How is a bond line determined?
Scott Paice
Vice President, Surety
FCCI Insurance Group
Surety underwriters consider many factors when determining how much bonding capacity they are willing to extend to a contractor. The primary determinant is usually the contractor’s analyzed “working capital” position, which is basically their current assets (usually cash and receivables) minus their current liabilities (accounts payable and any current debt due within one year).
A common rule of thumb is the 10 percent rule: For every $100,000 of analyzed working capital, you divide that figure by 10 percent to come up with $1,000,000 of bonding capacity ($200,000 of working capital would equate to $2 million of surety credit, etc.). The theory behind the 10 percent rule is that it gives the underwriter a reasonable expectation that the contractor can finance the typical 10 percent retainage payment that is usually held back by the owner or general contractor on a job until final completion. An underwriter may be willing to stretch this rule further when considering the contractor’s past experience, the nature or complexity of the project, and the net worth of the company and individual indemnitors.
Single job limits typically take into account a contractor’s largest successfully completed job to date. Most surety carriers will consider jobs within two to three times the contractor’s largest completed project to date. Of course, it is easier to rationalize a larger road or sidewalk project that is simply more linear feet versus constructing a two-story building and then wanting to build a 12-story building.
Aggregate program parameters usually are more flexible and will contemplate annual sales revenues, the number of working crews and project management capabilities, in addition to customary financial ratios. Ultimately, your track record and long-term relationships can help maximize your bond line capacity beyond any simple financial calculation.
Adrian Oddi
SVP, Chief Underwriting Officer
IFIC Surety
A bond line, unlike a bank line of credit with a defined limit, is guidance on routine credit parameters that a surety is willing to issue if the bond requests meet certain criteria. When establishing a line, we also consider where an account may potentially stretch those parameters, and how much we might stretch with them.
A bond line is established primarily by evaluating the time-tested three Cs of surety underwriting: character, capital and capacity.
1. Character: A contractor’s character is based on the owners/leaders of the construction firm. We consider the resumes of key players in the company, as well as a history of the firm’s accomplishments, such as prior completed projects. We also review the corporate credit and owners’ credit to see how they pay bills and the caliber of outside professionals with which they do business.
2. Capital: The numbers are critical. This is where we evaluate the balance sheet and the operating history based on the profit and loss statement. We also look at the owners indemnifying the surety and the net worth and liquidity of these individuals.
3. Capacity: We review the firm’s track record on individual projects over time and profit trends on each. Does the firm have adequate bank credit to support periodic cash flow shortfalls? What resources are available in terms of the management team, laborers, subcontractors and equipment? How do the current bond requests compare to the previous history in terms of customers, job size, scope and territory.
Evaluating the three Cs of surety has stood the test of time and continues to provide a trusted framework for successful partnerships.
Brady Mayer
Assistant Vice President Underwriting
Old Republic Surety Company
There’s no one size fits all approach to determining single job and aggregate backlog bond line limits. The main factors to consider are the contractor’s needs, experience and financial capacity. This is a collaborative process among the contractor, agent and surety.
Experience includes scale and scope of prior completed jobs, résumés of key personnel, labor/equipment capacity and historical financial performance.
From a financial standpoint, it’s important to understand the unique cash flow demands placed on each contractor client, and whether the balance sheet, bank capacity or access to other outside capital supports that. A quality, well-capitalized financial statement demonstrates the ability to cash flow normal operations, as well as weather the unexpected.
It is following this in-depth review of a contractor’s entire business operations that the contractor, agent and surety can determine appropriate single and aggregate surety program limits that correspond with the capacity of the organization and the contractor’s growth objectives.
What information does a surety company require from a construction firm, and how can a contractor prepare itself for this interview?
Michael P. Cifone
Senior Vice President – Surety Underwriting
Hudson Insurance Group
Successfully obtaining surety credit typically requires a construction firm to provide a completed application, current financial statements, tax returns and résumés of key employees. Good credit history, profitable operations and a strong balance sheet are helpful in achieving an adequate bond line from a surety.
Contractors’ ability to communicate their story of why they are in business, where they want to take their company and how they plan to get there is vital to developing a strong business relationship with a surety. The ideal construction candidate seeking surety credit has prepared a long-range plan that indicates how they are prepared to manage the risk they may encounter in the future.
The surety understands that contractors are confronted by risks associated with their labor force, subcontractors, contract terms, weather and unforeseen conditions. A construction firm that has prepared a long-range plan that addresses issues related to growth initiatives, succession planning, training and mentoring, equipment and financing needs will provide the surety with the important information they need. The contractor that focuses on specific types of work for familiar owners will have the best chance of success.
Firms that have the proper management team in place to execute their long-range plan and address the daily risks associated with construction are best prepared to meet with a surety. Continually providing a surety with timely financial information–free of surprises–will result in a long-term relationship.
