For more than a century, surety bonds have been the respected, sensible, supportive, restrained grand dames of the insurance industry. Then, about a decade ago, they began to change into aggressive, enterprising, high-stepping showgirls frequenting unusually risky places, and keeping company with some unsavoury characters.

This dramatic transformation has propelled these historically conservative insurance products smack into the middle of the slatternly Enron bankruptcy, the largest in American history. Along with Enron's collapse has come billions in losses for surety writers, which has reduced the profits of several major insurers. The losses, also, have produced a rocketing increase in surety bond pricing and contributed to the failure of a major retailer, Kmart. And it has also sent surety bonds, `sadder but wiser', back to the safety and security of their former conservative behaviour.

Traditionally, about two-thirds of the $3.5bn in global annual surety premiums come from guaranteeing performance of construction projects, both government and private. The other main category is commercial surety that covers financial transfer products, such as fiduciary, license, bail and financial guarantee bonds, a relatively recent addition to the bond portfolio. It is the growth of these financial guarantee bonds that brought the billion-dollar losses to the surety writers, resulting in them crying fraud and refusing to pay claims.

Surety bonds pushed
The increased interest in writing financial guarantee bonds began about a decade ago when insurers suffering from years of flat revenues and declining profits looked around for some means to lift operating results and latched onto surety bonds. Surety underwriters were pressured to search for new markets for their products. At about that time the Japanese banks, which were a main source of letters of credit (LOCs) in the US, began withdrawing from the market as they began suffering dire liquidity problems back home.

David Goodwin, co-chair of Heller Ehrman's insurance coverage national practice group in San Francisco, said that for years LOCs had been used extensively by major corporations which self-insured their workers compensation programs rather than buying expensive workers comp insurance. "Regulators, however, demand a financial guarantee that the companies will pay benefits to injured workers," he said, "and the companies purchase letters of credit to fulfill this obligation." Consequently, with LOC fees on the rise because of diminishing capacity, companies began buying financial guarantee bonds from surety writers to satisfy fiduciary requirements.

Surety bonds are used extensively in the US, Canada and Latin America, but in Europe letters of credit issued by banks are still the main form of financial guarantee. One reason for the lack of interest in Europe for surety bonds is that there are no uniform rules that govern or case law that interprets standard bond liability. Several international bodies are working to establish a set of uniform rules.

Lloyd's of London allows a few syndicates to write a limited number of types of financial guarantee insurance, though only after requesting pre-authorisation to issue the policies.

Another reason financial guarantee surety bonds began to have a surge in sales was that the bonds are not required to appear on a company's balance sheet, as do LOCs, nor do they pull down the company's credit facilities, according to Larry Bradish, head of the insurance/reinsurance group at Cadwalader, Wickersham & Taft, New York. As the recession deepened in 2001, companies began using surety bonds in greater numbers as a means of moving debt off their balance sheets. And with increased competition among surety writers, the bonds quickly became cheaper than LOCs. However, as demand remained strong, rates for surety bonds began edging upward.

Guidelines `winked at'
Soon, financial guarantee bonds were taking the place of not only LOCs, but escrows, deductibles, deposits and other forms of security that restrict capital resources. As this market expanded and competition among insurers heated up, underwriting criteria for these types of bonds began to loosen and too often the `pre-qualification process' was winked at. Bonds were issued to almost anyone regardless of experience, character or financial wherewithal. "The chase for surety bond business led company officials to cross over strict underwriting guidelines and they got into trouble," said Goodwin.

While the financial guarantee business could be profitable, it had the real potential to produce huge losses for insurance companies. In December 2001, Enron's ephemeral financial bubble burst. It declared bankruptcy and the grand, high-flying spree of financial guarantee surety bonds ended with a thud. Claims ranging from $2bn to $4bn were filed against property/casualty insurers, mainly for surety bonds, D&O liability and E&O coverages.

As the unravelling of Enron's complex partnership deals began, claims soon flooded in to surety bond writers. Among them were several from JP Morgan Chase & Co Inc claiming it was owed almost $1bn on six surety bonds that were written by 11 insurers on Mahonia Ltd and Mahonia Natural Gas Ltd, two limited partnership companies located in Jersey, Channel Islands. JP Morgan Chase said the companies prepaid Enron for future oil and gas deliveries that Mahonia then planned to resell and that the surety bonds guaranteed payment of the oil and gas contracts to JP Morgan Chase if Enron collapsed.

Insurers participating on the various bonds included Liberty Mutual Insurance Co, two units of Travelers Property Casualty Corp, St Paul Fire & Marine Insurance Co, two units of CNA Financial Corp, Fireman's Fund Insurance Co, SAFECO Insurance Co of America, Federal Insurance, Hartford Fire Insurance Co and Lumbermens Mutual Casualty Co.

