In economic boom times, credit conditions tend to ease.
It's easier to get financing and bonding for most projects under the assumption that there's a high likelihood of success. Conversely, as economic growth decelerates, obtaining financing and bonding becomes more difficult. But several other factors compound this natural ebb and flow of the surety market.
Slowing of the economy has the potential to cause an increase in defaults on surety bonds. In response, the surety industry tightens underwriting criteria and looks to be more conservative going forward. Furthermore, bankruptcies of several large public companies-driven in part by rising exposure to asbestos-claim liabilities-have had a ripple effect throughout the market. Some surety players have exited the market, while others are adjusting their risk assessments. Re-insurers, in turn, are requiring higher premiums, and ultimately those costs are passed on to contractors.
Clearly, the pendulum is swinging in the other direction and sureties are becoming more cautious. Contractors need to be aware of the trend and take steps to remain attractive in this more competitive environment, including doing the following:
- Bolster the balance sheet in times of tightening underwriting criteria. Reduce debt and explore strategies such as sale-leaseback of equipment or changing depreciation assumptions.
- Show more consistency in income statements. Take steps to eliminate wide swings in monthly performance. Be mindful of monthly cutoffs for recording transactions and perform regular reconciliations. If quarterly statements were once used to measure credit-worthiness, monthly statements may be requested by underwriters in a tighter credit market.
- Monitor receivables closely to help maintain a healthy level of working capital. Receivables older than forty-five days are likely to be discounted heavily by underwriters.
It's also critical to conduct thorough due diligence on customers. Sometimes it pays to walk away from a potential job, even in slowing economic times. The days of contractors being pursued aggressively by the surety industry are gone-at least for now. But a solid track record and clean financial statements will help ensure that a contractor has continued access to bonding, regardless of the greater economic outlook.
Evaluate Your Surety Company and Bonding Agent
Since most contractors will need bonding from a surety company at some point in time, it is important to establish a good relationship with a surety company and bonding agent. The contractor should evaluate the surety company and bonding agent as closely as the contractor will be evaluated by them. The following are some questions the contractor should ask the surety/bonding agent:
- To what bonding markets do they have access? This question is most important when a contractor is in a specialized industry or for some other reason, does not qualify for the standard bonding market.
- How will bonding capacity limits be calculated? Some surety companies multiply working capital by a specified multiplier, such as ten, to determine the total bonding credit to be extended. Other surety companies may use equity in addition to, or instead of, working capital in this calculation. This distinction may be crucial to heavy equipment contractors having a large investment in equipment, which would be reflected in the equity calculation, but not in the working capital calculation.
- What level of experience does the agent have with regard to bonding? It is important to develop a relationship with an experienced agent who deals solely with bonding so he can advise the contractor how to present the company most favorably to the surety and also act as a liaison between the contractor and surety.
- What is the financial position of the surety company? It is important to be associated with a financially strong and reputable surety company that will be acceptable to project owners.
In the face of rising insurance costs, contractors are reviewing their approaches to coverage and risk management. For some large commercial construction firms, one answer has been to replace performance and payment surety bonds with default insurance that protects them from losses if subcontractors or suppliers fail to perform as promised.
Default Insurance versus Surety Bonding?
An insurance industry hit hard in recent years by terrorism, corporate malfeasance, a struggling economy and a litigious society has responded with belt-tightening that continues to squeeze the construction industry.
Traditional coverage is expensive, when it's available at all, and contractors are reviewing their approaches to coverage and to risk management as they work to control insurance costs.
For some large commercial construction firms, one answer has been to replace performance and payment surety bonds with default insurance that protects them from losses if subcontractors or suppliers fail to perform as promised.
Default insurance was introduced in 1995 under the brand name Subguard® by Zurich North America. Proponents say it saves time and money. The surety industry counters that it merely shifts the burden of managing and resolving claims to policy owners and offers no protection to subcontractors or suppliers.
The appeal of both the surety and default options may be in the eye of the beholder, but four significant differences set them apart. They are:
1. Claim resolution-Default insurance makes the general contractor responsible for resolving subcontractor default issues, although the costs of completing the work are covered.
If a subcontractor with surety bond coverage defaults, sureties help resolve the claim, deal with unpaid creditors and assure work completion.
2. Coverage period-Default insurance coverage continues up to ten years after project completion. Subcontractor surety bonds often expire as soon as a year or two after project completion.
3. Coverage scope-With default insurance, general contractors choose one set of annual coverage limits applying to all projects, regardless of actual work volume.
Surety bonds cover every subcontractor who provides a bond. That means, for example, that a contractor who subcontracted $500 million worth of work in a year could have surety bonds totaling $500 million in coverage.
With default insurance, the coverage would be limited to whatever limit the contractor had selected.
4. Payment limit-Default insurance pays the amount of the claim, regardless of the contract price. Surety bonds cover 100 percent of the contract price for performance and payment.
Regardless of which type of coverage contractors seek, they will face rigorous scrutiny before winning approval. Both surety firms and default insurers seek to minimize risk by covering companies with strong financial and performance records. Both perform detailed analyses of contractors' financial strength, performance history, reputation and experience before approving coverage.
A Way to Minimize Risk
Contractors can minimize their own risk by applying equally rigorous standards in choosing subcontractors. Evaluating subcontractors' safety records, performance history and financial strength before jobs begin is an important first step in reducing subcontractor default losses and saving money.
Both default insurance and surety bond coverage have advantages and disadvantages. You need to carefully evaluate your company's needs and specific situation when deciding which approach is appropriate for you.
Construction Business Owner, March 2006
