Federal, state and local governments require surety bonds in order to manage risk on construction projects and protect taxpayer dollars.
However, surety bonds are not limited to public construction. Many private project owners stipulate bonding requirements on their projects, and prime contractors may require subcontractors to obtain bonds. In today's competitive construction environment, a contractor's ability to obtain surety bonds has a significant effect on that contractor's ability to acquire work.
What is a Surety Bond?
A surety bond is a three-party agreement in which the surety assures the project owner (obligee) that the contractor (principal) will perform a contract in accordance with the contract documents. When a contractor requires its subcontractors to obtain bonds, the contractor is the obligee and the subcontractor is the principal.
Most surety companies are subsidiaries or divisions of insurance companies, and both surety bonds and traditional insurance policies are risk transfer mechanisms regulated by state insurance departments. However, traditional insurance is designed to compensate the insured against unforeseen adverse events. [JG1] The policy premium is actuarially determined based on aggregate premiums earned versus expected losses. Surety companies operate on a different business model. Surety is designed to prevent a loss. The surety prequalifies the contractor based on financial strength and construction expertise and does not expect a loss.
How to Begin
Since most surety companies distribute surety bonds through the agency system, the first step is to contact a professional surety bond producer, also known as an agent or broker, who specializes in contract surety. A professional surety bond producer guides the contractor through the bonding process, helps establish and foster a business relationship with a surety company and assists in managing the contractor's surety capacity.
A professional surety bond producer can offer sound business advice and technical expertise, such as contract document review. The producer can introduce the contractor to professionals or consultants when appropriate.
"The surety bond producer and underwriter can help a contractor understand the opportunities and pitfalls of potential plans by bringing their experience into the discussion," advises Terrance Cavanaugh, chief operating officer of Chubb Surety.
After meeting with the contractor and gaining an understanding of the firm's business and needs, the producer tailors the contractor's submission for the specific requirements of the surety company. The producer then submits the account to a surety company best matched to the contractor's profile and needs. If necessary, the producer can guide the contractor through a formal presentation and meeting with the surety company. The producer is an essential link between the contractor and the surety company and should maintain communications with both.
"The best advice for any contractor in today's market is to select a bonding agent and surety that have experience and broad relationships throughout the marketplace," says Michael J. Cusack, senior vice president, managing director, surety and operations board member, Aon Construction Services Group. "Embrace the surety's interest in reviewing contracts and bond forms and endeavor to tap into the broad experience of your surety partners."
Surety Company Underwriter
Once the surety bond producer collects all the necessary information, he or she submits it to a surety company underwriter. The underwriter takes an in-depth look at the contractor's entire business operations and must be satisfied that the contractor is capable of completing the project.
"Sureties and agents have seen how lots of contractors run their business, and we've learned what works consistently and what usually doesn't," explains Michael Greer, vice president, surety, Penn National Insurance. "Having seen what can and does go wrong in the past allows a surety that is getting consistent quarterly information to see a problem developing, and hence they are able to ask questions and offer advice while the contractor is still a viable entity."
The underwriter may request a meeting with the contractor to form his or her opinion and obtain additional information. For example, the underwriter may want more information on the single job size and aggregate workload for all projects, bonded or not, in the contractor's current and projected work program. If the contractor wants to bid on a larger than usual project, the underwriter will want to know whether it is prudent for the contractor to undertake it from a risk/reward standpoint, how it fits into the current work program, how the project will be financed and a projection of the return.
Although it may seem as though surety underwriters focus on the contractor's finances and financial structure, they are also interested in other elements of the contractor's business. The contractor's organization, track record and approach to a job, once established, are not generally questioned with frequency if the contractor's results are consistent. However, should there be significant changes in ownership or key personnel or the contractor decides to move into a different type of construction or geographic area, this information should be shared with the surety along with any other changes in the contractor's capabilities or the way the contractor conducts business.
The contractor's financial situation fluctuates from day-to-day and from job-to -ob and consequently is the area subject to the greatest scrutiny. When applying for bonds, the contractor must be aware that once the surety is satisfied as to the technical ability to perform, he will then review the financial results of performance and translate that into a decision on the firm's present and future ability to pay bills, finance additional undertakings and accept or mitigate risk. The numbers are the scorecard that tells all parties how well the contractor is performing.
Prequalification Process
Each surety company has its own underwriting standards and requirements, but there are shared fundamentals common to the underwriting of most surety companies. Before a surety underwrites a bond, the contractor typically undergoes a careful, rigorous and thorough process known as prequalification.
