How-to obtain-surety-bonds-Interior-ltrBooklet

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 that contractor’s ability to acquire work.

What is a Surety Bond? A surety bond is a three-party agreementwhereby the surety assures the project owner(Obligee) t h a t the contractor (principal) willperform a contract in accordance with thecontract documents. When a contractor requiresits subcontractors to obtain bonds, thecontractor is the Obligee and the subcontractoris the principal. Most surety companies are subsidiaries ordivisions of insurance companies, and both suretybonds and traditional insurance policies are risktransfer mechanisms regulated by state insurancedepartments. However, traditional insurance isdesigned to compensate the insured againstunforeseen adverse events. The policy premium isactuarially determined based on aggregatepremiums earned versus expected losses. Surety companies operate on a differentbusiness model. Surety is designed to prevent aloss. The surety prequalifies the contractor basedon financial strength and constructionexpertise. Since the bond is underwritten with littleexpectation of loss, the premium is primarilya fee for prequalification services.We are discussing here how to Obtain and Establish a Standard Contract Bond Program... It should be noted that there are many “Entry Level Easy Application” programs available through your Surety Agent. These programs offer surety support on contracts up to $400,000 or higher and aggregates up to $800,000 and higher, with much less financial presentation. They do still rely upon credit and experience. To Grow or Obtain a larger Surety Bond Credit Line, Here is what you need to know: 1

Three Basic Types of Contract How to Begin Surety B onds Since most surety companies distribute surety ■ The bid bond assures that the bid is bonds through the agency system, the first step is submitted in good faith and that the to contact a professional agent or broker, also contractor will enter into the contract at known as a surety bond producer, who specializes the price bid and provide the required in contract surety. A professional surety bond performance and payment bonds. producer guides the contractor through the bonding process, helps establish and foster a ■ The performance bond protects the business relationship with a surety company, and owner from financial loss should the assists in managing the contractor’s surety contractor fail to perform the contract in capacity. accordance with its terms and conditions. A professional surety bond producer can offer ■ The payment bond assures that the sound business advice and technical expertise, contractor will pay specified such as contract document review. The producer subcontractors, laborers, and materials can introduce the contractor to professionals or suppliers associated with the project. consultants when appropriate. After meeting with the contractor and gaining an understanding of the firm’s business and needs, the producer tailors the contractor’s sub- mission for the specific requirements of the surety company. The producer 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 producer can guide the contractor through a formal presentation and meeting with the surety company. The producer is an essential link between the contractor and the surety company and should maintain communications with both.2

To find a producer who specializes in contract surety bonding, contact the National Association of Surety Bond Producers(NASBP) at (202) 686-3700 or www.nasbp.org. NASBP members adhere to a code of professional standards.Qualities of a Professional Surety Surety C om pan y UnderwriterBond Producer Once the surety bond producer collects all the■ Is well respected and has a reputation for necessary information, he or she submits it to a integrity in the construction industry; surety company underwriter. The underwriter takes an in-depth look at the contractor’s entire■ Demonstrates a personal interest in the business operations and must be satisfied that the contractor’s success; contractor is capable of completing the project.■ Has a track record of building solid The underwriter may request a meeting with relationships with surety underwriters; the contractor to form his or her opinion and obtain additional information. For example, the■ Possesses an understanding of the underwriter may want more information on the construction industry; single job size and aggregate workload for all projects, bonded or not, in the contractor’s■ Has knowledge of accounting and current and projected work program. If the finance, especially construction contractor wants to bid on a larger than usual accounting procedures; project, the underwriter will want to know whether it is prudent for the contractor to under-■ Has knowledge of construction take it from a risk/reward standpoint, how it fits contracts, subcontracts, and related into the current work program, how the project contract law; will be financed, and a projection of the return.■ 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. 3

Although it may seem as if surety underwriters The contractor’s financial situation fluctuates focus on the contractor’s finances and financial from day to day, from job to job, and structure, they are also interested in other consequently is the area that is subject to the elements of the contractor’s business. The greatest scrutiny. When applying for bonds, the contractor’s organization, track record, and contractor must be aware that once the surety is approach to a job, once established, are not satisfied as to the technical ability to perform, it generally questioned with frequency if the will then review the financial results of contractor’s results are consistent. However, performance and translate that into a decision should there be significant changes in ownership on the firm’s present and future ability to pay or key personnel or the contractor decides to bills, finance additional undertakings, and move into a different type of construction or accept or mitigate risk. The numbers are the geographic area, this information should be scorecard that tell all parties how well the shared with the surety along with any other contractor is performing. changes in the contractor’s capabilities or the way the contractor conducts business.4

