What should contractors know about the three Cs used to evaluate contractors?

Nick Newton
President
National Association of Surety Bond Producers

Though sometimes thought of as insurance, surety really acts as a credit arrangement in which the surety company assesses the character, capacity and capital of a given construction firm and its principals to determine whether the firm merits bid, performance and payment bonds for a particular contract. Those “three Cs” are the dispositive qualities on which all surety underwriting decisions are based.

Among other things, character refers to the contractor’s reputation for integrity and its history of following through on commitments. Capacity refers to the project size and scope capabilities of the contractor as assessed by its management, equipment, experience and other factors. Capital measures the contractor’s financial wherewithal by assessing its liquidity, working capital, net worth, profitability and bank credit lines. All these characteristics are part of an overall underwriting assessment by the bond producer and by the surety underwriting team to gauge the likelihood of the contractor successfully completing the contract it seeks.

The bond producer works hand-in-hand with the contractor to navigate this process and to place the contractor in position to qualify for the best-fitting surety market. The bond producer will provide invaluable insights in how different surety companies assess characteristics and will guide the contractor on strategies to mitigate or to remedy weaknesses. In the end, all parties in the surety underwriting process are focused on the ultimate success of the contractor, whether that is to earn its first bond or to maintain and increase its bonding program over time.

Why is it important to provide the surety with a certified financial report?

Dennis Ferretti
Vice President, Contract Surety
Philadelphia Insurance Companies

It’s important, first, to define what a certified financial report is. Generally speaking, a certified financial report represents financial statements that have been audited and approved by an independent auditor. The independent auditor provides the highest level of assurance available by observing, testing and confirming that the company’s financial statements are free from material misstatement and conform to Generally Accepted Accounting Principles (GAAP).

The three most important reasons to provide the surety with a certified financial report are:

1. A certified financial report represents an investment in transparency and credibility, which are two attributes a surety will embrace when partnering with a company and its leadership.
2. A certified financial report is the highest level of assurance as to the testing and examination of records, which gives a surety the highest level of confidence in the numbers used to initiate and sustain a surety program offering.
3. A certified financial report can help to improve a company’s internal controls and systems, leading to higher-quality internal reporting and more profitable results, both of which are viewed favorably by the surety and help position the company to maximize surety support.

A certified financial report is not a requirement of most sureties dedicated to servicing the small and middle market of the construction industry, but it is certainly a report that all sureties will welcome and weigh positively when considering a company for surety support.

Michael Ceschini
Managing Member
Ceschini CPAs

Financial statements are critical to a contractor’s bonding program. The financial statements should be prepared in conformity with Generally Accepted Accounting Principles (GAAP) using the percentage-of-completion method and include all the necessary job schedules and cost information.

There are three types of financial statements:

• Compilation (lowest level of financial assurance and least expensive)—Compiling the contractor’s internally prepared financial statements. The CPA makes no assurance or inquiries; therefore, sureties cannot rely on this for large surety decisions.
• Review (costs significantly more than a compilation)—Generally, the most common minimum surety requirement. A review is conducted to provide limited assurance that there are no material modifications necessary to the financial statements through certain analytical procedures of financial data and making inquiries of management.
• Audit (Certified Audit) (highest level of financial assurance and most expensive)—Most common for contractors who perform large, single jobs with large backlog. The CPA performs extensive tests and analytical procedures to the financial data—including third-party verification.

Audited financial statements are the most highly recommended because they offer the highest level of financial assurance. There are also the added benefits of a potential return on investment, the strengthening of the relationship between you and your surety—by showing your company’s commitment to the surety process—increased bonding capacity and lower rates.

Always work with a construction CPA firm that is known to the surety community, as they are experts in presenting your financial information, which helps to facilitate the surety’s evaluation.

Nick Romano 
Bond Manager
Old Republic Surety Company

The importance of annual certified financial reports cannot be overstated when it pertains to the surety bonding process. While this can be a surprise for many contractors that are bonding users for the first time, the reality is that this particular investment can produce very substantial benefits.