Carl G. Castellano
Vice President of Contract Surety
Philadelphia Insurance Companies
Construction firms need to prepare themselves for a surety company to assess their character, capacity and capability to underwrite and then assess overall risk. Key underwriting factors include the construction firm’s:
- Background and reputation: History and organization of the company, as well as references from owners, suppliers and subcontractors.
- Management capabilities: Business plan narrative and exhibits, including job selection, estimating and project management procedures, résumés of stockholders and key personnel, projected revenue, profit and cash flow for several years.
- Quality and reliability of information: Internal cost accounting systems and controls, timeliness and reliability of financial reporting, and several years trending of management projections of job and overall profit.
- Credit history: Banking relationships, lawsuits, claims, liens. The surety also will run business and personal credit reports.
- Financial condition and performance: Fiscal year-end financial statements for several years and recent interim statement, including work in progress, completed jobs and receivables aging; plus tax returns for several years
- Track record and experience: Description of completed projects, including owner, type, size, location and profitability.
- Projected bond requirements: Single and aggregate limits and duration of bonded projects.
- Indemnity structure: Construction firm, affiliates, personal. A personal financial statement and tax return will be required.
Be prepared to provide the surety with as much detail as possible to address these underwriting factors and any inevitable follow-up questions.
Finally, construction firms should engage an experienced surety agent who can provide guidance and counsel through the surety selection and underwriting process.
Why should contractors provide surety bonding for lenders on private construction projects?
Jason Dettbarn
Vice President Contract Underwriting
Merchants Bonding Company
Lenders are exposed to the risks of construction when underwriting a loan for a private construction project. The value of the collateral taken to secure the construction loan is at risk if the full performance of the construction contract is not completed. Performance and payment surety bonds are the best risk mitigation tool that contractors can provide to project owners and lenders.
A performance bond provides assurance that the project will be performed in accordance with the contract. A performance bond gives the project owner and lender the certainty that qualified contractors are hired to perform the work, and that financial protection is available if the contractors fail.
Payment bonds give subcontractors and suppliers payment security. Subcontractors and suppliers that have not been paid can seek financial recovery under the payment bond. With respect to private projects, a payment bond alleviates the burden of mechanic’s liens.
The scope of the surety’s review is broad and assesses the contractor’s ability to complete not only the project being bonded, but also its entire backlog. Experience has shown that one bad project can affect every project in the backlog. The surety’s review is also ongoing, rather than a one-time occurrence. As long as the surety-contractor relationship continues, the surety will continually assess the contractor’s abilities and in turn help them grow their capacity to successfully secure and complete bonded contracts.
What are the possible outcomes following a surety claim and loss?
Henry W. Nozko, Jr.
Chairman, President and Chief Executive Officer
ACSTAR Insurance Company
A claim may turn into a default or a termination of the principal (the prime contractor in this example) by the obligee (the project owner in this example). The surety is then required to independently investigate the situation and determine to accept or reject the default or termination. If the default or termination is accepted by the surety, the contractor might possibly continue with the project under a default, with assistance from the surety. In a termination, the contract most likely would be replaced.
In either event, it is in the best interest of the principal/contractor to cooperate with and assist the surety and/or replacement contractor to bring the claim to the earliest possible and least expensive conclusion. Under most indemnity agreements, the principal/contractor is obligated to assist with the claim and pay the surety for any loss or damage.
Good cooperation and assistance is a wise first step on the path to a continuing or new surety relationship after full resolution of the claim. An exemplary effort by the principal to assist and cooperate with the surety through the resolution of a claim will dramatically enhance the principal’s possibilities for a post-claim and loss surety relationship.
Finding future surety support rests to a great extent on how the principal manages its affairs during the claim and loss resolution. If the principal and surety become engaged in a dispute arising out of the claim, post-claim surety credit becomes complicated and more difficult to acquire. It’s not simple, but there is a path to surety credit after a claim and loss.
Why is an indemnity agreement so important to a surety bond contract?
Patty Catanese
Regional Vice President, Field Operations
Liberty Mutual Surety
A surety bond is a secondary obligation that supports another party’s (the bond principal) primary obligations to a third party (the bond obligee). The surety is guaranteeing to the bond obligee that the principal’s primary contractual obligations to the obligee will be performed. Surety business is underwritten to a zero percent loss ratio as the bond principal agrees to hold the surety harmless for any loss under the surety bond. Meaning, if the surety must pay out on a claim to the bond obligee, it will look to the bond principal.
To that end, the surety obtains an indemnity agreement to codify its common law rights and obtain additional contractual rights from the bond principal and possibly other parties (collectively the indemnitors). An indemnity agreement formalizes, among other things, the surety’s right to reimbursement from the indemnitors. From a surety perspective, the indemnity agreement is a critical piece of the underwriting process.
