By Christian Coleman, HUB
Subcontractor defaults have been a growing problem in construction, causing project delays or cancellations and sapping the construction industry’s financial strength.
According to a recent industry survey, half of the respondents cited defaults as a major issue, driven primarily by financial pressures and a shortage of skilled workers. The trades most commonly affected are electricians, plumbers, and concrete workers.
Such pressures are being felt by the industry as a whole, of course, even as it tries to balance them against an expected 7% increase in non-residential construction spending.
But those pressures are also being felt by insurers and reinsurers that help construction firms protect themselves against the risks of turbulent times, such as the many costs of subcontractor default. Re-insurers are experiencing losses that can be recaptured through pricing and retention increases on primary carriers. In this environment, underwriter scrutiny increases, and appetite grows more discerning.
Working with a surety-specific brokerage is mandatory. Construction firms should sharpen their understanding of the importance of sureties to their long-term success.
Surety bond basics
Surety bonds have never been more important to contractors. A bonding program protects owners, customers, and the business alike, enabling them to bid on larger projects, expanding project backlogs, and avoiding last-minute fire drills when securing a bond.
They are a guarantee that a company or individual will fulfill an obligation, legally required of contractors, suppliers, subcontractors, and project owners on all public construction projects in the U.S. and many in Canada. Demand has recently exploded, pacing government infrastructure spending. Inflation has driven up the total bond value.
But the current economic environment, with inflationary pressures and construction labor shortages, is boosting demand for surety bonds for private projects, too. One survey of private construction contractors ranked important benefits:
- More rigorous prequalification and review was performed by bonded projects (96%) versus non-bonded ones (61%).
- Nearly five times as many respondents prioritized bonded versus non-bonded projects during financial difficulties.
- Bonded projects tend to be finished ahead of schedule, five times as many public and private owners said.
They also reduce the risk of project default, ensuring business continuity and providing technical and financial assistance. Further, surety bonds ease the transition from construction-to-permanent financing by eliminating liens. They can even lower construction costs through improved bidding competition.
Bid, performance and payment bonds
The three most common surety bonds for construction are:
- Bid bonds. These are typically required for government projects and are required in order to submit a bid. They ensure that certain requirements are met, such as entering into the contract within a specified time frame and providing performance and payment bonds. They also demonstrate a business’s financial standing, an important pre-qualifier for larger and more complex projects.
- Performance bonds. These are the most common, providing a guarantee that work will be completed according to a contract’s specifications. They are a recourse against defaults, whether by a principal or a subcontractor (which are often required to secure them).
- Payment bonds. These guarantee the principal will pay all subcontractors, laborers, and suppliers under the contract.
Pricing varies based on factors such as contract scope and project duration. Payment and performance bonds are usually coupled and priced between 0.75% and 3% of the contract price.
Surety’s ‘Three C’s’
To qualify, contractors must measure up on three fronts – the three C’s – used by underwriters for their evaluations:
- Character. The applicant – or principal – must show a credit record and business history that reflect good character and integrity and a history of meeting obligations. Underwriters look at references and reputation, the quality of relationships with primes, subcontractors, and vendors, credit reports, bank records, and, often, the owner’s personal financial statements.
- Capacity. The firm’s principal must demonstrate it has everything in place to fulfill the contract. This encompasses everything from staff with the necessary skill and experience to the right equipment. The surety should be shown the history of successful projects, the backlog of new and existing ones, and contractual language. Continuity and succession planning are also examined, along with project management systems and controls.
- Capital. Financial strength must be evidenced to take on new projects while managing current obligations, and be able to respond to unforeseen problems. This requires extensive current financial documentation, including a CPA-prepared annual report and interim financial statements. Also necessary are work-in-progress schedules, a bank line of credit and personal financial information.
Securing a surety bond can be onerous. A broker partner with surety experience and know-how is not just a guide through a rigorous application process but is well-positioned to identify and remove potential barriers on the path.