Surety companies will require financial statements to determine the financial strength and stability of the contractor they are being asked to bond. Because a CPA is educated and trained on how to prepare financial statements, the surety will have greater confidence in the information presented if it is confirmed via an independent qualified financial source. The statement should be prepared on a percentage-of-completion method basis, with full supplemental notes, including a current and completed job schedule. This will also allow the surety to further evaluate larger bonding capacity limits for the contractor—both at the single-size job level and total backlog aggregate. The CPA-issued statement, therefore, is a key conduit that can help contractors take their construction businesses to the next level.

It should also be noted that because construction accounting is especially unique, not all CPAs are created equal. A CPA firm that is well-versed in construction accounting will always be preferred by the surety. In addition to the surety company seeing the contractor’s financial statements as more dependable, a quality, construction-oriented CPA can also further assist the contractor by providing guidance on tax planning, identifying operational trends to increase profitability, as well as improving its internal accounting. The CPA firm, like the surety, should be considered a critical business partner that can enable the contractor to take the next steps in profitable growth.

Ray Bastin 
Partner
Withum

Some of the key factors that help contractors secure surety bonds are its experience and reputation in performance of its contacts along with its overall financial strength via certified financial reports.

A surety gains comfort when it knows that the contractor has performed well on past jobs and will evaluate the contractor’s overall financial strength by analyzing its balance sheet to determine its ability to pay vendors and subcontractors, whether or not it is heavily leveraged with debt, and if it has positive equity or retained earnings.

The surety relies heavily on a contractor’s financial report when determining its bonding capacity. Financial statements that are timely and include all the disclosures required in accordance with Generally Accepted Accounting Principles add to a surety’s confidence in the contractor’s financial strength. When contractors face liquidity concerns, adequate disclosures regarding mitigating factors and management plans, line of credit status and facility with its banking relationship assist the readers of financial statements.

Therefore, obtaining a certified financial report from a CPA firm with years of experience performing audits and reviews of contractor financial statements can help a contractor secure or maintain surety bonding. The stronger the CPA firm’s reputation is with the surety industry, the more reliance a surety will place on the contractor’s financial statements and ultimately improve the contractor’s ability to secure bonding.

What should contractors consider when selecting a surety bond producer?

Andrea Warning
Surety Director
CNA Surety

Producers must satisfy the needs of both contractor and surety, so ideally, the characteristics that make a good producer align to bring all parties together into a mutually beneficial relationship.

There are qualities that enhance most partnerships and definitely apply when choosing a surety producer. First, finding a producer with strong industry knowledge. If the producer understands the contractor’s needs, as well as strengths and/or deficiencies of that company, they can consult on what is necessary to maximize a surety program, identify areas of improvement within the organization and target the sureties that would be the best fit.

Next, to find a fit, the producer should have strong relationships with their surety partners. Sureties tend to give optimal consideration to those agents with whom they’ve established a track record and a level of trust. That trust is built in part on communication and transparency, as well as important selection factors. A producer should be encouraging regular contact to service day-to-day requests, stay ahead of upcoming needs, inquire about company operations and identify risks that need to be addressed with the surety to maintain uninterrupted support. That communication works both ways, and the producer should be relaying that information back to the surety as well. While a producer’s objective is to make the best deal for the contractor, they can also facilitate a strong partnership to include the surety.

Michael Wiedemeier
Senior Vice President, Surety and Business Insurance
Marsh McLennan Agency

It’s important for contractors to work with a producer who will get to know their businesses—their short- and long-term goals, their organizational structures, as well as their dreams and aspirations. The producer’s intent should be to build a relationship and find the right surety partner that will support long-term success.

Contractors should seek out a surety bond producer that is “in the game,” meaning they are knowledgeable about inherent risks unique to the contractor’s trade, active in the construction and surety marketplace and have built meaningful connections with key community professionals such as CPAs, bankers and attorneys. This helps to ensure that the producer can leverage its resources to surround the option that will best help the contractor succeed.

