Intro to Contract Surety
What is Contract Surety? Surety - otherwise known as bonding - is NOT Insurance. Although Surety Bonds are usually issued by an Insurance Company, they are not really a form of insurance but a form of credit. The company issuing the bonds guarantees the contractor will fulfill contractual obligations and the liability is of a financial nature. Therefore the Bond serves as security for the contractual obligation.
Surety is three (3) party contract. In most cases these parties are: The Surety Company The Contractor (Principal) The Owner (Obligee) of the Project
The Surety is reimbursed for losses. When a bonds are issued to the contractor, the Contractor agrees to reimburse the Surety for any losses the Surety sustains on the Contractor's behalf. A bond is really an extension of credit and backed by the surety company's own resources.
In a nutshell, if the Contractor does default on a project, the Surety Company is responsible to complete the project, and the Contractor has to pay the additional expenses back.
Bonds Cannot be Cancelled. Unlike an insurance policy, a bond cannot be cancelled once issued. The Surety is bound to remain liable until the contract has been fully completed. Should the Contractor's financial position rapidly deteriorate, the Surety cannot "get off" the obligation.
Courtesy of Angela McKerlich, Capri Insurance Intro to Contract Surety
BOND FORMS AND THEIR OBLIGATIONS
Bid Bond This bond is issued at the tender time. It prequalifies the Contractor and assures the Owner of the project that they are serious about bidding the project and if awarded will enter into a contract with the Owner and provide the necessary contract security.
If the Contractor fails to enter into a contract, the Owner must be compensated for the difference between the amount of the bid and the amount for which the Owner contracts with another party to do the work, subject to the limit of the bond.
Often the amount of the bid bond is 10% of the tender price.
Example: Joe's General Contracting Ltd. puts in a Bid for $1,000,000 Andrea's General Contracting Ltd. puts in a Bid for $1,500,000 Billy's General Contracting Ltd. puts in a Bid for $1,560,000 Each of these contractors has provided a 10% of tender sum Bid Bond to the Owner of the project.
Joe is awarded the contract, and decides to NOT enter into a contract with the Owner. This will cost the Owner $500,000. The owner is entitled to make a claim on Joe's Bid Bond. 10% of Joe's tender is $100,000, which is what the Owner can make a claim for.
The Surety Company pays out the claims, and then Joe has to pay the Surety Company back.
Agreement to Bond (Consent of Surety) This document is executed by the Surety Company only and usually accompanies the Bid Bond at the tender time. It can also be issued without a Bid Bond. The Surety Company agrees to issue the necessary bonds (performance bond and labour & material payment bond) on behalf of the Contractor If the tender is accepted and the contractor enters into the contract.
Performance Bond A Performance Bond provides protection to the Owner of the project, up to the amount of the bond, should the contractor be unable to complete the project and be in default of the construction contract. The amount of the Performance Bond is typically 50% of the contract price or 100% of the contract price.
Courtesy of Angela McKerlich, Capri Insurance Intro to Contract Surety
Also included in the Performance Bond is any maintenance period stipulated in the contract. Usually this is one or two years. The Sureties will not usually go beyond 2 years in one shot, however will entertain a maintenance bond renewal after the first 2 years are over and only if the Contractor is still in good standing with the Surety Company.
In the event the Contractor defaults, the Surety Company has various options as outlined in the bond. In simple terms, the Surety needs to complete the contract or obtains bids from other contractors to complete the work. It should be noted that the Owner of the Project cannot be in default of their contractual obligations in order to make a bond claim against the Contractor. If the Owner of the Project needs to claim on the bond, this simply can be done through their lawyers to the Surety Company, or a phone call/letter in writing to the Surety Company.
Example: I had a civil contractor in Alberta, who in a very short time suffered financially after the economy tanked. He couldn't complete two of his bonded projects. The Surety received a letter from the Owners representative (Consultant/Engineer) of the projects (in this case municipalities). The Surety stepped in, investigated both sides, and helped the contractor complete the work.
Labour and Material Payment Bond This bond guarantees all Claimants who have supplied labour and materials to the contractor for use on the project will be paid, subject to the limit of the bond. The amount of the Labour and Material Payment Bond is typically 50% of the contract price or 100% of the contract price. In this case the Owner acts as a trustee for the benefit of the claimants as the Owner is not the beneficiary under the bond, and claimants are not a party to the contract between the Owner and the Contractor.
Claimants MUST have a direct contract with the Contractor, unless the wording of the Bond is a "Broad Form" wording, which includes all tiers of contracts, that is, contracts with the Subcontractors of the Contractor. This Broad Form Bond wording is more expensive than a Standard Bond Wording. It should be noted that Labour and Material Payment Bond is usually only issued with the Performance Bond.
Example: I had a General Contractor who completed a project, but ran out of money to pay out the holdbacks funds to it's subcontractors and suppliers. The Owner in this case gave a copy of the Labour and Material Payment Bond to every subcontractor and supplier on the project. The subcontractors and suppliers who were owed money simple wrote the Surety Company to put in a claim. The Surety worked out acceptable payment terms with each claimant, and settled the loss. Any expenses and claims the Surety paid out were reimbursed by the General Contractor.
