SURETY AND INSURANCE BUSINESSES

David W. Kash, Esq.

© 1994 David W. Kash

Jennings, Strouss & Salmon, P.L.C.

Two North Central Avenue, Suite 1600

Phoenix, Arizona 85004

(602) 262-5919

On January 1, 1994, the North American Free Trade Agreement ("NAFTA") went into effect. It establishes a free trade zone between Mexico, the United States and Canada involving a market of more than 360 million persons and a combined gross national product in excess of $6 trillion. NAFTA's provisions will affect all businesses that trade or export goods or services through North America. The words "Free Trade," in the NAFTA means that all tariffs will be phased-out over the next 15 years and ultimately eliminated. Tariffs on many goods will be eliminated immediately. NAFTA's direct benefit is to those who produce and manufacture products and finished goods and those who supply services within the North American region. Detailed "rules of origin" set forth in NAFTA designate the circumstances under which products and services will be eligible for preferential tariff benefits. These rules are designed to assure the production and final assembly of trade items from within North America, and not from outside the region. This paper focuses on Mexico because through NAFTA, Mexico now allows for greater foreign participation in Mexico's insurance and surety markets by lifting barriers to foreign investment.

NAFTA, which encompasses approximately 2,000 pages, covers a wide range of topics including: customs administration, the elimination of price discrimination, special rules for trade and textiles and apparels, automotive goods, energy and petro chemicals, agriculture, standards relating to measures and technical standards, safeguards for industries adversely affected by surges in imports, anti-dumping procedures, government procurement, cross-border trade in services, transportation, telecommunication, financial services, intellectual property, and the safeguarding of investments, among others.

NAFTA also provides a mechanism to arbitrate and settle disputes between NAFTA parties and investors in a NAFTA country. A special commission will be set up to hear disputes placing a priority on settlement. It is anticipated that NAFTA will encourage and facilitate the use of alternate dispute resolution (ADR) as a means of settling private commercial disputes although the agreement does not specifically cover this issue. Canada, the United States and Mexico have agreed to provide for the enforcement of arbitration provisions in cross-border private agreements. This policy will influence the negotiation and enforcement of bonded contracts and the use of ADR as a means to resolve cross-border surety claims. Unfortunately, NAFTA makes no provision for the enforcement of cross-border judgments. Therefore, private alternative dispute resolution (ADR) and the venue for conducting the ADR, should be seriously considered when drafting cross-border agreements.

The immediate benefit of the NAFTA for United States-based companies interested in doing business south of the border is that it takes advantage of the great reforms that Mexico has made over the past six to ten years. Mexico has drastically lowered its once triple-digit inflation to the current rate of about eight percent. The Mexican government also successfully implemented what is referred to as a "privatization program." The government sold off the country's banks, airlines, TV channels and other businesses resulting in a massive infusion of capital into the government. Unlike the United States, Mexico now has a fiscal surplus. Mexico's economy is rapidly expanding. In addition to a large amount of natural resources, it has an extensive labor pool and a sophisticated accounting system.

The NAFTA will end all of Mexico's restrictions on insurance companies by the end of this century to facilitate the creation of subsidiaries by U.S.-based investors or companies. There currently exist several United States insurance joint venturers in Mexico. They will be able to acquire 100% ownership by 1996. New joint venturers are limited to 30% ownership in 1994, but their interest can be increased to a majority in 1998 with full ownership by year 2000. U.S.-based insurance companies can establish subsidiaries in Mexico subject to a graduated limitation on market share through year 2000 when the limits are eliminated. Under the NAFTA, foreign investment in Mexican insurance companies is allowed immediately but no more than 30%, to be increased on a graduated basis to 100% by year 2000.

Under NAFTA, United States bonding companies will be able to establish Mexican subsidiaries without any market share limitations on investment. Foreign participation in existing Mexican bonding companies will be limited to 49%. The establishment and operation of bonding companies in Mexico as well as applicable claim law is a matter of Mexican Federal law. The Mexican Finance Ministry has the discretion to authorize foreign participation in the paid-in capital of the Mexican surety by foreign insurance, reinsurance or other companies or individuals. In practice, the Finance Ministry has never authorized more than 30% for an ownership of a bonding company.

Foreign investment can be 100% with prior government authorization, for insurance agencies and brokerages.

In Mexico, NAFTA has the status of a treaty and it is therefore superior to other Mexican legislation. As a result, foreign companies and foreign investors have greater assurance that their investments will not be depredated by the Mexican government.