The producer should be part of a team of thought leaders that includes excellent account servicers that can respond quickly and accurately to questions and concerns.

Most importantly, contractors should select a producer who will tell them not necessarily what they want to hear but what they need to hear. A surety bond producer should be upfront and thorough. It should not cut corners just to get a deal done. Ultimately, contractors should build a relationship with a bond producer that will be their partner and guide them through the challenges and changes their organization will face.

Tim Mikolajewski
President
Liberty Mutual Surety

Contractors have a lot of choices when it comes to selecting a surety producer. It is important to vet both the agencies and the producers. Contractors should think about not only their short-term needs but where they’ll be in five or 10 years (or more), because while they may initially only need a small performance bond, their surety needs may be different and more complex as they grow and expand.

As such, contractors should find out which carriers the agency has appointments with. Does the agency have appointments with sureties that write both small and large bonds? Are their sureties able to write bonds globally? Do their sureties offer any value-added services that will benefit contractors, such as construction consulting services or peer benchmarking reports? Even if the producer isn’t overly versed in these facets, its sureties should be. That way the agency and contractor can continue their relationship as the contractor grows. Conversely, contractors need to make sure their producers work with agencies that offer programs to help contractors when times are a little tough.

Lastly, and possibly most important, contractors should make sure they trust and feel comfortable with their producers, since these relationships should last decades.

Brandon Raether
Regional Manager of Contract Surety
IAT Surety, a division of IAT Insurance Group

From a carrier’s perspective, picking the right surety producer is very important. An experienced bond producer will have strong relationships with sureties, CPAs, construction lenders and attorneys. It will know which surety your company best fits with and be able to anticipate the desired information, questions and concerns the surety may have. This will greatly expedite the approval process.

Furthermore, the producer will be able to advise your company if you are looking to grow and will help you understand the steps needed to increase your surety support. This may include referring a construction-oriented CPA or lender or advising an increase to your capital or labor force to support the increase in backlog.

For seasoned companies, an experienced surety producer will also be able to help advise on business continuity and provide options for the best plan to transition your company to the next generation without sacrificing your surety support. An experienced surety producer has the benefit of handling other contractors throughout the years and has seen what works and does not work. This experience can be invaluable to any contractor not looking to learn these hard truths firsthand.

It is often said that this industry is all about relationships, and that is true. Anyone responsible for the growth and profitability of a large organization should try to partner with those experienced surety producers, and rely on those relationships and the trust and familiarity they create.

Jeffrey Deldin
Executive Vice President/Head of Surety
World Insurance Associates LLC

When selecting a surety bond professional for your business, it is important to make sure they come from an extensive background working in the industry and that the surety bond professional participates in the industry in order to keep on top of current issues and trends. Your surety bond professional should be not only experienced in the surety industry but also active in the construction industry in order to better serve their clients by understanding the marketplace their customers have to compete in every day. Furthermore, this involvement needs to extend to other centers of influence that surround the areas of accounting, banking and law. Finally, your surety bond professional must have a strong relationship with several A-rated and U.S. T-listed surety companies, which will provide a client a competitive advantage to negotiate bonding capacity, conditions and pricing.

Why do some owners require surety bonding for private sector projects?

Robert Murray
Head of Surety for Zurich North America
Zurich

Private owners often wonder about the cost versus the benefits of requiring bonding from contractors. Simply stated, a bond significantly increases the owner’s probability of having a project completed on time and on budget, and the benefits of bonding far outweigh the costs. Recent studies completed by a national consulting firm under the guidance of Tthe Surety and Fidelity Association of America indicate that the prequalification efforts of the bonding companies significantly decrease the likelihood of a contractor defaulting on a project. Further, in the unfortunate event of a contractor default, the same study indicates that post-default costs are considerably less, as the sureties have the tools and resources necessary to help complete a project in the most cost-effective manner. This reduces the burden for the owner in resolving the completion issues and is especially important as the pain associated with a contract default can be severe if managed unsuccessfully.