Contracts a ruse
In counter-complaints, insurers charged that Enron never intended to deliver oil or gas to Mahonia and further, Mahonia had no facility to accept the products and there were no contracts to sell the oil and gas to others. Rather, insurers charge that the contracts were a ruse meant to disguise hundreds of millions of dollars of loans that JP Morgan Chase made to Enron and thus the bonds were obtained under materially false descriptions which voided them.

Bradish of Cadwalader, Wickersham & Taft, which is representing several insurers in suits against Enron, said he believes the reason Enron sought to protect its Mahonia contracts with surety bonds rather than financial guaranty policies was that bond underwriters would have looked closely at the world's supply of oil and gas but not so thoroughly at Enron's balance sheet. Surety companies can choose to replenish the commodity rather than making a cash payment if a bond goes into default. Financial guaranty insurance policies, however, such as those written by MBIA or FSA, are irrevocable and cover all types of risk, including fraud, and must be paid in cash if the bond goes into default.

While the financial guaranty policies would have provided much broader coverage for Enron, Bradish said, the financial guaranty firms would have examined Enron's balance sheet very, very closely. "This may be one reason," he said, "that Enron did not go to financial guaranty firms for their protection of these contracts. Enron officials may have known they would have been subjected to much greater fiscal scrutiny than what surety bond underwriters would require. And being denied a policy by a financial guaranty company would have sent a very damaging signal to the financial community." Also, buying surety bonds allowed Enron to keep the transactions off its balance sheet and it didn't have to draw down its credit balances.

A further argument that says insurers were writing surety bonds and not financial guaranty policies is that under New York law, financial guaranty policies may only be written by mono-line insurers. Goodwin of Heller Ehrman said since no surety bond writer is a mono-line insurer, it could not write the type of bonds that the bank states that it wrote. "Insurers were not told the truth about the risk. They were analysing the risk of providing gas and oil if Enron could not fulfill its delivery promise," Goodwin said. "When Enron defaulted, banks wanted cash, but that is not what the surety bonds guaranteed."

Redux old standards
The fallout from the Enron debacle will continue for years and may compel changes in accounting regulations, as well as how companies report their financial dealings and arrangements. For surety bonds, certainly significantly higher loss ratios will be reported for 2001, probably for 2002 and perhaps onward. A welcome change coming from this ill-fated foray into financial guarantee bonds is that both reinsurers and primary surety writers will return to more consistent and fundamental underwriting standards. Certainly, it will be very difficult for companies resembling Enron to get a surety bond. Once burned, twice shy, as the cliché goes.

Further, the surety bond segment, already an elite group of companies, will constrict even more, as is already evident. WR Berkley Corp, admitting it has a loss of at least $12m from reinsuring surety bonds from primary insurers that issued the bonds to Enron Corp, "will cease writing business with exposures to large national risks commencing 1 January 2002, and will focus primarily on its regional surety reinsurance business."

SAFECO President and CEO Mike McGavick, who joined the company on January 30 2001, said: "We've closed the books on one of the most difficult years in our company's history." The company reported an $18m loss from surety bonds written for Enron,

The St Paul Companies acquired the right to renew 800 surety bonds previously underwritten by Fireman's Fund. Two small contract surety players, Frontier Pacific and Amwest Surety, have been liquidated. American International Group, hurting from a loss of $57.2m on policies directly related to the collapse of Enron, is now writing only jumbo net worth contractors. Chubb had losses of $183.6m from surety bonds it wrote for Enron. Describing the loss as a "gross embarrassment," Chairman and CEO Dean O'Hare said that because of the loss there was no holiday bonus for most employees. Many in Chubb's surety department were fired.

Following the catastrophe of Enron, rates for surety bonds have gone up, capacity is going down, underwriting has become more restrictive, and, Mr Bradish noted, when these forces occur, creative people in risk management look for alternatives.

Déjà vu Enron
In the short-term, surety bonds will not be used because they will become expensive, and auditors will require some sort of disclosure of surety bonds, and for that reason, the relatively inexpensive balance sheet relief offered by surety bonds will disappear, Mr Brandish continued. "But in the long run, what will be the ultimate result of Enron? Will people go to jail, will executives have to give back excessive profits, and will Arthur Andersen, Enron's accounting firm, go out of business? If nothing serious happens in a year or more, then one day we will see a repeat of this destructive scenario."

By Ronald Gift Mullins
Ronald Gift Mullins is a US-based insurance journalist.