Within the NAFTA, Mexico reserves its existing prohibition and restrictions on cross-border trade in insurance services. These restrictions do not now include the right of Mexicans to purchase life and health insurance. Mexico is eliminating its present restrictions on its residents to purchase the following types of insurance from cross-border insurance providers of another Party: tourist insurance, including travel accident and motor vehicle insurance for nonresident tourists, but not insurance of risks of liability to third parties; cargo insurance for goods on international transit from point of origin to final destination; insurance for a vehicle during the period of its use in the transportation of cargo, other than insurance of risks of liabilities to third parties, provided that such vehicle is licensed and registered outside of Mexico. The definition of vehicles includes, ships, airplanes and space vehicles.

Many United States-based surety companies have signed joint venture agreements with one of the 17 Mexican-based sureties in order to enter the Mexican surety market. In such a case the U.S.-based manufacturer, lessor, contractor or supplier will have the risk underwritten by the U.S.-based surety joint venturer. The Mexican-based surety joint venturer will issue the bond to the Mexican owner or importer.

Targeted areas for surety underwriting and claims include the following:

C Trade enhancement bonds C designed to protect exporters who extend credit terms to buyers in the event that the buyer refuses or delays payment.

C Customs bonds C including licensing bonds for brokers, freight forwarders bonds and duty bonds.

C Trade finance bonds C issued to financial institutions that finance international trade transactions.

C Lease guarantee bonds C to protect lessors for loss from non-payment and loss of lease property.

C Franchise bonds C to guarantee the performance of a franchise contract.

C Construction surety bonds.

C Bid bonds.

C Performance bonds.

C Supply bonds.

C Miscellaneous bonds C various judicial and court bonds (e.g., alimony bonds).

The Association of Mexican Insurance Companies indicates that the Mexican insurance market generated premiums of roughly $4.85 billion in 1992. Of this amount, general liability insurance constituted only 1% (lowest), while automobile insurance made up 31% (highest). Because the Mexican legal system is not as litigation oriented as the U.S., liability insurance premiums are significantly less than comparable U.S. insurance. United States companies with equity investments in Mexican insurance companies are Aetna, Chubb, MetLife, AIG, Cigna and Reliance. In 1993, they held roughly 30% of equity or less. General bonds, which includes construction bonds, are the most commonly purchased in Mexico and they accounted for roughly 78% of the bond premium in 1991. Fidelity insurance accounted for about 10%. It is anticipated that the demand for fidelity insurance will dramatically increase with the heightened interest of investors in the creation of financial institutions.

Bonding companies and insurance companies are completely separate in Mexico, whereas in the United States, an insurance company will often issue policies as well as bonds.

The United States Customs service relies upon customs bonds to ensure payment of import taxes, customs duties, service and handling charges, and the legal documentary proof requirements concerning entry, movement and disposition of imported merchandise. Under the Code of Federal Regulations, these bonds are required to be guaranteed by a surety authorized and recognized by the Treasury under a certificate of authority to do business with the United States. If an importer does not discharge his responsibility, the Customs Service will notify the surety who is required to come forward with the amount secured by the bond. The surety must then seek reimbursement from its principal. Historically, types of customs bonds that have been employed include: warehouse bonds, bonds for the carriage of merchandise, export bonds, import bonds and cargo bonds. Basic import and export bonds can be in the form of a continuous transaction bond or a single transaction bond.

A carnet is an international customs document which serves simultaneously as a customs entry document and as a customs bond. The associations that issue the carnet and the guaranteeing association must be approved by the U.S. Commissioner of Customs. The guaranteeing association guarantees the payment of the obligation covering the merchandise entering the United States.

A customs house broker is licensed by the U.S. Customs Service to arrange for the entry of the goods through customs and represents a client in the importation or exportation of merchandise. Customs house brokers are required to obtain a license bond. Sometimes customs brokers also act as freight forwarders. Both brokers and freight forwarders have a practical need for bonds to ensure the performance of their obligations, including proper handling of funds received from a client for payment of duties, taxes and other obligations to the government.

Attendant to NAFTA and in an effort to facilitate environmental improvements to the communities at the United States-Mexico border, a "side agreement" was entered entitled, "Agreement Between The Government Of The United States of America and The Government Of The United States Concerning The Establishment of a Border Environment Corporation Commission and a North American Development Bank." Through this agreement, the United States and Mexico have committed themselves to a multi-billion dollar public works program for environmental infrastructure projects in Arizona, other U.S. border states as well as states on the Mexican side of the border. Environmental development work will be concentrated in an area extending roughly 100 kilometers on both sides of the border. During its most recent fiscal year, the World Bank lent $2 billion for roughly 23 environmental projects. Much of the lending is for pollution control, natural resources management, construction of improvements to protect the rural environment, drainage, sewer, water and other waste treatment projects. The NAD bank will be one of the lending institutions that will finance what is expected to be a mammoth public works program in the region during the next ten years. These works will obviously generate the need for construction surety bonds.