The current economic environment brings with it uncertainties that we have not seen for some time. Inflation, labor shortages and supply- chain disruption are issues we have previously seen, but the current combination makes the road ahead especially slippery. Private owners wishing to increase the probability of successful project completion would be wise to include bonding as a part of their risk mitigation strategy.

Jason Dettbarn
Senior Vice President, Contract Underwriting
Merchants Bonding Company

Increasingly, private construction project owners are limiting exposure to delays, contractor failure and project liens the same way public project owners have been doing it since 1894: with surety bonding.

What's driving the trend? Both the list of risks and their severity have ballooned in a post-pandemic world. Global supply-chain delays and materials shortages continue to be a big problem. Pile on the risk from the tightest labor market in history and the uncertainty of whether subcontractors are available when your materials finally arrive, and the combination can wreak havoc on project timelines.

The majority of projects for federal, state and local governments in the United States require surety bonds by law, protecting the taxpayers’ investment. Private construction project owners, their bankers and investors are seeing the wisdom and value of using surety bonds to protect them from those same risks.

What ratios and Benchmarks does a surety use to evaluate financial health?

Matt Semeraro
Senior Vice President, Head of Surety
Skyward Specialty Insurance Group

While many underwriters use similar ratios to evaluate the financial health of a contractor, it's not a one-size-fits-all undertaking. Individual classes of construction are held to varying degrees of ratio evaluation, and each underwriter will have its own standards and expectations when analyzing the financial performance of a contractor. Some of the most common ratios used are working capital as a percentage of backlog, liquidity ratios (e.g., current, quick and operating cash flow), debt-to-equity ratio, profitability (gross profit and net income as a percent of revenue), as well as consideration of over and under billings in relation to cash flow and profit estimates. Some of these ratios and key performance indicators are benchmarked against industry averages; however, they will not apply broadly to all cases.

While financial ratios tell one part of the story, other factors should be considered when determining a contractor's qualifications, such as experience, project history, banking relationships and available personal resources to bridge short-term capital needs. Calculating the ratios is the easy part. It is how an underwriter applies them to the individual risk that helps guide the contractor into making sound business decisions that affect their overall surety capacity.

Andrew A. Dickson
Senior Vice President, Head of Surety
Hudson Insurance Group

Liquidity, level of debt and personal credit score (PCS) are extremely important and will continue to be as the surety industry faces several headwinds. Specifically, a surety looks for a strong working capital balance equal to a certain percentage of contractor backlog depending on the type of contractor, as well as an equally strong net worth, high PCS and a debt-to-worth ratio of less than 3:1. With respect to reviewing the PCS, sureties look for a high score, as they believe the PCS is indicative of how one runs their business. Significant business cash balances and available (zero balance) bank line of credit are viewed favorably. One of the many approaching challenges for these metrics is rising bank interest rates. The industry has had unprecedentedly low interest rates during the last decade, which has given businesses a false sense of security and buoyed net income with artificially low interest expense. As rates rise, debt-heavy firms and individuals will have their income statement stressed. They will need to either make up the difference via higher margin work or cut expenses. This is especially true for private equity firms that take on large levels of debt as standard practice. Since retained earnings and net worth mainly come from retained profits, equity growth will be limited and may lead to a higher debt-to-worth ratio. For contract surety accounts, sureties look favorably on low levels of bank debt, a strong PCS, ample liquidity, a relatively low debt-to-worth ratio and an available line of credit.

What are the most common reasons a surety bonding application is denied?

Antonio Albanese
Executive Vice President, Head of Surety
Nationwide Surety

A surety bonding application can be denied for many reasons. The most common ones include financial statements that are missing or weren’t prepared by a CPA. In addition, a lack of experience with the size, type and scope of the requested project/bond, as well as inadequate financial capacity for the bond, can lead to the denial of a surety bonding application. Other barriers to an approved application include an incomplete submission, insufficient indemnity, a poor or nonexistent credit history, prior bankruptcy, unsatisfactory historical job performance and weak references. Without these fundamental elements, there is a high likelihood that an application will be rejected.

