February 26, 2021 | Industry Insights
Managing Your Customs Bonds – The Financial Review
The Purpose of the Customs Bond Risk Assessment
Why does a surety underwriter choose to to review the customs bond principal’s financial position? Because the bond represents a financial risk to the surety. The customs bond is a three-party contract between the surety company, US Customs and Border Protection (CBP), and the importer who is the principal on the bond. It is the principal’s responsibility to pay CBP all duties, taxes, and fees on entries made, and the bond is a guarantee that, if the principal can’t or for some reason doesn’t pay the duties, taxes, and fees on an imported shipment, the surety will make that payment to CBP. As they are obliged by the bond to pay only if the bond principal fails to do so, it is in the surety’s best interest to be as certain as possible that the importer will be financially stable enough to make payment. It is important for all parties in the bonding process that the surety payments to CBP stay as low as possible. Low loss ratios help to keep bond rates low and the issuing authorities of customs brokers high.
Due to the pandemic, the so-called “trade wars”, and other economic factors, increased numbers of importers have been defaulting on standard payment of duties, taxes, and fees, causing liquidated damages claims for these payments to skyrocket from 10% of all bond damages in 2018 up to 30% in 2020. For this reason the underwriters are focusing even more closely on an importer’s financial condition and liquidity – indicators for their ability to pay duties, taxes, and fees as well as any damages issued by CBP.
The Underwriter Financial Assessment
When they ask for “financials” the surety underwriters are looking for a complete year-end report that is usually defined as a 12-month, CPA-prepared financial statement including:
- Income Statement
- Balance Sheet
- Statement of Cash Flows
- Accompanying Notes
If there is not a CPA-prepared 12 month financial statement available, the surety underwriters will typically accept the income statement and balance sheet available via internal accounting platforms such as Quickbooks. On these self-produced financials, the surety usually requires a company officer to attest to the accuracy via a signature to confirm that all the information presented is true and valid. These internal reports may also accompany a CPA-prepared financial if the risk review comes near the end of the bond principal’s fiscal year.
Tangible assets are what the underwriters are looking for in the financials provided, as well as current assets and the sorts of things that can liquidate within a year. Tangible assets include cash, working capital, inventory, and other real things that contribute to the bond principal’s net worth. The ability to turn non-cash assets within a year into cash is critical to the underwriter. A bond holder might seem to have strong assets because they have a lot of inventory, but an underwriter could discount inventory if it is long-term and is not selling quickly. Fundamentally, the customs bond is a financial exposure to the surety, and the underwriter’s chief concern is whether or not the importer can pay up to that bond amount for any entry duties, taxes and fees or any damages that CBP may issue.
Similar to inventory that isn’t easy to sell, intangible assets and goodwill or trademark have limited value in an underwriter’s review. While something like a trademark or brand name might be a means to making money for a bond principal as it is owned and possibly could be sold, the surety underwriter doesn’t have a good way to estimate how soon that money could be available. Additionally the market value of a brand name can shift dramatically within the term of the bond. This is a significant difference in the way a CFO would look at a company’s financial review versus how the surety underwriters approach the same document.
The main underwriting concern on the income statement will be consistent profitability. The underwriter will want to determine whether or not the company is profitable. They will look for a positive net worth and a positive net income. They may need to find net profit greater than or equal to the bond amount, but the critical factor is that the principal is making money and can show a history of making money.
The cash flow is a critical component as surety companies need to determine liquidity. The cash flow demonstrates the cash availability that the company has for a given time frame.
The accompanying notes section is important as well because the information in the notes can explain many factors in the financials such as why a bond principal is in a certain amount of debt, what kind of bank rate they have, or even where their cash is going or the source and cause of large deposits. If there has been a big deposit from an owner because the company may have needed that to pay debts or for anticipated growth, the notes section is where that type of information is made clear. The notes will also show bank loans and long-term debt that might be on the balance sheet as well as lines of credit and interest rates. Another financial indicator and potential concern for an underwriter is the interest rate obtained for any bank loan. If a bond principal has a loan with an interest rate higher than normal in the current economic environment, this can be an indication that the loaning bank may have some financial concerns and will be considered by the surety when reviewing the bond principal.
When the Financial Statement is Insufficient
What happens if the bond principal’s financial statement does not support the risk of the bond? Surety underwriters may agree to review third-party financials. If the bond principal has a parent company or some related company that is in a stronger financial position and is willing to sign an indemnity agreement, underwriters are often able to provide an approval in this way. An indemnity agreement is similar to a parent cosigning a loan for their child for school or a vehicle. The indemnity agreement between related companies serves the same purpose: it indemnifies the company in a stronger financial position on behalf of the principal.
If there is no indemnifying company or individual to provide a superior financial statement for underwriter approval, the bond principal may be required to procure collateral. The most secure form of collateral is a letter of credit (LoC) issued by an approved bank. Sureties may also accept cash, but there are risks with possible bankruptcy cases, so cash approvals are usually granted only on a case-by-case basis. Because of the nature of the customs bond auto-renewal and stacking liability from exposed bond terms, additional collateral may be required every year, and the surety will monitor the financial strength of the bank issuing the LoC. The surety will generally hold the collateral until after final entry liquidation and through the re-liquidation period, as well as after any and all claims have been exhausted. It is important for a bond principal to read and understand the surety’s collateral release agreement before posting any collateral.
The Role of the Customs Broker and Bond Provider
The customs broker and bond provider work together to obtain the underwriting materials requested by the surety. As a matter of policy, some customs brokers will not want to handle client financials and will send them directly to Roanoke as the bond provider. We can even provide non-disclosure agreements to assist with meeting any internal requirements the principal’s compliance may have. Both the customs broker and bond providers such as Roanoke are here to act as advocates for the bond principal. Roanoke’s bond team is highly experienced and trained to understand the intricacies of financial statements, and we will help to present the facts to the surety underwriters in support of your bond principals. We will also leverage the principal’s import and liquidation history, our relationship with the surety and the customs broker, as well as the customs broker’s track record and loss ratio in order to help obtain approvals.
For more information please contact your local Roanoke bond office or watch our recently recorded webinar, 5 Tips for a Customs Bond Risk Assessment Roundtable.