Facilitate credible bonds between contractors and project owners
by Jay Mann
March 17, 2015

Recent economic news has been mostly positive. The stock market is at an all-time high, the unemployment rate is at its lowest level in years and the price of oil is in a free fall, which has the effect of putting more dollars in consumers' pockets both directly (through lower prices at the pump) and indirectly (for example, lower transportation costs of goods bought by consumers). But construction, particularly commercial construction, is lagging and a contractor needs sufficient bonding capacity to bid and obtain some share of available projects. All public projects and most commercial non-public projects require the contractor to be bonded. A contractor who is unable to obtain performance and payment bonds is at a competitive disadvantage in today's difficult business conditions.

How to Get Bonding in a Tight Construction Market

Important to obtaining bonding is an understanding of the difference between surety and insurance. While sureties (also known as bonding companies) are typically insurance companies, the contractor bonds they issue are not insurance policies. An insurance policy is a two-party contract, between the insurance company and the insured.

A contractor bond is a three-party contract among the surety, the bond principal or contractor and the individual requesting the bond, typically the project owner. An insurance policy is a risk management insurance product, which assumes losses will be incurred, and premiums are set to cover the anticipated losses. A contractor bond does not anticipate losses and the premiums are based on credit risk. An insurance policy protects the insured against risk of losses; a contractor bond protects the project owner by guaranteeing project completion and payment of project subcontractors and suppliers but provides no protection to the bond principal. In fact, a bonded contractor must repay its surety in the event that the surety incurs bond losses.

The important takeaway from these differences between surety and insurance is that a surety underwriter will not authorize issuance of a contractor bond if any significant risk of loss is perceived. Unlike an insurance underwriter who anticipates an actuarially acceptable amount of losses in connection with insurance policies, the surety underwriter will only approve issuance of bonds to a contractor if he is persuaded that a contractor default (and resulting bond losses) is unlikely.

Essential to obtaining bonds is making changes to the contractor's operation in order to meet the mindset of the risk avoidance surety underwriter. The surety literature often refers to the underwriting factors as the three Cs—capital, capacity and character. There is actually a fourth C, communication, which is equally important to increasing bonding capacity.

Working with an experienced bonding agent is important. Like an independent insurance agent, a bonding agent will analyze the markets and determine which sureties may consider bonding applications from applicants of the size and type comparable to the contractor. A contractor should work with its bonding agent to compare its options with a number of different sureties. The bonding agent will also help the contractor with the four Cs of underwriting.

Capital

Capital is based on the contractor's financial statement. Particular attention will be paid to the contractor's net worth, cash flow, work in process (WIP) and accounts receivable. A starting point for the surety underwriter is to compare current assets with current liabilities (thus determining working capital with further modifications for related party receivables and accounts receivable over 90 days past due).

A cash flow calculation is made by taking net income plus depreciation, amortization and other non-cash items, then deducting principal payments on debt. WIP schedules are analyzed for job profitability, and the surety underwriter's confidence in this analysis is dependent upon the perceived reliability of internal job reporting systems. This is only a brief description of a surety underwriter's review of a contractor's overall financial condition to determine if there is sufficient capital for the subject bonded projects.

Aggressive collection of accounts receivable, reduction of debt, personal borrowing by the owners to infuse cash into the business and improvement in internal management reporting systems are all steps which may be recommended to make the contractor more attractive to the surety underwriter.

Capacity

The surety underwriter must be persuaded that the contractor has the capacity to do the subject bonded projects. Bonds will not be approved for an over-extended contractor. The contractor must demonstrate that it has the skill, experience and resources (including an adequate line of credit) to avoid getting into a default situation. One point often overlooked by contractors is that sureties will evaluate the management experience of personnel at the project level. Accordingly the contractor should be selective in the hiring of project managers and superintendents.

Character

A level of trust must be established with the surety underwriter for the underwriter to approve bonding for the contractor. The contractor's integrity in business and reputation among customers, design professionals, subcontractors, vendors and employees will all be considered in the surety's evaluation of the contractor's character. A track record of success and a history of stability and profitability is highly desirable. Accordingly, the contractor should present itself in the best light possible to the surety underwriter.

Communication

This refers to the need to keep the surety informed of both positive and negative developments in the contractor's business. Every business goes through some adversity, and it is more beneficial for the surety to learn about a negative development directly from the contractor. Clear communication and accurate information may persuade a surety to continue bonding despite a particular business problem affecting the contractor.

Obtaining bonds in the current construction market is not easy and requires flexibility and persistence by the contractor. Changes to the contractor's operation may be required, and professional advice from an experienced bonding agent is invaluable. The bottom line is that unlike an insurance policy, a bond will not be issued unless the surety is convinced that a contractor default and resulting bond losses is highly unlikely. The contractor must do everything possible to persuade the surety underwriter that it has the skill, resources and character to perform the bonded work.