Letter of Credit vs. Surety Bond

In the construction industry, where large-scale projects are the norm and intricate financial agreements underpin every undertaking, ensuring financial security is essential.

As an insurance brokerage that specializes in protecting construction professionals, we’ve witnessed firsthand the complexities and nuances that come with safeguarding investments and mitigating risks. Two common instruments that often emerge in this landscape are the ‘letter of credit’ and the ‘surety bond’. Both play huge roles in ensuring contractual obligations are met, but they operate on distinct principles, structures, and implications.

In this guide, we’ll break down the differences between a letter of credit vs surety bond, as well as the advantages and potential pitfalls of each. Let’s get started.

Surety Bond vs. Letter of Credit: Involved Parties & Processes

How a Letter of Credit Works

This is a type of financial guarantee that uses the bank as the guarantor. As such, a letter of credit (LC) involves three parties:

• The Buyer: This party purchases the letter of credit as a performance guarantee.
• The Beneficiary: The party that is entitled to draw funds from the letter of credit in case the buyer cannot or does not meet their obligations.
• The Bank: The financial institution that writes the letter of credit and holds the funds.

For a letter of credit in construction, the contractor (the buyer) approaches the bank to issue one in favour of the project owner. The bank typically holds a predetermined amount of funds or liquid assets as some form of security interest that the buyer will perform their duties as per the project contract. This value is stated in the letter of credit.

These funds are inaccessible until the buyer can finish the contract within the deadline and following industry standards. If the buyer cannot or does not meet their obligations, the beneficiary can cash in the letter of credit—without consulting with the buyer—to be reimbursed for the losses incurred.

How a Surety Bond Works

One of the similarities between a letter of credit vs. a surety bond is that they both bind three parties. When looking into bonds, this arrangement involves:

• The Principal: The party that purchases the surety.
• The Obligee: The party that requires the principal to obtain a bond.
• The Surety: This is the party that provides the surety bond and guarantees the principal will meet their obligations to the contract.

Whether you’re looking at performance bonds, a payment bond, or any other type of surety bond, each promises that the obligee will be covered against financial liabilities and additional losses caused by delays in case the principal (the contractor) defaults. If the principal cannot complete the project within the given deadline, the project owner can claim the bond.

Letter of Credit vs. Surety Bond: Similarities and Differences

Both LCs and surety bonds are legally binding contracts that serve as financial instruments designed to offer risk mitigation assurance in various commercial transactions, but they operate on different principles and have distinct characteristics. Here’s a breakdown of their key similarities and differences:

Key Similarities

Financial Safeguards:

Both instruments are mechanisms to provide a financial guarantee that certain obligations will be fulfilled.

Third-party Involvement:

Both involve a third party, either a bank (in the case of LCs) or a surety company (in the case of a surety bond), that agrees to step in if the primary party fails to meet its obligations.

Risk Mitigation:

They are both tools used to mitigate risks associated with non-performance or default by a party in a contractual relationship.

Key Differences

Nature and Purpose:

An LC is primarily used in international trade to ensure a seller will receive payment once they meet the specific terms and conditions stipulated by the buyer. It’s a guarantee of payment.

A surety bond, on the other hand, is a third-party agreement where the surety company guarantees the performance of the principal (a contractor) to the obligee (the project owner). If the principal fails to perform, the surety steps in to fulfill the obligation.

Cost and Fees:

Letters of credit typically involve annual fees charged by the bank (around 0.5% to 1% for issuing the LC and may require the buyer to provide collateral.

Surety bonds involve a premium paid to the surety company. The average cost of a surety bond premium is about 0.5% to 10% of the bond amount, which is calculated based on the underlying risks identified in the bond.

Handling Claims:

Surety bond vs. letter of credit claims handling is quite different.

In the example of submitting a claim for a payment or performance bond, the surety company will investigate to determine the validity of the claim and the extent of the principal’s default.

Depending on the terms of the bond and investigation findings, the surety can choose to complete the project using another contractor or compensate the obligee for the losses incurred. If the surety company fulfills the claim, the principal remains obligated to reimburse the surety for any amounts paid out, including legal fees and other associated costs.

For an LC, the primary focus is on the compliance of documents presented by the beneficiary with the terms and conditions stipulated in the LC. The bank will only honour the LC if the presented documents are in strict compliance with the LC terms. They do not concern themselves with the underlying transaction or the performance of the parties involved.

Once compliant documents are presented, the bank is typically obligated to make immediate payment to the beneficiary, regardless of any disputes between the buyer and seller.

Gain Greater Financial Assurance with KASE Insurance

The letter of credit vs. surety bond debate shouldn’t be much of a debate at all—the former is the better risk management solution for construction projects. Whether you’re new to the industry or running an established business, surety bonds are simply the better choice.

KASE Insurance is the leading provider of surety bonds in Ontario. We offer fair rates and attentive customer service to ensure your bond is an agreement that benefits you just as much as the party issuing the project. Your interests matter.

Contact us today to learn more or request a quote!