As a general matter, the Mexican construction industry has increased from $2.1 billion in 1988 to $10.6 billion in 1992. The majority of the money invested in construction has been in manufacturing plants, power plants and housing. On the low end of the spectrum has been transportation and water supply. Because of this, it has been proposed that there will be a need for over 3,000 miles of toll roads. The focus of the NAFTA and the previously discussed side agreement on environmental issues will be to increase the amount of public sewer and water work. NAFTA's direct impact to the construction industry is that it guarantees fair and open competition for the procurement of public and private projects. NAFTA provides for a bid challenging system to ensure procurement and information on procurement will be available as public information.

In a typical construction project in Mexico, there are four possible types of bonds: (1) Bid Bond B to guarantee compliance with the terms of the contractor's bid. The value of this bond is usually 5% of the bid price; (2) Advance Payment Bond B Under Mexican construction practices, both public and private improvements call for an advance payment to the contractor. This basically constitutes startup money advanced for the project. An advance payment bond guarantees that the contractor will properly use the startup money; (3) Performance Bond B to guarantee performance of the contract. In Mexico this bond is generally limited to only 10% of the contract price; (4) Maintenance Bond B guarantees the workmanship for up to 12 months after the work is completed. An unusual difference from a U.S. performance bond is that a Mexican bond will not necessarily cover all the terms of the contract. A claim for loss must be made against the bonded portions of the contract.

It is common for a Mexican surety to take collateral like U.S. sureties. However, under current Mexican law there is no practical way for a creditor to place a lien on inventory, accounts receivable, bank accounts or other assets which are not readily identifiable and static. Direct and indirect ownership of Mexican property by foreign companies is still subject to restrictions in Mexico and this will affect the manner of securing collateral as well as other underwriting concerns. Underwriters need also be aware that Mexican accounting practices take into consideration inflation in the preparation of financial statements.

Mexican law specifically provides for a surety to spread risk assumed under a bond by means of reinsurance. A foreign insurer can participate as a reinsurer in these transactions as long as they are registered with the Mexican Finance Ministry. Because there is no Treasury Listing in Mexico, this form of reinsurance is required to gain governmental approval for a surety to issue a bond in excess of the penal sum formally authorized by the government. A reinsurance arrangement is also common when a credit bond is obtained for a United States exporter who is fearful that it may not receive payment for the merchandise form a Mexican company. Because a Mexican surety cannot issue a bond with a foreigner as obligee, it will enter a "fronting arrangement" whereby the Mexican company will arrange for a United States bonding company to issue a bond. The Mexican surety will then reinsure the bond issued by a United States surety. Under the Mexican Law of Bonding Institutions (July, 1993), foreign companies are precluded from being a co-surety with a Mexican company and may not issue bonds between Mexican residents.

Various insurance activities involving the Parties to the NAFTA or their interests are reserved. The activities and operations of the existing Mexican governmental insurance programs for employees, agencies and public entities will remain under the control of the Mexican Government for an indefinite period of time. The NAFTA contains a provision opening U.S. insurance markets to foreign insurers; however, foreign insurers and their branches are prohibited from providing surety bonds for federal construction projects in the U.S.

This publication should not be construed as legal advice or a legal opinion on any specific fact or circumstance. The contents are intended for general information purposes only. The laws of Mexico change often; therefore you are urged to consult your own lawyer concerning your situation and any specific legal questions you may have. For further information about these contents, contact the author, David W. Kash, at (602) 262-5919.

BIBLIOGRAPHY AND SOURCES

1. North American Free Trade Agreement (NAFTA) (1993).

2. "Mexico's Bonding Industry," International Trade Information Corporation, Mexico Trade and Law Reporter, November 1, 1992, Vol. II No. 11.

3. "In NAFTA's wake, billions of dollars will go toward improving the environment at the United States-Mexico border, but who will determine how the money is used? National Law Journal for Monday, March 21, 1994.

4. "NAFTA: Now We Have It, Where From Here?", Associated General Contractor's Building Chapter Seminar, February 18, 1994.

5. Eugene T. Rossides, "United States Customs, Tariffs and Trade," Bureau of National Affairs, Inc., Washington D.C. (1977).

6. Code of Federal Regulations, Part 113 et seq. - Customs Bonds (1989).

7. "NAFTA's Key Features," Arizona International Business Perspective, Thunderbird and the Greater Phoenix Economic Counsel, Volume III Issue 3, (1993).

8. David A. Gantz, "Principal features of the North American Free Trade Agreement," National Law Center for Inter-American Free Trade (1993).

9. Goldberg, "South of the Border," ABA Journal March, 1994.

10. Guillermo Lagos, American Bonding Company, International Division, 6245 East Broadway Blvd., Suite 600, Tucson, Arizona 85711.

11. "New Law of Bonding Institutions," (synopsis written 7-30-93), U.S. Embassy, Mexico City, (Unclassified Mexico 08634/02).

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