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Introduction to Contract Surety Bonding for Contractors

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Introduction to Contract Surety Bonding for Contractors HOW TO OBTAIN SURETY BONDS: An Introduction to Contract Surety Bonding for Contractors 1140 19th Street NW, Suite 500 Washington, D.C. 20036 www.surety.org Federal, state, and local governments require surety bonds in order to manage risk on construction projects and protect taxpayer dollars. However, surety bonds are not limited to public construction. Many private project owners stipulate bonding requirements on their projects, and prime contractors may require subcontractors to obtain bonds. In today’s competitive construction environment, a con- tractor’s ability to obtain surety bonds has a significant effect on that contractor’s ability to acquire work. What Is a Surety Bond? A surety bond is a three-party agreement whereby the Three Basic Types of Contract Surety Bonds surety assures the project owner (obligee) that the con- tractor (principal) will perform a contract in accordance with the contract documents. When a contractor requires • The bid bond assures that the bid is submitted in its subcontractors to obtain bonds, the contractor is the good faith and that the contractor will enter into obligee and the subcontractor is the principal. the contract at the price bid and provide the required performance and payment bonds. Most surety companies are subsidiaries or divisions of insurance companies, and both surety bonds and tra- • The performance bond assures the owner that, in ditional insurance policies are risk transfer mechanisms the surety’s opinion, the contractor is capable and regulated by state insurance departments. However, tra- qualified to perform the contract and protects the ditional insurance is designed to compensate the insured owner from financial loss should the contractor against unforeseen adverse events. The policy premium fail to meet the terms and conditions of the con- is actuarially determined based on aggregate premiums tract. A qualified, bonded contractor is more earned versus expected losses. Surety companies oper- likely to complete the project according to the con- ate on a different business model. tract provisions. Default is not in the best interest of the surety, contractor, or owner. When prob- Surety is designed to prevent a loss. The surety prequal- lems occur, the surety may offer financial, tech- ifies the contractor based on financial strength and con- nical, or managerial assistance to the contractor in struction expertise. The bond premium is an actuarially order to prevent default. based fee that takes into consideration the potential for claims payments and also serves as a fee for the surety’s • The payment bond assures that the contractor in-depth prequalification service. will pay specified subcontractors, laborers, and materials suppliers associated with the project. To find a producer who specializes in contract surety How to Begin bonding, contact the National Association of Surety Bond Producers (NASBP) at 202-686-3700 or Because most surety companies distribute surety bonds www.nasbp.org. NASBP members adhere to a code through the agency system, the first step is to contact of professional standards. a professional agent or broker, also known as a surety bond producer, who specializes in contract surety. A pro- fessional surety bond producer guides the contractor through the bonding process, helps establish and fos- producer tailors the contractor’s submission for the spe- ter a business relationship with a surety company, and cific requirements of the surety company. The produc- assists in managing the contractor’s surety capacity. er then submits the account to a surety company best matched to the contractor’s profile and needs. It is im- A professional surety bond producer can offer sound portant to recognize that all surety companies are not business advice and technical expertise, such as contract the same. For example, some specialize in large contrac- document review. The producer can introduce the con- tors, some in middle markets, and others in emerging tractor to other professionals or consultants when ap- contractors. If necessary, the producer can guide the propriate. contractor through a formal presentation and meeting with the surety company. The producer is an essential After meeting with the contractor and gaining an link between the contractor and the surety company and understanding of the firm’s business and needs, the should maintain communications with both. Surety Company Underwriter Qualities of a Professional Surety Bond Producer Once the surety bond producer collects all the necessary information, he or she submits it to a surety company • Is well respected and has a reputation for integri- underwriter. The underwriter takes an in-depth look at ty in the construction industry the contractor’s entire business operations and must be • Demonstrates a personal interest in the contrac- satisfied that the contractor is capable of completing the tor’s success project. • Has a track record of building solid relationships with surety underwriters The underwriter may request a meeting with the con- • Possesses an understanding of the construction tractor to form his or her opinion and obtain addition- industry al information. For example, the underwriter may want • Has knowledge of accounting and finance, espe- more information on the single job size and aggregate cially construction accounting procedures workload for all projects, bonded or not, in the con- • Has knowledge of construction contracts, sub- tractor’s current and projected work program. If the contracts, and related contract law contractor wants to bid on a larger-than-usual project, • Is aware of local, regional, and national construc- the underwriter will want to know whether it is prudent tion markets for the contractor to undertake it from a risk/reward • Is experienced in strategic planning and manage- standpoint, how it fits into the current work program, ment practices that promote successful how the project will be financed, and a projection of the contracting return. • Is actively involved in and supports local and national construction and surety industry Although it may seem as if surety underwriters focus on associations thecontractor’s finances and financial structure, they are also interested in other elements of the contractor’s busi- ness. The contractor’s organization, track record, and Verify Your Bond approach to a job, once established, are not generally questioned with frequency if the contractor’s results are Several resources are available to ensure your consistent. However, should there be significant changes bond is from a legitimate source. You may con- in ownership or key personnel or the contractor decides tact your state’s insurance department to verify to move into a different type of construction or geo- that the surety is a legitimate company, licensed to graphic area, this information should be shared with the issue surety bonds in that state; you may review surety along with any other changes in the contractor’s the U.S. Department of Treasury’s List of Approved capabilities or the way the contractor conducts business. Sureties Department Circular 570 (for federal proj- ects); and you also may verify the strength of the The contractor’s financial situation fluctuates from day surety company through a private company such to day, from job to job, and consequently is the area as A.M. Best, which issues financial strength ratings that is subject to the greatest scrutiny. When applying that measure the company’s ability to pay claims. for bonds, the contractor must be aware that, once the Furthermore, The Surety & Fidelity Association of surety is satisfied as to the technical ability to perform, America has a Bond Obligee Guide, designed to it will then review the financial results of performance serve those that want to verify the authenticity of and translate that into a decision on the firm’s present the surety bonds presented to them. SFAA also and future ability to pay bills, finance additional under- provides a Bond Authenticity Model Inquiry Form takings, and accept or mitigate risk. The numbers are the on its website. You should undertake these steps scorecard that tells all parties how well the contractor is to verify your bond protection early, preferably performing. before signing the contract. Prequalification Process Each surety company has its own underwriting standards must be satisfied that a contractor has the ability to meet and requirements, but there are shared fundamentals current and future obligations, has a good reputation, common to the underwriting of most surety compa- has experience meeting the requirements of the nies. Before a surety underwrites a bond, the contrac- projects to be undertaken, and has (or can readily obtain) tor typically undergoes a careful, rigorous, and thorough the equipment necessary to perform the work. The sure- process, often referred to as prequalification. The pre- ty also looks for contractors who run a well-managed, qualification process takes time as the producer collects profitable enterprise, keep promises, deal fairly, and per- information, answers questions the surety underwriter form obligations in a timely manner. may have, and assists in verifying information. The surety Prequalification Checklist • Schedule of general/administrative expenses— Here is what a contractor may need to provide: may reveal how well overhead expenses are • An organization chart of key employees and their controlled and managed responsibilities • Explanatory footnotes—qualifications made by the • Detailed
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