1. The Sensible Choice For Managing Risk
Surety Bonds
The Sensible Choice For Managing Risk
Surety Bonds – the sensible choice for managing risk.

2. U.S. Department of Housing & Urban Development
Presented By:

3. Can Surety Bonds Help You?
How do you evaluate & manage risk?
How do you ensure projects are completed on time, on budget, and to contract specifications?
How do you ensure contractors successfully meet obligations?
As a project owner, how do you evaluate and manage risk on construction projects? How do you ensure projects are completed on time, on budget, and to contract specifications? How do you ensure that contractors successfully meet obligations?

4. Can Surety Bonds Help You?
Bid Bond
Performance Bond
Payment Bond
One way is with bid, performance, and payment bonds. Specifying a surety bond ensures capable and qualified contractors and protects you from financial loss in the event of contractor failure.

5. Surety Bonds vs. Traditional Insurance
3-party
2-party
Risk transfer
Duty to obligee
Duty to insured
Regulated by State Insurance Departments
Premium fee for prequalification services
Premium actuarially determined
Project specific
Usually term specific
Penal sum
Policy limits
Surety bonds and traditional insurance are provided by insurance companies and both are licensed and regulated by state insurance departments. However, surety bonds are more like bank credit in that the surety company’s financial resources back the contractor’s commitment to enter into a contract with an owner.
In order to obtain a surety bond, the contractor must qualify – that is meet the surety’s comprehensive underwriting standards.
Bonds are a three party agreement among the owner (referred to as the obligee), the contractor (referred to as the principal), and the surety company. Traditional insurance is a two-party agreement between the insurance company and the insured. With surety bonds, the premium is a fee for the surety’s prequalification services. With insurance, the premium is based on expected loss. There is no deductible on a surety bond, although the surety may require the contractor to reimburse the surety in the event of claims payment.

6. Contract Surety Bonds Bid Bond Performance Bond Payment Bond
There are three basic types of contract surety bonds.
The bid bond assures that the bid has been submitted in good faith, that the contractor intends to enter into the contract at the price bid, and the contractor will provide the required performance and payment bonds.

7. Contract Surety Bonds Bid Bond Performance Bond Payment Bond
The performance bond assures the owner that the contractor is capable and qualified to perform the contract and protects the owner from financial loss should the contractor fail to perform the contract in accordance with its terms and conditions.

8. Contract Surety Bonds Bid Bond Performance Bond Payment Bond
The payment bond assures that certain subcontractors, laborers, and materials suppliers will be paid in the event of contractor default and prevents subcontractors from filing mechanics’ liens on a project.

9. Fundamentals of Surety
Contractor default is preventable
Surety companies & producers prequalify contractors
Surety companies back the bond with their own assets
The fundamental concept of contract surety is that contractor default is preventable. Surety companies and surety bond producers spend a great deal of time and expense in the underwriting process to qualify a contractor before issuing a surety bond. Since surety companies back the bond with their own assets, they conduct a careful, professional, and rigorous prequalification review of the contractor.

10. The 3 Cs Of Prequalification
Capital
Capacity
Character
Prequalification is an in-depth look at the contractor’s entire business operation to determine the contractor’s ability to meet current and future contractual and financial obligations. Basically, underwriting is a look at the three Cs of prequalification:
Capital, which looks at the contractor’s financial strength,
Capacity, which analyzes the contractor’s ability to perform the contract, and
Character, which is a look at the contractor’s reputation.

11. Analyzing Financial Strength
Capital
Financial statements
Working capital
Work-in-progress
Indemnity
The surety underwriter and surety bond producer have access to detailed financial information that most contractors will not share with a project owner. The surety team analyzes:
Annual and interim financial statements
Investment strategies
Cost control mechanisms
Work in progress, including bonded & non-bonded projects
Cash flow
Net worth
Working capital and
Bank & other credit relationships

12. Evaluating Ability To Perform
Capital
Financial statements
Working capital
Work-in-progress
Indemnity
Capacity
Resumes
Contingency plan
Business plan
Equipment
The surety also investigates the contractor’s business operations and ability to perform. It will look at
Prior experience and whether the contractor has completed similar projects.
Whether the contractor has or can obtain the necessary equipment to perform the work.
It will review organizational charts of key employees and request resumes of the principal and key employees.
The surety also reviews reports on past, current, & future work load, including bonded & non-bonded projects.
It will analyze the contractor’s business plan and
Ask how the business will continue in the event of the principal’s or key employee’s death or disablement.

13. Business plan – short & long term
Assessing Reputation
Capital
Financial statements
Working capital
Work-in-progress
Indemnity
Capacity
Resumes
Contingency plan
Business plan – short & long term
Equipment
Character
Reputation
Relationships
References
The surety will also investigate business relationships with
Subcontractors
Suppliers
Project owners and
Lenders
to determine the contractor’s reputation in the industry.

