Posts|July 25, 2022
Surety 101 for Contractors-Part II: Establishing a Surety Bond Program
By Oliver Craig
Surety Risk Advisor
In the first part of this series, we covered the types of bonds needed by contractors for bonded construction projects and the purpose of these bonds. Next, we will walk through what it means to establish a Surety Bond Program, key considerations, selecting a Broker and the steps involved in submitting an application.
There are various types of bonding relationships, which are driven by the frequency and magnitude of a contractor’s bonding needs. The first, which is considered a ‘Transactional’ relationship, allows an infrequent bond user to obtain a bond based on credit scoring and a (potentially) reduced level of financial disclosures. This type of relationship provides bonding support, but also offers the lowest level of clarity into the contractor’s financial situation to project Owners. If an infrequent bond user has multiple bond needs in a short timeframe, this type of relationship may leave the contractor unable to provide a bond, and/or mean they must walk away from the contract.
The preferred relationship would be establishing a formal Surety Bond Program with a corporate Surety. This type of relationship provides the contractor with guidelines for what size and types of contracts the Surety would generally be comfortable supporting. Surety Bond Programs have a single-size job guideline, as well as an aggregate program limit. You will often see or hear these limits expressed as single-size threshold over the aggregate threshold (i.e. 25/50). In this example, it means the surety is generally supportive of single-size jobs up to $25 million, and a total backlog for the contractor of $50 million (the “aggregate”). Most small-to-middle size contractors will have programs ranging from 5/10 up to 250/500. It’s important to note the single size threshold is not always one-half of the aggregate. As Surety Bond Programs grow, it’s not uncommon to see the single-size threshold increase at a slower rate than the aggregate limit. A contractor may experience considerable growth, but stick to its focus on smaller jobs, in which case you might see a 25/100 program.
Besides the benefits of understanding what bonded projects your company is able to pursue, and providing comfort to the project Owner your firm has the financial/operational capacity to complete the work, there can be administrative benefits as well. It may allow your Surety Broker to obtain an Agency Line of Authority, which is an agreement between the Broker and Surety allowing the broker to approve and process bonds up to a certain dollar amount. This tool is simply for ease of facilitation, and provides the contractor with the necessary bonds in the most timely, efficient manner.
There are a number of underwriting considerations a Broker and Surety will evaluate when putting together a Surety Bond Program, which include Character, Capacity and Capital (“Three C’s of Credit”). The most tangible of these – Capital – analyzes the financial considerations shown below:
- Working Capital – a contractor should aim to maintain working capital (current assets minus current liabilities) equal to 10% of largest job the contractor plans to pursue (a “10% case”). In some situations, a Surety may consider a single size limit based on a 5% working capital case; however, it is in the contractor’s best interest to target the higher threshold to ensure cash is available if an issue arises (see “Loss Paying Power” below).
- Net Worth – Sureties want to see a contractor retain earnings in the company, growing Net Worth over time to provide a stronger balance sheet with reduced leverage. This ensures the contractor is adequately capitalized to absorb a loss on a job if it arises. If a company distributes 100% of profits each year, the contractor may face challenges obtaining increased bonding support from its Surety.
- Cash Flow – ensuring a contractor has enough cash flow to complete a job is vital when a Surety evaluates a bond request. This metric should be evaluated at both the company and job level, as one large job can create cash shortfalls for a company as a whole. In the event of a large request, the contractor should complete a detailed evaluation of their schedule of values to make sure billings will cover expenses as they are incurred. EBITDA is the simplest evaluation of cash flow; however, a true Statement of Cash Flows is the best measure, as it also incorporates changes in cash items on the balance sheet.
- Access to Capital – this is most common in a bank line of credit. Given the working capital expectations of sureties, a contractor should look to obtain a line of credit equal to roughly 50-75% of working capital. Most banks evaluate the size of a line of credit based on a percentage of accounts receivable, generally in the 70-80% range. Having the line of credit in place ensures the contractor can finance a short-term cash shortfall in the event of delayed payment or other issues. A Surety will also assess the liquidity of owners of a contracting firm as an additional source of capital if the need presents itself.
- Other Considerations – a Surety will also analyze certain aspects of a specific contract, which may include the geography, scope, warranty period for the work, or payment terms, among others. It is a benefit to the contractor to have another experienced professional evaluate these requirements and identify the potential impact it could have on the business.
- Loss Paying Power – all of these metrics are evaluated by a Surety to arrive at a contractor’s Loss Paying Power. Construction has inherent risks, and most contractors know there will always be contracts that are ultimately unprofitable. A contractor’s ability to absorb these additional expenses and continue to perform on other profitable projects is vital to maintaining a Surety Bond Program.
So how do you go about obtaining a Surety Bond Program? The first step is to identify and engage with a Professional Surety Broker. Some qualities to consider when selecting a Surety Broker include:
- Respected and reputable for integrity within the construction industry
- Has established, solid relationships with surety underwriters
- Possesses an understanding of the construction industry
- Knowledge of construction accounting and finance
- Familiar with construction contracts and related contract law
- Has experience in strategic planning and operational management to promote successful contracting
- Actively involved in and supports local and national construction and surety associations
Once you have selected a Surety Broker, they will request information needed for the Surety to underwrite your account. An experienced Broker will be able to underwrite the account internally before submitting to their surety market(s). This allows the Broker to develop a solid understanding of the construction company, identify potential credit enhancement strategies, and present a strong case for the program being requested. This case should be made with a “write-up” prepared by the Broker telling the story of the company’s past, where they expect to go in the coming years, and justifying the requested program. The items a contractor will need to submit to their Broker include:
- Last three years of fiscal-year end financial statements
- Interim financial statement with work-in-progress schedule, receivables and payables aging reports
- Current Personal Financial Statements (PFS) for owner(s)
- Copies of bank loan agreements
- Business Plan / Organizational Chart
- Resumes of owners and key employees
- Statement of Qualifications
- Contractor’s Questionnaire, including company information, prior job experience and references
Once this information is received by the Broker, an expedited review should be completed, with feedback provided to the client based on initial observations. After meeting to discuss this feedback, the Broker and contractor should discuss the desired Surety Bond Program limits, and confirm the Broker’s marketing strategy (i.e. single market submission, targeted markets submission, etc.). Once the program limits and marketing strategy have been determined, the Broker will facilitate the information above to the Surety to complete their own underwriting.
You have now completed the initial steps in the application process for a Surety Bond Program. In the next part of this series, we will further discuss the Three C’s of Credit, an introductory meeting with a Surety, formalizing an agreement with the Surety to establish the Surety Bond Program, as well as the terms, conditions and pricing that come with an established program. If your company is currently in the process of establishing a Surety Bond Program and feel the process and considerations outlined in this series have been overlooked, we would be happy to assist in finding your company the best Surety solution available.
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