To ensure a successful surety bonding application, it’s always a good idea to partner with an experienced and knowledgeable surety agent who can guide you through the process and help you avoid any potential pitfalls in your efforts to secure a surety bond. An expert surety agent can help you identify areas where your application falls short and offer advice on how to better qualify for a bond. If required, a seasoned surety agent can direct you to resources designed to help you prepare for the bonding process. A savvy agent can also help businesses that are new to identify the appropriate level of surety bonding for smaller-scale or stretch projects, if applicable. In the end, partnering with a surety professional can help increase your chances of success as you navigate the surety bonding application process.

What is an electronic surety bond and what are the benefits of an electronic surety bond over a paper bond?

Joseph Sforzo Jr.
Chief Operating Officer
Surety2000

A true electronic surety bond is entirely paperless and created in a web-based application in which all parties to the bond interact in a secure environment. Surety companies grant powers of attorney electronically to agents. Agents create bonds and then sign them digitally, as do principals. Obligees receive the fully executed bond electronically—all in one secure platform. It is important that this criteria be met. Many systems may brand themselves as electronic surety without really meeting this standard.

The benefits of electronic surety bonding are numerous and realized by all parties involved.

For the surety agent, a true ebonding system will have a workflow that helps reduce errors, provides for a fast and easy bond creation process and eliminates the need for mailing and transporting physical documents to their client.

For a surety company, granting or revoking powers of attorney is done quickly and easily. Surety company users receive email notifications of bonds executed using their powers of attorney, as well as the ability to view each bond when they log into the system. A fully transparent process that eliminates fraud should be at the heart of any ebonding system.

Principals must be able to sign bonds directly within an ebonding platform or sign bids along with a bid bond via secure integration with one of the many ebidding systems available. This will eliminate mailing or hand delivering physical documents to an obligee.

Owners are now able to view and maintain records of fully executed bonds without the need for handling physical documents. They can be confident in the authenticity of the bond, the elimination of errors and the assurance that a low bid on a project will not be disqualified over a clerical error on the bid bond.

A true ebonding platform will maintain integration points with agency management systems and ebidding systems to assure a seamless flow of information throughout the surety supply chain.

How do surety bond claims impact a contractor’s ability to obtain future bonding?

Henry W. Nozko Jr.
President
ACSTAR Insurance Company

Surety bond claims may not need to impact the ability to obtain future surety. Some surety claims may arise out of good-faith disputes that may not necessarily be ripe as a claim.

For example, in a good-faith dispute regarding materials or supplies purchased and/or regarding subcontractor services provided, the supplier or subcontractor might file a claim with a principal’s surety. After an investigation by the surety, it could be determined that the claim is found to be groundless. When a situation such as this arises, at the very onset of the dispute, the principal should provide documented details of the dispute with its surety and surety agent. The report should include a detailed outline of the principal’s reason for withholding payment to the supplier or subcontractor. This preemptive and proactive action will assist the surety in its investigation of the claims and provide the surety with supplemental information to make an appropriate determination regarding the surety’s course of action. This will also preserve and reinforce the principal’s relationship with the surety. If the surety’s investigation finds that the direction taken by the principal was deemed appropriate, the claim will not have an effect on the surety’s support for providing future bonds. Likewise, the incident would not have an effect on a possible new relationship with another surety. To effect such a result, early and complete communication with the surety is essential.

If a claim is valid and the principal does not have the means or resources to resolve the claim, the principal should take the same preemptive and proactive course by providing full details about the claim, including a proposed plan for resolving the matter. Even if resolution might require some assistance from the surety, if there is a plan in place, and under implementation for restitution and compensation, many sureties will continue to provide surety support and additional bonding. A path based upon frankness, honesty and openness, as well as the adherence to a proposed make-whole plan, is the key to rehabilitating a surety relationship. “All relationships go through hell, real ones get through it.”

