An Introduction to Contract Surety Bonding for Contractors

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 contractor’s ability to obtain surety bonds has a significant effect on the contractor’s ability to acquire work.

What Is a Surety Bond?
A surety bond is a three-party agreement whereby the surety assures the project owner (obligee) that the contractor (principal) will perform a contract in accordance with the contract documents. When a contractor requires its subcontractors to obtain bonds, the contractor is the obligee and the subcontractor is the principal.

Most surety companies are subsidiaries or divisions of insurance companies, and both surety bonds and traditional insurance policies are risk transfer mechanisms regulated by state insurance departments. However, traditional insurance is designed to compensate the insured against unforeseen adverse events. The policy premium is actuarily determined based on aggregate premiums earned versus expected losses. Surety companies operate on a different business model. Surety is designed to prevent a loss. The surety pre-qualifies the contractor based on financial strength and construction expertise. Since the bond is underwritten with little expectation of loss, the premium is primarily a fee for pre-qualification services. — top —

How to Begin
Since most surety companies distribute surety bonds through the independent agency system, the first step is to contact an independent agent who specializes in contract surety. A professional surety agent guides the contractor through the bonding process, helps establish and foster a business relationship with a surety company, and assists in managing the contractor’s surety capacity.

A good surety agent can offer sound business advice and technical expertise, such as contract document review. The agent can introduce the contractor to professionals or consultants when appropriate.

After meeting with the contractor and gaining an understanding of the firm’s business and needs, the agent tailors the contractor’s submission for the specific requirements of the surety company. The agent then submits the account to a surety company best matched to the contractor’s profile and needs. It is important to recognize that all surety companies are not the same. For example, some specialize in large contractors, some in middle markets, and others in emerging contractors. If necessary, the agent can guide the contractor through a formal presentation and meeting with the surety company. The agent is an essential link between the contractor and the surety company and should maintain communications with both.

There are three basic types of contract surety bonds.

• The bid bond assures that the bid is submitted in good faith and that the contractor will enter into the contract at the price bid and provide the required performance and payment bonds.
• The performance bond protects the owner from financial loss should the contractor fail to perform the contract in accordance with its terms and conditions.
• The payment bond assures that the contractor will pay specified subcontractors, laborers, and materials suppliers associated with the project. — top —

Qualities of a Professional Surety Agent

• Is well respected and has a reputation for integrity in the construction industry;
• Demonstrates a personal interest in the contractor’s success;
• Has a track record of building solid relationships with surety underwriters;
• Possesses an understanding of the construction industry;
• Has knowledge of accounting and finance, especially construction accounting procedures;
• Has knowledge of construction contracts, subcontracts and related contract law;
• Is aware of local, regional, and national construction markets;
• Is experienced in strategic planning and management practices that promote successful contracting; and
• Is actively involved in and supports local and national construction and surety industry associations. — top —

Surety Company Underwriter
Once the surety agent collects all the necessary information, he or she submits it to a surety company underwriter. The underwriter takes an in-depth look at the contractor’s entire business operations and must be satisfied that the contractor is capable of completing the project.

The underwriter may request a meeting with the contractor to form his or her opinion and obtain additional information. For example, the underwriter may want more information on the single job size and aggregate workload for all projects, bonded or not, the contractor’s current and projected work program. If the contractor wants to bid on a larger that usual project, the underwriter will want to know whether it is prudent for the contractor to undertake it from a risk/reward standpoint, how it fits into the current work program, how the project will be financed, and a projection of the return.

Although it may seem as if surety underwriters focus on the contractor’s finances and financial structure, they are also interested in other elements of the contractor’s business. The contractor’s organization, track record, and approach to a job, once established, are not generally questioned with frequency if the contractor’s results are consistent. However, should there be significant changes in ownership or key personnel or the contractor decides to move into a different type of construction or geographic area, this information should be shared with the surety along with any other changes in the contractor’s capabilities or the way the contractor conducts business.

The contractor’s financial situation fluctuates from day to day, from job to job, and consequently is the area that is subject to the greatest scrutiny. When applying for bonds, the contractor must be aware that once the surety is satisfied as to the technical ability to perform, it will then review the financial results of performance and translate that into a decision on the firm’s present and future ability to pay bills, finance additional undertakings, and accept or mitigate risk. The numbers are the scorecard that tell all parties how well the contractor is performing. — top —

Prequalification Process
Each surety company has its own underwriting standards and requirements, but there are shared fundamentals common to the underwriting of most surety companies. Before a surety underwrites a bond, the contractor typically undergoes a careful, rigorous, and thorough process, often referred to as prequalification.