14. Reviewing Business Ventures
Surety
Document business commitments that can affect the contractor’s business
Owning property
Side ventures
The surety is also interested in business commitments that can affect the contractor’s business, such as owning property and side ventures.
One contractor with 13 contracts underway used $850,000 in contract funds for outside investments and could not raise the capital to continue. The surety company provided financing so the projects could be completed.

15. Source: Dun & Bradstreet
Contractor Failure
While the premise of surety bonding is to prevent contractor failure, construction is filled with risk. Contractor default is an unfortunate, and sometimes unavoidable, circumstance.
According to Dun & Bradstreet, in the 1990s, an average of 10,000 contractors failed each year leaving liabilities of $3 billion per year. They also found that the number of years a failed contractor was in business had no effect on the likelihood of default.
Based on the Engineering News-Record (ENR) annual “Top 400 Contractors” list, of the top 50 contractors for the year 1990, 26% were not represented at all in the “Top 400” list of 2000.
Source: Dun & Bradstreet

16. Why Do Contractors Fail?
Inadequate
Management
New
Owner
Failure
Over
Expansion
Change in
Scope
Failure
Usually it takes a combination of events to force a contractor into default. Factors that can contribute to contractor failure are
Management problems, including:
Inadequate accounting, financial, and project management systems
Changes in ownership or personnel
Changes in scope of business
Rapid over-expansion, either in volume or expansion into new geographic territory.
Labor and material problems that can lead to default include:
Subcontractor failure
Labor and materials shortages and
Cost escalations.
Sub
Failure
Materials
Shortages
Cost
Escalations

17. Why Do Contractors Fail?
Economic
Downturn
Inclement
Weather
Failure
Failure
Onerous
Terms
Work
Environment
Other factors may occur that are simply beyond the contractor’s control, such as inclement weather, unexpected economic downturn, onerous contract terms or work environment, unforeseen changes in job site conditions, or death or illness of a key employee.
Death or Illness
of Key Employee

18. Claims Principal Obligee Surety
In the unfortunate event the contractor does fail, the surety has legal obligations to the project owner and the contractor.
Surety

19. Expediting The Claims Process
Clearly define default in contract
Submit status reports to surety
Promptly notify surety of performance or payment problems
Owner must file formal declaration of default
To expedite the claims process,
make certain that what constitutes default is defined in the contract and
keep the surety informed with status reports of job progress and
notification of performance and payment problems as they occur.
In the event of contractor default, the project owner must file a formal declaration of default.

20. Responsibility Of The Surety
Acknowledge claim
Investigate claim
Determine & fulfill obligations
Once notified, the surety will:
acknowledge the claim and
then conduct an impartial investigation.
If the surety finds the contractor to be in default, it has certain obligations as defined in the bond form.

21. Performance Bond Protection
Surety
Re-let the job
Provide replacement contractor
Retain original contractor
Reimburse owner penal sum
The surety generally does one of four things:
Re-lets the job for completion
Provides a replacement contractor
Retains the original contractor, providing trained personnel or financial assistance, or
Reimburses the owner the penal sum of the bond.

22. Payment Bond Protection
Assures payment
No mechanics’ liens
Keeps subcontractors on the job
Surety
When a payment bond is in place, certain subcontractors, suppliers, and laborers are assured payment in the event of contractor default.
This protects the owner from mechanics’ liens and keeps key subcontractors on the job because they know they will be paid.

23. Surety Bonds vs. Letters of Credit
Surety Credit
Bank Credit
Premium
Interest
Expect reimbursement if loss
Repay loan
Principal benefit of surety credit
Borrower has benefit of bank $
There are alternatives to surety bonds, the most common being a letter of credit. So how do letters of credit measure up to surety bonds?
The surety company analyzes the contractor’s ability to perform. With a letter of credit, the banker examines the quality and liquidity of the collateral in case there is a demand on the LOC. If the bank is satisfied of the contractor’s ability to pay, there is no further prequalification.
The performance and payment bond each cover 100% of the contract price. A letter of credit is limited to the stated amount, usually only 5-10% of the contract price.
The surety bond remains in effect for the duration of the contract and may include a one-year maintenance period as well. The letter of credit is usually date specific, generally for one year. It may contain an “evergreen” clause for automatic renewal, with related fees.
In the event of contractor default, the surety conducts an impartial investigation of the claim. If the contractor is in default, the surety company completes the contract. With a letter of credit, the bank pays on demand of the holder. The owner must then administer completion of the contract with the funds remaining.
Under the payment bond, the surety pays rightful claims on certain subcontractors, laborers, and suppliers. With a letter of credit, the owner must determine the validity of these claims. If there is not enough money from the letter of credit, the owner must decide which claims to pay. If subcontractors are not paid, they may file liens on the project.

24. The Value Of Surety Bonds
Bid Bonds
Performance Bonds
Payment Bonds
One way to reduce the risk of construction is with bid, performance, and payment bonds.
A bid bond means that the contractor is capable and responsible. It also limits unrealistic bids from contractors who would not be capable of performing the contract. If the contractor is awarded the contract but fails to enter into the agreement, the surety may be required to pay the difference between the awarded bid and the next lowest bid or pay the bond penalty, usually 10% of the contract amount.

