Construction is a unique industry in many ways, one of which is the distributed nature of the business model. An architect may design a project, then hand the execution to a general contractor. In turn, the general contractor will retain numerous other firms to deliver services on specific parts of the project. This model has many advantages but also some risks involved.
Understanding Risk Management in the Construction Industry
The unique aspect of construction is the financing and risk management profile. After all, construction involves both a service and a deliverable product. In addition, the product becomes more and more expensive throughout the process but its value is only realized at the end, once a project is completed. A building may be 85% completed with all of those investment dollars sunk into its development, but it’s not able to be utilized until it’s 100% completed.
This creates a clear need for unique tools to help manage the risk associated with a construction project. One of those tools is a surety bond. To help us understand the how, what, when and why of surety bonds in construction, we asked Zach Dixon of Delmarva Surety to walk us through ten things every small construction contractor should know about surety bonds.
Q. What is surety?
Surety is a three-party relationship between the surety, the owner/obligee (project-giver) and the contractor. The surety guarantees the owner the successful performance and payment of subs and suppliers of a contract by the contractor. Unlike insurance, sureties have a zero expectation of loss.
Q. What is a bid bond?
A bid bond is used as a prequalifying instrument before the contract is awarded. Its purpose is to guarantee that the contractor will enter into a contract with the owner if the bid is accepted and the contractor will provide final bonds (performance and payment bonds). The bid bond penalty could be used to secure the difference between the first and second bidder. The issuance of a bid bond does not guarantee the issuance of a performance and payment bond.
Q. What is a performance and payment bond?
Performance and payment bonds serve as guarantees that the contractor will perform the work and pay their subcontractors and suppliers. They are required after the contractor has been awarded the project. They are separate bonds but are both issued and billed together.
A performance bond assures that the contractor will perform the work it was contracted to perform in accordance with the plans, specifications and obligations per the contract. A payment bond assures that the subcontractors, vendors and suppliers will be paid the monies owed to them.
Q. What is the underwriting process used by a surety to issue a bond?
Sureties use the “Three Cs” to underwrite any construction account. These collectively give the surety a clear picture of the level of stability and risk involved in issuing the bond. The “Three Cs” are:
- Character – Credit history, bankruptcies, liens, judgments, etc. are all underwriting considerations. It is the integrity and commitment of the contractor to meet the obligations of a person or entity.
- Capacity – The surety seeks to understand and have confidence in the history and experience of the contractor. Have they done the size and scope of this type of work before? A surety will run references, review business plans and resumes, and more.
- Capital – The surety looks at finances, working capital and equity in the company.
By doing this, they are looking to answer two primary questions:
1. Can this contractor cash flow the project (i.e. do they have sufficient working capital)?
2. Can this contractor take a loss on a project, not involve the surety and maintain their company’s financial health (i.e. what is their overall net worth)?
Q. How are working capital and net worth calculated?
Working capital is a measure of the firm’s liquidity. It is calculated using this formula:
Working Capital = current assets – non-liquid current assets – current liabilities
Net worth is the equity in the company. It is calculated using this formula:
Net Worth = assets – liabilities
Q. Why would my bond go into claim?
There are two reasons that a bond would typically go into claim. They are:
- Performance – Notice from the owner to the surety of non-performance by the principal.
- Payment – Notice to the surety from subcontractors of suppliers that they are experiencing non-payment.
Please note that bonds protect 2nd tier subcontractors and suppliers (2nd tier means that they are the sub-subcontractors or suppliers).
Q. What happens if my bond goes into claim?
The surety has a duty to investigate and defend against the claim. The surety and contractor will attempt to remedy the situation before going into an actual claim situation.
Sureties have various options when a bond claim arises. These include:
- Advancing Funds – The first option applies to when the contractor is performing the job sufficiently but cannot finance the job any longer. In this case, the surety may advance funds to finance the completion of the project and allow the contractor to finish the project.
- Tender Option – A second option is called the tender option. The surety and owner choose a replacement contractor who will finish the project in lieu of the original contractor.
- Take-Over – A third option is take-over, in which case the surety takes over the management responsibilities of the project. They can either hire a replacement contractor or act as a construction manager and leave the same subcontractors to finish performing the work.
There are some additional options available to the surety not listed here and applicable to various unique conditions.
Q. What is the difference between an irrevocable letter of credit and a bond?
Unlike a bond, in a claim situation, an irrevocable letter of credit (ILOC) can be drawn down at the discretion of the owner and can be cashed without approval of the contractor. With an ILOC, the burden of claim resolution is on the owner. With a bond, the claimant must prove default and have the supporting documentation, and the contractor is entitled to a defense of the claim.
Another significant difference is that a bond provides a 100% guarantee, while an irrevocable letter of credit may only require a percentage of the contract value (e.g. 6%). Generally speaking, ILOCs are fully secured, while bonds are typically unsecured.
Q. What is the role of indemnification?
Surety bonds are written without the expectation of a loss. As such, sureties generally require the corporate, personal and spousal indemnity of the contractor (principal). Financially strong contractors may have negotiation room in regards to indemnity.
Indemnity can be structured in a variety of ways, which the surety will determine. If the contractor causes the surety a loss, the contractor is responsible for reimbursement.
Q. How is a bond rate determined?
The cost of the bond is based on the contract price and there are many variables that effect your bonding rate. The stronger the contractor is financially the more favorable rate they will receive. The more frequent bond user coupled with strong finances get even better rates. If the contractor is on a sliding scale rate, the larger the project the lower the rate. Unlike insurance, the bond premium is a pass through cost to either the owner or GC.
Zach Dixon is a Surety Bond Specialist with Delmarva Surety, a division of Risk Strategies. Based in Hunt Valley, Maryland, Zach is a graduate of Towson University. He specializes in performance and payment bonds, bid bonds, subdivision bonds, site improvement bonds and insurance. Zach may be reached at (443) 804-2800 or via email to firstname.lastname@example.org.