added that new entrants in the surety markets are also increasing the amount of capital to the surety line, dwarfing the revenue growth of the space. Despite all this, Rynerson stressed that Surety Bonds have become more important than ever to guarantee protection that projects are completed by contractors within the specified contract. “Simply put, construction bonds provide assurance that the project developer will recover any financial losses if the contractor does not complete a contract,” Rynerson said. http://www.gurufocus.com/news/457977/complexities-of-construction-risks-make-surety-bonds-more-crucial

After 2 successive years of growth, rally in overall premiums is expected to continue Things are looking bright for the surety bond industry. After two successive years of growth, the rally in overall premiums is expected to continue next year despite an expected rise in loss activity. Industry experts say the U.S. economy is showing signs of true recovery and most contractors are reporting a return of acceptable profit margins. After all, the health of the surety sector is correlated with the construction industry. From its peak of $5.5 billion in premium in 2008, the volume saw a sharp drop as the financial crisis spread across all sectors, particularly hurting the construction sector that saw public construction drop significantly. However, surety premiums saw a steady rebound in recent years with the improvement in the U.S. economy and as the construction industry gathers its pace again. Surety premiums surpassed the $5.5 billion high mark in 2015. Surety industry in slow but steady rise As the U.S. economy and the financial markets improve, the surety industry also saw its share of modest gains. Over the past several years, the sector has recorded a slow but steady rise. This year, the industry is expected to close 2016 on a positive note. Indeed, 2015 was the most profitable year in the history of the surety industry. Total industry direct-written premium reached $5.62 billion last year with an 18.3% loss ratio compared to the industry standard of 34% break-even loss ratio, according to U.S. Surety Industry data. The growth in the industry spilled over through the second quarter of this year with nearly $3 billion in total direct premiums written in just six months and an 18.4% loss ratio. The figures edged the 2015 numbers. The expansion in the industry will likely grow as the market capacity rises. As a result, some new entrants have joined the industry and are offering new products that provide better alternatives to clients, including subcontractor default insurance (SDI) and letters of credit. The steady supply of new surety bond products is likely outpacing demand. And while the number of carriers is on the rise, the top five surety companies – Travelers (NYSE:TRV), Liberty Mutual, Zurich (ZSA), CNA (NYSE:CNA) and Chubb (NYSE:CB) (recently acquired by ACE LTD Group [ACE]) – still control the lion’s share of the market. These top carriers control 50.3% of the written premiums. The other five carriers comprising the top 10 of the largest surety companies in the U.S. write 13.4% of the overall premiums. The 10 biggest surety companies in the country control 63.7% of the surety market. Still, the U.S. surety sector is considered competitive, and there are signs of more relaxed underwriting terms and conditions for sureties with the aim of broadening the markets and maintaining clients. Sure ‘arms race,’ new trends Industry players have noted concern over emerging trends wherein “noncontract” surety companies have joined the contract underwriting field. This so-called “arms race” for premium could prove costly for the players, many of whom have set relaxed underwriting standards because they are used to issuing commercial (noncontract) bonds. This trend could result in a rise in loss frequency and force market corrections if not closures. Another industry trend is the rise in mergers and acquisition activities. Chubb & Son Inc. Group was acquired by ACE LTD Group and HCC Surety Group (NYSE:HCC) merged with Tokio Marine Holdings (TSE:8766). Philadelphia Insurance Cos. (PHIN) launched its surety operation three years after being acquired by Tokio Marine Holdings. New entrants bring fresh capital, new products Even with the unexpected exit of XL Catlin in the first quarter that took away over $1 billion in capital capacity, it had no significant impact on the overall industry. But as expected, the sector saw an increase in the number of new entrants over the past few years, bringing with them fresh capital and property as well as new products with the idea of expanding profits. “The future of the surety market remains bright indeed,” commented Greg Rynerson, president and CEO of Surety Bonds Authority, a full-service surety bond company and one of the new players in the sector. “There are just too many opportunities in the surety sector, including energy, construction, transportation, etc.,” he said. “There are too many insurance firms that also want to get in.” Rynerson explained that surety underwriters are also facing intense pressure to grow. Many of these sureties are publicly traded stock companies that are expected to report consistent growth to their shareholders. Data released by the Surety & Fidelity Association of America, the sector’s loss ratio, is below 20% in seven of the past 10 years. In the first six months of this year, the loss ratio was a little above 18%. Contract surety vs. commercial surety The surety industry is divided into two main sectors: Contract surety used in the construction industry and commercial surety serves the rest of the bonding requirements. Both sectors face tough competition but more so in the commercial bond. Susan Hecker, director of national contract surety and area executive vice president at Arthur J. Gallagher & Co. (NYSE:AJG), commented, “Where we see severe competition to the point where rates are significantly impacted, or underwriters are complaining about other companies doing things that are ‘hypercompetitive,’ it’s typically in the commercial surety space. That’s also where we see most of the new entrants as well.” Because of the cutthroat competition in the commercial surety sector, some bonding companies are offering premiums that alarm and concern the industry. Ed Titus, senior vice president of surety for Philadelphia Insurance, complained that some sureties are undercutting existing companies by at least 20%. The same grim prospect faces the contract surety side with some underwriters being lenient in conducting personal financial backgrounds, particularly on personal indemnity and relaxing some requirements. Some are skipping financial presentation that is normally required from contractors. “A highly competitive contract surety market has definitely impacted underwriting,” says Carl G. Castellano, surety chief risk officer and vice