25. The Value Of Surety Bonds
Bid Bonds
Performance Bonds
Payment Bonds
The performance bond protects the owner from financial loss should the contractor fail to meet the terms and conditions of the contract. A qualified, bonded contractor is more likely to complete the project according to the contract provisions. Default is not in the best interest of the surety, contractor, or owner. When problems occur, the surety may offer financial, technical, or managerial assistance to the contractor in order to prevent default.

26. The Value Of Surety Bonds
Bid Bonds
Performance Bonds
Payment Bonds
Payment bonds assure that certain subcontractors, suppliers, and laborers will be paid.
Subcontractors and suppliers cannot file mechanics’ liens on the project and the owner is protected from unwarranted double-payments to subs and suppliers. The absence of liens can smooth the transition from a construction loan to permanent financing. As an added bonus, subcontractors and suppliers may lower prices when they know they are assured payment protection.
There is no cost for the payment bond when it is issued with the performance bond.

27. Cost of Surety Bonds Project Amount Approx. Bond Premium $1 Million
$7,700 – $13,500
$5 Million
$33,200 – $47,250
$10 Million
$56,950 – $81,000
$20 Million
$101,950 – $146,000
* Premiums may vary depending on size, type & contractors bonding capacity.
The cost of a performance bond is a one-time premium, which typically ranges from ½ to 2% of the contract amount, depending on the size and type of the project and the contractor’s bonding capacity. There is usually no charge for the bid bond or payment bond.
*For a small and emerging contractor, premiums can start around 2.5-3%.

28. Premium Calculation Examples
Established Contractor
$500,000 Contract
Reviewed/Audited Financial Statements
Frequent Bond User
< % Bond Rate (average – 1.35%)
<$5,000-7,500
Likely no other costs involved (collateral, escrow, SBA)

29. Premium Calculation Examples
Emerging Contractor
$500,000 Contract
Limited Financial Info. (Tax Returns/Quickbooks)
Limited Bonding History
% Flat Rate (average – 2.5%)
$9,000-12,500
May not include cost of getting bond (i.e., funds control, collateral, SBA fees)

30. How Is Premium Paid? Premium is billed BY the contractor TO the owner
Usually paid on first billing, along with:
Mobilization
General Conditions
Bond
Cost of bond is included in final contract price
Contractor pays the bond premium to the surety
Prompt Pay Is Key To A Contractor’s Success!

31. The Underlying Agreement
Look at obligations
Determine risks
Match capable principal to fulfill agreement
Surety
Just as the endorsement of a loan stands as a guarantee of the fulfillment of the terms and conditions of a loan agreement, a performance bond on a construction contract guarantees the fulfillment of a contract. The underlying agreement is the primary instrument to establish the risk associated with the guarantee.
A surety underwriter is trained to look at obligations, determine the risk, and match up the principal that he/she feels is capable of fulfilling the agreement. A bond is much like a “consultant’s report.” However, should this consultant make a mistake, he/she will back the decision with his/her money.

32. Bond Specifications Owner specifies surety bonds in contract documents
Contractor contacts surety bond producer
Producer guides contractor through prequalification
Contractor obtains bonds & delivers to owner
Specifying a bond for a project is easy. Simply state the requirement in the contract specifications. It is the contractor’s responsibility to contact a surety bond producer and obtain the necessary bonds. The surety bond producer guides the contractor through the prequalification process and helps him or her develop a business relationship with a surety company.

33. The Owner’s Responsibilities
Provide working set of plans and specifications
Establish terms of the agreement
Ensure full & timely payment
Maintain adequate insurance
Pay property taxes
Communicate
Owner
However, there are things an owner can do to get the most from the surety bond:
Provide a working set of plans and specifications
Establish terms of the agreement
Make payments to the contractor in full and on time
Maintain adequate insurance
Pay property taxes and
Communicate with the contractor and surety

34. Qualify Your Contractor’s Surety
A.M. Best Company
Dun & Bradstreet
Standard & Poor’s
Moody’s
Treasury Dept.
State Insurance Dept.
Before you accept the bond, it is important to verify that it is from a reputable surety company. A.M. Best, Dun & Bradstreet, Standard & Poors, and Moody’s all analyze and rate insurance companies.
The U.S. Treasury Department maintains a list of surety companies it has qualified to write surety bonds on federal projects.
State insurance departments license companies that write surety bonds and can provide information on these companies. Most state insurance department Web sites include a list of surety companies licensed to do business in that state.

35. For More Information Construction Bonds, Inc.
For more information on contract surety bonds, contact the Surety Information Office at or visit us online at
Construction Bonds, Inc.
A Division of Murray Risk Management and Insurance
1110 Herndon Parkway, Suite 307
Herndon, VA 20170