How should a contractor prepare for an initial surety bonding meeting?

Bryan Porter
Director
Ellin & Tucker

Operating a successful construction business has been difficult in recent years. Owners and executive management teams have had to consider labor issues, supply-chain shortages, materials pricing escalations, difficult contract clauses and a host of other concerns. But a proper surety program can be the difference between successfully growing your company and having to walk away from opportunities that could lead to future prosperity. Once in place, a proper surety program can also provide a competitive advantage that allows the contractor to decrease daily challenges and keep the company focused on its long-term strategy. That’s why it’s vital to be well-prepared before meeting with a potential surety partner.

The three most significant items a contractor should accomplish prior to their initial surety-bonding meeting include:

• Organizing a financial presentation that helps prove the company thoroughly understands their historical financial performance and future projections.
• Preparing a historical analysis of the steps taken to implement or improve the company’s safety program.
• Offering general information on what they hope to accomplish by having a surety program in place.

While the initial meeting may focus on discussing the history of the company, key people within the organization and a general description of what the company is in business to do, it will be extremely helpful to the surety if you can answer detailed questions about these three critical areas in real time. Although this all seems very formal, the goal at the beginning of any important relationship is to make a good first impression.

What should contractors consider before making a claim against a surety bond?

Michael C. Zisa
Co-Managing Partner, Washington, D.C., and Chair, Surety Practice
Peckar & Abramson, P.C.

Asserting a claim against a surety bond is a significant action that will set off a series of events. Therefore, a contractor must consider several issues before making a claim. First, a contractor must read and understand the bond against which it intends to assert claim. A surety bond is a tripartite agreement between the surety, principal and obligee, in addition to and the parties’ rights and obligations are defined by the terms of the bond. The terms of a bond may vary from bond form to bond form. Therefore, a contractor must carefully read the bond to determine what steps it must take to pursue a claim against the bond.

Second, surety bonds typically incorporate the terms of the bonded contract. Therefore, in addition to considering the terms of the bond, a contractor must consider the terms of the bonded contract. Failure to comply with the terms of the bond or the bonded contract can be fatal to a contractor’s claim against a surety bond.

Finally, a contractor should consider calling for a meeting with the bond principal and surety as soon as the contractor has concerns about the bond principal’s performance. Raising issues early and encouraging open communication prior to a default or formal bond claim can often “nip a problem in the bud,” which is better for all parties involved and the project overall.

What is the difference between a payment or contract bond and a performance bond?

Charles J. Nielson
President
Nielson, Hoover & Company

Performance and Payment Bonds are generally used together on what we refer to as “bonded projects”. The Performance Bond very literally guarantees that the contractor providing the bond will abide by the terms and conditions of the contract. The roots of the written Performance Bond obligation go back to the 1677 Statute of Frauds enacted by the English Parliament which stated that promises to answer for another’s debts and defaults must be in writing and signed by persons making the contract. Performance Bonds are therefore “common law obligations”.

Payment Bonds are issued for potential third-party claimants such as subcontractors, material suppliers and laborers on a project. The purpose of the Payment Bond is to ensure that those parties not in privity with the owner are both acknowledged and paid. Payment Bonds in the State of Florida and many other states in which the contractor is in privity with the owner can be a Statutory Lien Law Bond (fs 713.23). In that case, the owner (developer) is guaranteed a lien-free project as all liens can be transferred to the Payment Bond leaving the project free of non-payment claims. Payment Bonds issued from subcontractors to the general contractor are Non-Statutory Common Law Payment Bonds. Liens placed by material suppliers or labors of a subcontractor cannot be transferred to the subcontractors Payment Bond as the lien law does not apply to any entity not in privity with the owner.

Performance and Payment Bonds are very different instruments as it relates to what each guarantee, but together, they guarantee that the project the owner contracted for will successfully be built and all third-party subcontractors, materials suppliers and laborers will be paid for their services.