Courtesy of Angela McKerlich, Capri Insurance Intro to Contract Surety
Maintenance Bond This bond covers defective material and workmanship for the specified period of time after substantial completion of the work. This is typically issued if there was no Performance Bond issued upon award of the contract. If there was a Performance Bond issued, the maintenance is included in that bond. We typically see this type of request for Commercial Painters.
BASIC UNDERWRITING REQUIREMENTS FOR A CONTRACT BOND FACILITY It is VERY IMPORTANT for Owners and Consultants to know the underwriting process a Contractor goes through, as by requesting bonds on a project is far more than a pure financial guarantee like an Irrevocable Letter of Credit. This process lets the Owner know what they are getting by requesting a bond.
Bonding ensures that all bidders are capable, competent and serious. Unqualified or irresponsible bidders are eliminated. Project Owners can be confident that the contractors they select have the necessary skills and resources to complete work on budget and to specified standards. In the rare cases where unforeseen circumstances create problems, the surety company will provide the resources to complete the work.
Bonding can assure that specific standards are met and that appropriate payments to subcontractors and suppliers will be made. This virtually eliminates the filing of liens, making the transfer on completion a far smoother process.
Courtesy of Angela McKerlich, Capri Insurance Intro to Contract Surety
Following are the KEY areas a Surety Company considers before they will issue bonds for a Contractor.
THE THREE C'S: CASH, CHARACTER & CAPACITY
CASH The Surety wants to see a Construction Company that is profitable, have working capital and equity. The Surety will review the last three years of financial statements. These statements have to be prepared by a recognized accountant, that is, a CA, CMA, or a CGA AND at least on a "Review Engagement" basis. This verifies the accuracy of the numbers in the company. "Notice to Reader" statements are generally not acceptable as the accountant has simply compiled the company's financial records into statement form and nothing has been verified.
Working Capital: In Simple Terms, Working Capital is made up of Current Assets less Current Liabilities on the financial statement. The Surety Underwriters make sure working capital levels are in line with the Contractors total Work Program (including bonded and unbonded projects) at all times.
Work Program = Costs to complete on all (bonded and unbonded) projects the Contractor has on the go. As a General Rule of thumb, a Contractor should have a working capital of 1/10th of their Work Program. This formula varies depending on the type of contractor.
Example: Contractor has $100,000 of Working Capital, this gives them $1,000,000 of Work Program
Equity: Equity is made up of Share Capital, Retained Earnings, and Shareholders Loans. The Surety looks at growth in these areas and a strong position in relation to the work program underway.
CAPACITY The Surety reviews the capacity of a contractor. They analyze the project sizes, total amount of work the contractor takes on, have the manpower, and the experience of the contractor.
Single Job Size: The Surety will determine what size of project they will support based on the contractors experience and financials. If the contractor's largest completed contract is $100,000 and then want to bid on a $5,000,000 project, the Surety will decline, as the Contractor does not have experience at the level. It would be reasonable for a Surety to allow the Contractor to tender on a project with a size of $200,000 - $300,000.
Courtesy of Angela McKerlich, Capri Insurance Intro to Contract Surety
Total Work Program: The Surety will determine what total amount of work the Contractor can take on by reviewing their financials, manpower and experience to determine a maximum limit the Contractor is able to take on. There is a work on hand report the Sureties use to help this process. If they are at their maximum, they may allow any more bonds until some of the Contractor's projects have been worked off. As discussed under "Cash", the leveraging ratios must be adequate to support the Total Work Program.
Other Experience: Another item the Surety will consider, is the type of experience the contractor has. If an electrical contractor to date only has experience on homes and multi-family buildings, they may not allow a bond for the contractor on a hospital. The Surety may allow however, a very small contract on a hospital to allow the contractor to gain experience, even though they have completed larger contracts sizes.
CHARACTER The Surety Company will request references ideally from the Contractor's most recent and largest projects to determine what it was like to work with the Contractor, how the project went, did it complete on time, and the project size. This process is ongoing as well. On every bonded project, the Surety will send the Owner/Consultant a Contract Status Report to determine how the project is going or how the project went, substantial completion date, and final contract price. If there is a problem, it can often show up on this report.
The Surety also reviews the key employee's resumes, reviews who the Contractor has relationships with in the Construction Industry. This information often comes from the completion a Contractor's Questionnaire and possible the Contractor's Website.
10 REASONS CONTRACTORS SUCCEED. 1. Strong Accounting and Financial Management 2. A Comprehensive Business Plan 3. Realistic Growth and Expansion 4. Thorough Project Management 5. Accurate Estimated and Job Costing 6. Superior Communication 7. Continuity of Ownership and Key Staff 8. A Focus on Areas of expertise 9. The Ability to deal with uncontrollable factors 10. A Loyal Customer Base.
Courtesy of Angela McKerlich, Capri Insurance