An Examination of the Construction Underwriter’s Outlook

As we have learned since the start of the pandemic, strong professional relationships are critically important in the face of such unprecedented uncertainty. Having a group of professionals to turn to for support has proven to be essential, and a contractor’s ability to develop and maintain a solid relationship with a surety can dramatically impact its ability to sustain or expand operations and, on the opposite end, discontinue operations.

Even in the best of circumstances, it’s important for contractors to have a clear understanding of several factors, including how a surety evaluates a construction firm for surety credit, what information the underwriters need and how to communicate both positive and negative company information. This extensive level of understanding will help mitigate a construction firm’s risk of compromising the relationship with a surety firm and, ultimately, impact operations.

While there are many ways to ensure project completion (such as subcontractor default insurance, aka a subguard), traditional surety bonds are still the most prevalent. The most common surety bond is a performance bond, which guarantees the performance of the general contractor and related subcontractors to the completion of a construction project. The bond amount is generally equal to the cost of the project and remains in place until the project is complete.

The other two bonds, which generally go hand in hand with a performance bond used in the construction industry, are the bid bond and payment bond. The bid bond is issued at the time of the initial bid and ensures that the bid has been submitted in good faith. The contractor will execute the contract and provide the required performance and payment bond. The payment bond ensures that the contractor will pay subcontractors and job-related costs on time and in full.

Surety bonding lines are established between the contractor and surety firm, very similar to the establishment of a banking line of credit. While a construction firm’s banking line of credit is important and is underwritten with financial scrutiny, a company’s bonding line can be even more important and have a more intense underwriting process. This is because a credit analyst with a surety firm is well-versed in all nuances of a construction firm and is skilled at dissecting financial data at the job-cost level, as well as the global operating level of a contractor. Surety firms will evaluate many variables prior to determining bonding capacity and establishing bonding lines at the project level and company level, including:

• Financial health and liquidity
• Impact of COVID-19 implication on current and future operations
• Bank lines of credit terms and conditions
• Prior job performance experience and references
• Prior job gross profit fade experience
• Prior job revenue, cost and profit control
• Claims and change order history
• Level of perceived open and integrity-driven communication

Surety companies should not be viewed in an adversarial way due to the importance of the relationship and financial risks that they bear in the construction marketplace. When a surety firm turns a contractor down for a particular job there is usually a good reason. Generally, a financially sound, successful firm should be able to obtain bonds on a somewhat routine basis if the firm is focused on key operational areas:

• Project selection—Successful contractors are highly selective about the projects they take on, focusing on work that is within their core capabilities and makes both financial and operational sense.
• Project management and oversight—Successful contractors are focused on assigning experienced project teams to high-risk jobs.
• Project change order resolution controls—Successful contractors are very good at controlling, negotiating and collecting project change orders.
• Corporate overhead cost control—Successful contractors regularly monitor operating costs to ensure the company does not overspend in its day-to-day operations.
• Financial checks and balances—Successful contractors ensure sound, thoughtful financial decisions are made on a frequent basis.

The key to a successful bonding relationship is open, active and honest communication, especially during this pandemic. As construction firms start to plan for the 2020 year-end, it is imperative that the surety firm be kept up to date on a variety of matters, including:

• Projected 2020 financial results
• Projected 2021 financial operations
• Status of the firm’s Paycheck Protection Program forgiveness application and any related tax consequence
• Strategic plan in the event of another economic shutdown
• Changes to banking relationships
• Status of significant under-billings and potential construction claims
• Status of significant construction litigation
• Estimate of cash flow requirements for 2020 tax liabilities
• 2021 and 2022 backlog update
• 2020 job-fade issues

It is absolutely critical for the contractor to establish open lines of communication with the surety, especially today as the industry contends with the pandemic’s ability to shut down a jobsite or company operations overnight. Surety firms do not like “bad” surprises, such as job fade issues, litigation, changes in bank financing and key personnel changes. This is important when things are going well, but perhaps even more so today, as major job issues can present themselves quickly with little or no warning signs.

They are looking to see how contractors handle the impact of a bad project as this may determine whether the business will maintain its bonding relationship or not. While it may be tempting to try and hide this information from the surety firm, waiting to address bad news is a mistake.

At a minimum, and to maintain integrity with the surety firm, communication should occur on an interim basis and this should continue to an even greater extent once the certified public accounting (CPA) firm completes the final, year-end financial reporting. There are three very important concepts in cultivating and maintaining a positive relationship with a surety:

• Timely, open communication with the company’s CPA, bonding agent and surety firm on a periodic basis
• Transparent communication with the surety firm on positive and negative operational issues as well as opportunities on upcoming job opportunities hitting the marketplace
• Responsiveness to questions posed by the surety on a specific job matter so issues can be addressed and, hopefully, resolved quickly

Managing a surety relationship is no different than managing any other business connection. But in today’s pandemic environment, when even the best laid plan can become obsolete overnight, communication is even more important. A construction company must understand that viewing a surety firm as a business partner rather than an adversary can be the difference between finding success in today’s global crisis or wondering what could have been done differently to avoid shuttering its doors for good.