What are Surety Bonds?
A surety bond is an instrument under which one party, the surety, guarantees a project owner that the contractor will perform the contract. It guarantees the contractor’s performance and that they will pay costs associated with the project including certain laborers, subcontractors and suppliers.
Bonds vs. Insurance
- They are both risk transfer mechanisms.
- Insurance is underwritten based on actuarial studies of the probability of loss and premiums are based on the probability factor.
- Bonds are underwritten in the nature of a credit transaction and premiums are rated as a service charge for prequalification and providing the guarantee—not on the expectation of paying losses.
Types of Surety Bonds
Provides financial assurance that the bid has been submitted in good faith and the contractor intends to enter into the contract a the price bid and provide the required performance and payment bonds.
Protects the obligee from financial loss should the contractor fail to perform the contract in accordance with the terms and conditions of the contract documents.
Guarantees that the contractor will pay certain laborers, subcontractors and material suppliers associated with the project.
License and Permit Bonds
Guarantees to a public entity (i.e., a state, municipality or township) that specific statutory provisions will be followed in order to obtain or renew a particular construction license or permit.
Guarantees the workmanship (and defective materials) of a project for a stipulated number of years after completion. The performance bond typically includes a one year maintenance period
Who Requires Bonds?
Miller Act of 1936 requires performance and payment bonds on contracts over $100,000
State and Local Government
“Little Miller Acts” require performance and payment bonds on state and local public works projects (provisions vary by state).
For assurance the project will be completed with the contract and that the subcontractors and suppliers will be paid
To protect construction lending capital.
To mitigate default due to subcontractor failure.
How to Obtain a Bond
“Obtaining bonds is more like obtaining bank credit than purchasing insurance.” Contractors must qualify for surety bonds through the surety’s prequalification process.
- Select a knowledgeable surety bond agent (also known as producers or brokers).
- Agent should specialize in insurance and bonding for the construction industry.
- Agent will work with the contractor to prepare case and help establish business relationship with surety company.
- Select a construction-oriented CPA
- Knowledge of American Institute of Certified Public Accountants Audit Guide for Construction Contractors
- Agent/producer submits case to selected surety company for underwriting.
- Surety Selection/Surety Company Rating:
- A.M. Best is A- or Better
- U.S. Treasury List
- Licensed with State
Provides an in-depth look at the contractor’s entire business operation and determines the contractor’s ability to meet current & future contract and financial obligations.
The goal of prequalification is to provide assurance that the contractor:
- Runs a Well-Managed, Sound Enterprise
- Maintains Fair Business Practices
- Performs Obligations as Agreed
Elements of Surety Bonding Prequalification
Organizational and owner reputation for fair dealing with project owners, subcontractors, suppliers, lenders and other creditors, as well as general reputation within the industry.
Capacity to Perform
- Track Record & History of Company
- Trade References
- Organizational Structure & Reporting
- Resumes of the Contractor & Key Personnel
- Tools & Equipment
- Business Continuation Plans
- Analysis of Past, Current, & Future Projects
- Detailed Financial Statements
- Contract Schedules
- Accounting/Cost Records
- Profitability Trends
- Cash Flow Projections
- Credit References
- Bank Line of Credit
- Personal & Corporate Assets
Examples of Surety Industry Ratios
Accounts Receivable Days Accounts Payable Days Current Ratio Underbillings/WorkingCapital
Operating Income/Revenue Return on Equity
Total Assets/Net Worth Total Liabilities/Net Worth
Analyzed Working Capital %
Analyzed Net Worth %
Underwriting Process Continued…
- Financial Statement Trend Analysis
- Open and Completed Job Analysis
- Gross Profit Trend Analysis
- Overall Judgment of Financial Trends
- Review Additional Information in Overview
- Complete Financial Forecast
- Judgment of Future Finances
- Character and Capacity Considerations
- Formulate Underwriting Considerations
- Annual Year-end CPA Statement(3 y)
- Annual Personal Statements
- Annual Bank Letter
- Quarterly Work on Hand
- 6 Month Interim Financial Statement
- Copy of Business Succession Plan
- Written Business Plan
Why Contractors Fail
Although prequalification greatly reduces the likelihood of contractor default, many things can cause contractor failure.
- Rapid Over Expansion
- Changes in Line of Work, Scope of
- Business, or Territory
- Poor Accounting/Financial Controls
- Project Management Problems
Factors Beyond a Contractor’s Control:
- Unexpected economic down-turn
- Weather delays
- Labor difficulties
- Material and equipment shortages
- High inflation
- Owner’s inability to pay
Benefits of Surety Bonds
- Increases the number of projects for which a contractor can qualify
- Ensures payment protection for subcontractors, suppliers, & laborers
- Technical, managerial, or financial assistance can be made available in certain circumstances
- Provides owners with a pool of qualified bidders
- Reduces the risk of liens and financial loss
- Increases the likelihood of timely project completion
- Protects against defective materials and workmanship
- Provides assurance that if the contractor is paid, the project securing the loan will be completed
- Lender may be named as an additional obligee (beneficiary) of the bond
Tips for Improving Your Surety Relationship
- Seek the advice of a professional surety producer
- Meet with your Surety and producer to review financial results and business plan
- Understand the information they are seeking and why. Provide it on a timely basis
- Build a relationship! Invite their feedback – your results vs. other accounts they handle, what trends they see, how they view your account, how they view the market changing
- Understand your surety’s capacity to perform