"Sureties can help contractors grow by providing them the prequalification that will get them into doors that they otherwise would not get into without a bond," notes Henry W. Nozko Jr., president of ACSTAR Insurance Co. "Bonding helps them bid more jobs"
The prequalification process takes time as the producer collects information, answers questions the surety underwriter may have and assists in verifying information. The surety must be satisfied that a contractor has the ability to meet current and future obligations, has a good reputation, has experience meeting the requirements of the projects to be undertaken and has (or can readily obtain) equipment necessary to perform the work. The surety also looks for contractors who run a well-managed, profitable enterprise, keep promises, deal fairly and perform obligations in a timely manner.
Accounting Methods
Complete and accurate accounting systems are extremely important to surety companies. The American Institute of Certified Public Accountants' (AICPA) Audit Guide for Construction Contractors recommends the percentage-of-completion accounting method, which is also preferred by most sureties. The percentage-of-completion method best represents a contractor's financial condition and most accurately measures results of work performed during the accounting period. The percentage of contract values recognized as revenue typically is done on a cost-to-cost percentage-of-completion method.
Depending on the time elapsed since the last fiscal year-end statement, the surety may ask for an interim financial statement every three or six months to show how the current year is progressing.
Contractors also need to prepare a quarterly schedule of work-in-progress. This schedule should list each job by name and include:
- Total contract price
- Approved change orders
- Amount billed to date
- Cost incurred to date
- Revised estimate of the cost to complete
- Estimated final gross profit
- Anticipated completion date
The format of this exhibit and the amount of information required varies among surety companies and almost always is required in connection with the full CPA reports.
Commitment
The surety company expects the contractor to perform his contractual obligations under the bond. Surety companies usually require a demonstration of commitment from the construction company's owners through personal and/or corporate indemnity.
"Contractors need to be willing to lay it all on the line and put themselves at risk if they expect us to help them prevent a default," notes William Cheatham, president of Zurich North America Surety.
The indemnity agreement obligates the named indemnitors to protect the surety company from any loss or expense caused by the contractor's failure to fulfill his bonded obligation on the project(s) and any resultant loss under the surety bond. This gives the surety company some assurance that the contractor will stand fast in the face of problems and use its talent and financial resources to resolve any difficulties that may arise in the performance of the bonded work.
Surety companies stand behind the commitments undertaken by a contractor through a bonded contract. The contractor is primarily responsible to fulfill the contract's obligations and the surety's obligations are secondary to the contractor's.[JG2]
After the bonds are written, the surety continuously evaluates the overall performance and financial position of the contractor. Adverse changes may cause the surety to reduce or terminate the bonding program, whereas positive results may serve as the basis for an increase in surety capacity.
"Don't take on more work than you can manage. Grow your balance sheet in relation to your work program. Keep your debt as low as possible," advises Dennis S. Perler, president of Liberty Mutual Surety. "Work to develop a strong relationship with your surety and provide them with full disclosure. You may not always agree, but if you're willing to work together over the long term, the surety will support you."
What Do Bonds Cost?
Surety bond premiums vary from one surety to another but can range from one-half of 1 percent to 2 percent of the contract amount, depending on the size, type and duration of the project and the contractor. Typically, there is no direct charge for a bid bond, and in many cases, performance bonds incorporate payment bonds and maintenance bonds.
When bonds are specified in the contract documents, it is the contractor's responsibility to obtain the bonds. The contractor generally includes the bond premium amount in the bid and the premium generally is payable upon execution of the bond. If the contract amount changes, the premium will be adjusted for the change in contract price. Payment and performance bonds typically are priced based on the value of the contract being bonded, not necessarily on the size of the bond.
Maintaining the Surety Relationship
To maintain and increase surety capacity, it is important for a contractor to develop and maintain an ongoing relationship with the underwriter and producer. Developing a relationship requires commitment, trust and above all, communication.
"Communicate often with your surety team, and view your relationship with the agent and underwriter as individuals or firms who are stakeholders in your business," Aon's Cusack adds.
Maintaining the relationship through open communication and timely reporting on the company's financial condition and job status builds trust with the surety. Maturing into a growing partnership requires teamwork and an organized effort among the contractor, the surety underwriter and the surety bond producer. There may be difficult times, and the surety may not always be willing to extend the surety capacity the contractor would like, but maintaining a relationship with the surety company builds trust and increases the surety's commitment to the contractor over time.
Even after all the information is provided to the surety, there is no guarantee it will result in approval. The bond will be approved only if the surety is confident the contractor is qualified to perform the contract and work program successfully and has the financial capacity to withstand the numerous risks involved in the construction business. The decision to seek surety bonds should be based on long-term considerations. To obtain bonds, some changes in the way a contracting firm does business may be necessary, and these changes could have associated costs and benefits.
Construction Business Owner, February 2007