Prequalification Process information, answers questions the surety underwriter may have, and assists in verifying information. Each surety company has its own underwritingstandards and requirements, but there are shared The surety must be satisfied that a contractor has the ability tofundamentals common to the underwriting of meet current and future obligations, has a good reputation, hasmost surety companies. Before a surety under- experience meeting the requirements of the projects to bewrites a bond, the contractor typically undergoes undertaken, and has (or can readily obtain) the equipmenta careful, rigorous, and thorough process, often necessary to perform the work. The surety also looks for contractorsreferred to as prequalification. The prequalification who run a well-managed, profitable enterprise, keep promises, dealprocess takes time as the producer collects fairly, and perform obligations in a timely manner.Prequalification Checklist life insurance on key owners with the construction company named asHere is what a contractor may need to provide: beneficiary);■ An organization chart of key employees and their responsibilities;■ Detailed resumes of key employees; ■ Evidence of a bank line of credit to augment working capital and to handle■ A business plan outlining the type and size temporary cash flow deficits or strains. of work sought, prospects for such work, the Sureties will look at the security for the credit geographic area in which the company and the extent to which bank loans are used operates, and growth and profit objectives; and the amount and terms of their repayment.■ Current work in progress as well as a history of the largest completed jobs, including Sureties generally look for an unsecured line the name and address of the owner, the of credit or a line of credit obtained through contract price, and date completed, and the the long-term financing of equipment or gross profit earned; real estate; and■ A continuity or completion plan outlining ■ Letters of recommendation or references how the business will continue in the event from subcontractors, owners, architects, and of the owner’s death or disablement (the engineers on completed projects. surety may suggest that the plan include 5

Financial Statements ■ Schedule of general and a dministrative expenses may reveal how well overhead Depending on how long the contractor has expenses are controlled and managed. been in business, the surety will request fiscal year-end statements for at least the past three ■ Explanatory footnotes qualifications made years and may require a financial statement by the accountant. audited by a certified public accountant (CPA). Financial statements typically include the following: ■ Management letter conveys the CPA’s ■ Accountant’s opinion page—discloses findings, observations, and recommendations about the contractor’s business. Not all CPAs whether the statements were prepared provide management letters. according to audit, review, or compilation standards. Accounting Methods ■ Balance sheet shows the assets, liabilities, and Complete and accurate accounting systems net worth of the business as of the date of the are extremely important to surety companies. statement. This helps the surety company evaluate the working capital and overall financial condition of the company. ■ Income statement measures how well the The American Institute of Certified Public business performed. The surety analyzes each Accountants’ (AICPA) Audit Guide for Construction item, including gross profit on contracts, Contractors recommends the percentage-of- operating profit, and net profit before and completion accounting method, which is also after tax provisions. preferred by most sureties. ■ Statement of cash flow discloses the cash The percentage-of- completion method best movements from operating, investing, and represents a contractor’s financial condition and financing activities. most accurately measures results of work performed during the accounting period. The ■ Accounts receivable and payable percentage of contract values recognized as schedules should reflect aging. revenue typically is done on a cost-to- cost percentage-of-completion method. ■ Schedules of contracts in progress and contracts completed show the financial Depending on the time elapsed since the last performance of each contract and provide fiscal year-end statement, the surety may ask for insight into the potential for future earnings an interim financial statement every three or six from contracts in progress. This should tie into months to show how the current year is the balance sheet. progressing.6

Contractors also need to prepare a quarterly ■ Revised estimate of the cost to complete;schedule of work in progress. This scheduleshould list each job by name and include: ■ Estimated final gross profit; and■ Total contract price; ■ Anticipated completion date.■ Approved change orders; The format of this exhibit and the amount■ Amount billed to date; of information required varies among surety companies and almost always is required in■ Cost incurred to date; connection with the full CPA reports.Quality of Financial Statements A review statement, which does not require the outside verification present in an audit, Financial statements are only as good as the consists principally of a thorough review of theaccountant preparing them. That is why it is contractor’s financial records and theimportant to select a CPA who is application of certain analytical procedures toknowledgeable of construction accounting and the financial data.the American Institute of Certified PublicAccountants’ Audit Guide for Construction Although narrower in scope than a full audit,Contractors. the review does provide some limited assurance about the financial statements. Sureties prefer, and at certain levels require,audited fiscal year-end statements, but there A compilation, however, provides little orare occasions when a surety may accept a no assurance of the credibility of the figuresreview or compilation statement. presented and would typically be accepted only for interim statements. An audit verifies relevant items in thefinancial statement with internal and external In general, statements prepared by the con-investigations of their accuracy. The account- tractor’s staff are not acceptable to suretiesant certifies that the financial statement is because they are difficult to verify and lack thepresented in accordance with generally approval of an independent auditor.accepted accounting principles. While sureties may offer modest programs based on review or compilation statements, audited financial statements are most often required, especially for larger work programs. 7