The prequalification process takes time as the agent collects information, answers questions the surety underwriter may have, and assists in verifying information. The surety must be satisfied that a contractor has the ability to meet current and future obligations, has a good reputation, has experience meeting the requirements of the projects to be undertaken, and has (or can readily obtain) the equipment necessary to perform the work. The surety also looks for contractors who run a well-managed, profitable enterprise, keep promises, deal fairly, and perform obligations in a timely manner. — top —

Financial Statements
Depending on how long the contractor has been in business, the surety will request fiscal year-end statements for the past three years by a certified public accountant (CPA). Financial statements typically include the following:

• Accountant’s opinion page—discloses whether the statements were prepared according to audit, review, or compilation standards.
• Balance sheet—shows the assets, liabilities, and net worth of the business as of the date of the statement. This helps the surety company evaluate the working capital and overall financial condition of the company.
• Income statement—measures how well the business performed. The surety analyzes each item, including gross profit on contracts, operating profit, and net profit before and after tax provisions.
• Statement of cash flow—discloses the cash movements from operating, investing, and financing activities.
• Accounts receivable schedules—should reflect aging.
• Schedules of contracts in progress and contracts completed—show the financial performance of each contract and provide insight into the potential for future earnings from contracts in progress. This should tie into the balance sheet and income statement.
• Schedule of general and administrative expenses—may reveal how well overhead expenses are controlled and managed.
• Explanatory footnotes—qualifications made by the accountant. — top —

Quality of Financial Statements
Financial statements are only as good as the accountant preparing them. That is why it is important to select a CPA who is knowledgeable of construction accounting and the American Institute of Certified Public Accountants’ Audit/Review Guide for Construction Contractors. Most cases require that a contractor have his CPA prepare a review financial statement at year-end and a compilation financial statement at six months.

An audit verifies relevant items in the financial statement with internal and external investigations of their accuracy. The accountant certifies that the financial statement is presented in accordance with generally accepted accounting principles.

A review statement, which does not require the outside verification present in an audit, consists principally of a thorough review of the contractor’s financial records and the application of certain analytical procedures to the financial data. Although narrower in scope than a full audit, the review does provide some limited assurance about the financial statements.

A compilation, however, provides little or no assurance of the credibility of the figures presented and would typically be accepted only for interim statements.

In general, statements prepared by the contractor’s staff are not acceptable to sureties because they are difficult to verify and lack the approval of an independent CPA. — top —

Accounting Methods
Complete and accurate accounting systems are extremely important to surety companies. The American Institute of Certified Public Accounts Guide for Construction Contractors recommends the percentage-of-completion accounting method. The percentage-of-completion method best represents a contractor’s financial condition and most accurately measures results of work performed during the accounting period.

Depending on the time elapsed since the last fiscal year-end statement, the surety may ask for an interim financial statement every six months to show how the current year is progressing.

Contractors may also need to prepare a quarterly schedule of work in progress. This schedule should list each job by name and include:

• Total contract price, including approved change orders
• Amount billed to date;
• Cost incurred to date;
• Revised estimate of the cost to complete.

This exhibit, along with a schedule of closed jobs, is always required in connection with CPA reports. — top —

Maintaining the Surety Relationship
To maintain and increase surety capacity, it is important for a contractor to develop and maintain an ongoing relationship with the underwriter and agent. Developing a relationship requires commitment, trust and above all communication. Maintaining the relationship through open communication and timely reporting on the company’s financial condition and job status reports builds trust with the surety.

Maturing into a growing partnership requires teamwork and an organized effort among the contractor the surety underwriter, and the surety agent. There may be difficult times, and the surety may not always be willing to extend the level of surety the contractor would like, but maintaining a relationship with the surety company builds trust and increases the surety’s commitment to the contractor over time. — top —

Conclusion
Even after all the information is provided to the surety, there is no guarantee it will result in approval. The bond will be approved only if the surety is confident the contractor is qualified to perform the contract and work program successfully and has the financial capacity to withstand the numerous risks involved in the construction business. The decision to seek surety bonds should be based on long-term considerations. To obtain bonds, some changes in the way a contracting firm does business may be necessary. — top —