Value of the Surety Process

Not much has been said about the surety process, which was highlighted by the highly publicized fallout from the U.K. Carillion bankruptcy and resulting economic tsunami. A tragedy may have been averted or at least significantly lessened if the rest of the world had surety requirements similar to those in North America.

To many contractors, insurance costs money, bonds help make money. Yet when the process fails, bonds can also be the death of a company. The vast majority of construction firms are private and are usually family held assets. When contractors default and bonds are called, the effects can be devastating on these companies and its principals who often provide personal guarantees to back up the surety credit extension.

Does the surety process have social impact and value?

The surety process, albeit far from foolproof, answers the social value question. The focus of the underwriting process is on increasing the likelihood of success, while diminishing the chances of failure.

It is the business equivalent of preventative medicine. Measuring a company’s resources, tangible or otherwise, through an ongoing evaluation is a service surety companies and professional brokers provide – free of charge. This rather unique perspective can prove invaluable.

The benefit flows down through to subcontractors, vendors and subcontractor laborers that might otherwise find themselves on the short end of the cash flow train. It is usually these people who end up holding the bag when things go awry. While exact statistics are difficult to come by, most of the cost to the surety companies are to these same subcontractors and material suppliers, union benefit funds and sometimes underpaid labor.

This is not a perfect science by any means. Years ago, underwriters were taught to underwrite to a zero percent loss ratio. Of course, this is unattainable considering the dynamic realities of the world, and the ofttimes unfair nature of the construction business. Losses do happen, and when they do, it’s disturbing on many levels. The trickle-down effect can be devastating for those involved. Not the surety – to the contractor.

History suggests that more failures occur during a recovery than during a preceding economic recession. Statistics prove this out, but not in the years following the great recession of 2009 when surety wide loss ratios uniformly averaged less than 20%.

The reason was a combination of things, including the strength of a decade-long economic recovery, all time low interest rates, etc. However, at least some credit belongs to the value and veracity of the surety underwriting process itself and the lessons learned from the past. While some may argue that the benefit derived (paid claims) doesn’t justify demand for the product, it is evident that meaningful bonding requirements have led to the development of a sophisticated service industry that does, in fact, have a social benefit.

Surety Profiles Elsewhere

In the U.K. Carillion disaster, Carillion’s liquidation resulted in:

• 2,000 lost jobs;
• $3.4 billion in unpaid pension liability;
• $2.6 billion owed to 30,000 suppliers, subcontractors and creditors; and
• $195 million public funding bailout.

The vast majority of the world maintains percentage requirements for performance security, or partial bonds. Typically, this runs 5-10% of the contract value. Rarely, it may reach as high as 20%. These obligations, whether secured via bank guarantees or surety bonds, are “on demand” instruments, meaning the beneficiary can draw against the guarantee without declaring a formal default, and for almost any reason they choose.

Is 5-10% Sufficient?

Modern history dates surety back to 1837 in North America, and through experience it’s been clearly demonstrated that 5-10%is not nearly enough to solve a problem. The loss ratio on surety claims approaches 40% of the backlog at the time of default or insolvency.

It is important to point out that where limited percentage performance guarantees exist, payment guarantees do not generally follow. Consider a $100 million project, with 10% performance security that goes into default. That $10 million must cover cost overruns (because the project was likely underpriced in the first place), defective workmanship and, perhaps, unpaid vendors to the project.

Some might argue that the system of low percentage bank guarantees and bonds works just fine, but loss results are nearly impossible to come by on the banking side. It ignores some rather obvious flaws.

As pointed out above, traditional payment bond or guarantees are largely absent. Any surety claims professional would agree that on average sums paid to subcontractors, labor and vendors far outstrips payments made to ensure performance. Claims typically occur when the contractor runs out of money, not because it doesn’t know how to build. Termination for performance is rare, unless it is a result of cash flow problems. Failure to staff the project, obtain and install materials and equipment or having critical path subcontractors abandon the project are all cash flow driven. Once in dire straits a contractor will “create” financing sources by delaying or simply not making payments to subcontractors, material suppliers and taxing authorities. Then the bomb goes off - as it did with Carillion.

Contractors of any meaningful size operating in the international percentage bond arena may have dozens of sureties participating at different levels on some, but not all bonded projects. Further, the surety may not have any idea how much and what kind of risk exists in any of the projects where they are not participating.

So, who’s in control? The answer is no one. And that’s the problem.

The direct economic value that surety bonds provide is visible only when something bad happens. The percentage bond system has developed an underwriting platform based almost exclusively on that scenario. Conversely, the North American model is based on preventing the disaster from happening in the first place. It’s a check valve on unrealistic and financially questionable appetites, unreasonable contractual obligations and places a premium on capabilities and project management. This is the direct result of the large percentage bonds (100% in the U.S., 50% in Canada), both performance and payment, and the obligation on the part of the surety to remedy defaults and deliver a completed project.

The unseen services of the surety industry

A byproduct of the large percentage system is the development of much closer relations among the surety, the broker and their client. So, it is extremely rare that a problem comes as any surprise. More often than not the surety will fund the contractor through to completion, make payment to vendors subcontractors and direct labor to move the project to completion. In the small percentage bond arrangement, contractors often don’t know if there’s a problem until someone demands a payment. Now. In full.

So, the message is clear, meaningful performance guarantee and surety requirements work on many levels, for many reasons.