Commitment After the bonds are written, the surety continuously evaluates the overall performance The surety company expects the contractor to and financial position of the contractor. Adverse perform its contractual obligations under the changes may cause the surety to reduce or bond. terminate the bonding program, whereas positive results may serve as the basis for an increase in Surety companies usually require a surety capacity. demonstration of commitment from the construction company’s owners through Sufficient lead time should be allowed when personal and/or corporate indemnity. seeking surety bonds—especially when seeking a bond for the first time. The indemnity agreement obligates the named indemnitors to protect the surety company from In no event should a bid be submitted for a any loss or expense caused by the contractor’s bonded project before surety arrangements are failure to fulfill its bonded obligation on the project(s) and any resultant loss under the surety in place. bond. This gives the surety company some assurance that the contractor will stand fast in the face of problems and use its talent and financial resources to resolve any difficulties that may arise in the performance of the bonded work. Surety companies stand behind the commitments undertaken by a contractor through a bonded contract. The contractor is primarily responsible to fulfill the contract’s obligations and the surety’s obligations are secondary to the contractor’s. Surety bond premiums are service fees for the surety’s expertise, underwriting services, and financial backing.8

What do Bonds Cost? When bonds are specified in the contract documents, it is the contractor’s responsibility Surety bond premiums vary from one surety to obtain the bonds. The contractor generallyto another, but can range from one-half of one includes the bond premium amount in the bidpercent to two percent of the contract amount, and the premium generally is payable upondepending on the size, type, and duration of the execution of the bond. If the contract amountproject and the contractor. Typically, there is no changes, the premium will be adjusted for thedirect charge for a bid bond, and in many cases, change in contract price. Payment andperformance bonds incorporate payment bonds performance bonds typically are priced basedand maintenance bonds. on the value of the contract being bonded, not necessarily on the size of the bond.Benefits of Bonding ■ Funding verification - this service becomes very important if a contractor is involved in The surety industry is an integral part of the private construction. Many contractors haveconstruction business. A good surety under- faced bankruptcy because they did not ask thewriter and surety bond producer can be two of source of funding on private projects. The suretya contractor’s greatest assets. The producer and will insist on knowing the source and adequacyunderwriter are professionals who possess or of funds before it will commit to bonding ahave access to a wide variety of resources to project.assist contractors. They do all they can to seethat a contractor remains viable. The surety ■ Contract reviews - Many sureties performteam interacts with a cross section of the contract reviews to identify contract terms,construction industry and can assist the general condition requirements, or anomaliescontractor with: in the specifications, or bond forms that may be onerous, unacceptable, or add undue risk■ Professional references - The surety team to the project.knows accountants, bankers, and lawyers whounderstand the construction business.■ Corporate experience - Producers and ■ Continuity plans - Sureties can assist thesurety company personnel can share theirexperience on issues facing a contractor. contractor with a continuity plan to protect the contractor’s family, estate, partners, creditors, employees, and assets. 9

Maintaining the Surety Relationship To maintain and increase surety capacity, it is Maturing into a growing partnership requires important for a contractor to develop and teamwork and an organized effort among the maintain an ongoing relationship with the contractor, the surety underwriter, and the surety under- writer and producer. Developing a bond producer. There may be difficult times, and relationship requires commitment, trust, and the surety may not always be willing to extend above all communication. Maintaining the the surety capacity the contractor would like, but relationship through open communication and maintaining a relationship with the surety timely reporting on the company’s financial company builds trust and increases the surety’s condition and job status builds trust with the commitment to the contractor over time. surety. 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 success- fully 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 and these changes could have associated costs and benefits.10

ResourcesU.S. Small Business Administration (SBA) Surety Information Office (SIO) For information on the SBA Surety Bond Contact SIO at www.sio.org, (202) 686-7463,Guarantee (SBG) Program that helps small and or [email protected] for free publications including:emerging contractors obtain bonds, visit ■ The Importance of Surety Bonds in Constructionwww.sio.org/contractor/contractor6.html. ■ Helping Contractors Grow: Surety Bonds for New To contact the SBA Office of Surety Bond & Emerging ContractorsGuarantees, go to www.sba.gov/OSG or call(202) 205-6540. ■ Surety Companies: What They Are & How to Find Out About ThemNational Association of Surety BondProducers (NASBP) ■ Surety Bonds for Contractors CD NASBP is a resource for information about the For more information on building a relation- ship with a surety bondrole of the bond producer, how to find a producer and a surety company, go to www.sio.org/contractor/producer in your state, bond assistance contractor2.html.programs, and NASBP’s top issues. NASBP also offers many educationalopportunities and programs that are organizedby its professional development department.Contact NASBP at www.nasbp.org, (202) 686-3700, or [email protected] Surety & Fidelity Association of America(SFAA) For information on current surety industryinformation and issues, or to buy Glossary: Fidelityand Surety, contact SFAA at www.surety.org,(202) 463-0600, or [email protected]. 11