Surety Bonds: The New Reality

Surety Bonds: The New Reality

To many electrical contractors, surety bonds and those who provide them are a necessary evil. That view may even have hardened a bit in recent years as surviving sureties have ratcheted up their scrutiny of contractors, clamped down on the availability of bonds, and raised prices. But the new, harsher realities of the surety bond industry that have emerged since 2000 mean most contractors can't treat

To many electrical contractors, surety bonds — and those who provide them — are a necessary evil. That view may even have hardened a bit in recent years as surviving sureties have ratcheted up their scrutiny of contractors, clamped down on the availability of bonds, and raised prices. But the new, harsher realities of the surety bond industry that have emerged since 2000 mean most contractors can't treat bonding as a given. Instead, they have to be willing to let sureties probe their businesses in a far more exhaustive fashion than ever before.

At the same time, however, the new rules of the surety marketplace may present contractors with a golden opportunity to tap the valuable insight and expertise of surety providers. In the course of forging closer relationships with bond producers and underwriters — much more vital today than five years ago — contractors may be in a position to see sureties as a business management resource rather than an expensive annoyance. Getting to that point, however, will mean letting go of fond memories of the construction boom of the late '90s and the free and easy surety-bonding climate it produced.

“During the 1990s, surety reviews for many contractors were often hour-long meetings over cocktails,” says Brian Scott, treasurer and chief financial officer for Morse Electric, a $52 million electrical contracting firm based in Freeport, Ill., which employs upwards of 350. “Now they can involve three-and-a-half-hour meetings in your office looking over project schedules and financials and talking through potential jobs to give the surety a good idea of where things are going with your company. They're wanting a much better and more detailed picture of your company than they did just a few years ago.”

For contractors, the new rules of surety bonding require not only a shift in attitude toward bond providers, but also internal operational changes with respect to managing the business and keeping a keener eye on financial matters. Increased scrutiny can require allocating more resources to monitoring cash flow, backlogs, and job progress as well as compiling other information surety providers need to adequately assess risk.

For Morse Electric, the biggest operational impact of the need to share more information with sureties has been getting more of the staff involved in bonding-related issues. As an established contractor, the company has had no trouble securing bonds at competitive prices. However, the company has had to allocate more time and resources to the surety bonding review process nonetheless.

“We've trained our insurance and financial people in a more detailed fashion to give them more in-depth knowledge of how to position things for surety review,” Scott says. “And we've had to involve more of our staff in surety-related meetings, including high-level managers who've never been involved in that area before. We could walk into surety meetings with just a few people before. Now we have two presidents involved, the CEO, myself, and the head of our insurance operation.”

For larger electrical contractors, though, the more stringent review processes have not required a significant re-deployment of resources. John Conroy, president of Xcelecom, Inc., a $283 million, Hamden, Conn.-based commercial and industrial contractor employing more than 150, says the company's internal financial reporting guidelines yield the type of information sureties need.

“Since we're part of a public company, we're subject to Sarbanes-Oxley [the law requiring stricter financial reporting], so we've had to beef up our financial reporting staff to meet those requirements,” Conroy says. “So that's made it easier for us to comply with what sureties want these days.”

Still, when it comes to securing a surety bond, public companies are no less scrutinized by producers and underwriters than private companies, which may be less transparent. While pertinent data may be more readily available for public companies, it still comes down to an in-depth analysis by a surety who knows what to look for in a sea of numbers.

Surety underwriting involves the same principles for a publicly held or private contractor,” says William Cheatham, president of Zurich North American Surety, a Baltimore-based national surety. “The Internet provides easy access to public record information for a publicly held firm. But, you can't provide surety credit until you meet with the contractor and understand their business model.”

Raw financial information, of course, is just the tip of the iceberg when it comes to what sureties want to see from contractors before writing a bond for a prospective job. The numbers tell a story — and the story sureties are interested in hearing today is about companies that are financially sound, know their business, and have a history of completing jobs in accordance with contract specifications.

To better understand contractors, some sureties have been developing and refining sets of objective measurement tools that hone in on factors they deem important (such as those listed in the Sidebar above). For example, as the construction bubble was starting to pop and industry losses started to roll in five years ago, Zurich began laying down a set of criteria that could be used to reliably evaluate contractors. Cheatham says the goal was to bolster the underwriting process in an effort to better manage risk.

“In an effort to take the process beyond merely issuing a piece of paper [the bond], we ended up building a method to analyze significant factors affecting the financial capabilities of contractors, and we came up with a list of 25 major areas,” he says. “All of the contractors we work with are scored on these areas so they can be compared on a peer-level basis. It allows us to identify those we think are either high-risk or high-quality. Not every surety does this kind of scoring, but we think this is the direction of the industry.”

Of all the criteria that Zurich considers, Cheatham says the focal point usually ends up being core financial stability. Specifically, Zurich looks at equity and working capital. The more solid those benchmarks, the more likely the company will be able to complete a bondable job — and the better positioned the company will be to handle unforeseen issues that may arise.

“Knowledge is important, but every contractor will encounter situations where they have to deal with a bad job, and they end up having to manage the problem,” Cheatham says. “In the event that happens contractors need excess cash in place to solve problems that arise.”

The ability to manage cash flow and tap working capital to deal with unforeseen issues is vital in a climate where interest rates are on the rise and in which construction contracts have fewer escape hatches for contractors.

“Today, terms and conditions in construction contracts for construction projects are more onerous than ever; everyone wants to pass more risk to the next party,” Cheatham says.

Though financial stability is essential for contractors in the current surety climate, experience and expertise in a contracting arena are equally important. While that may seem like a prerequisite to securing a bond, those qualities may actually be a little more difficult for contractors to prove, especially in today's changing electrical contracting climate.

Michael Cusack, managing director of Aon Construction Services Surety, a Los Angeles-based surety producer, says fewer electrical contractors may pass muster if they're trying to land jobs that are beyond their capabilities — a position more contractors may find themselves in given the increasingly sophisticated nature of the work involved in electrical contracting.

“In some circles in the surety community there's a growing perception that the electrical contracting industry has become so sophisticated that it's surpassed the capabilities of many smaller electrical contracting firms,” Cusack says. “So some firms may receive a higher degree of underwriting scrutiny and be held to higher standards. Sureties are more concerned about electrical contractors remaining current with technology, as well as having more net worth and working capital on the books.”

But even more important from a surety producer's perspective is the ability to fully understand a contractor's business. More than ever, getting to that comfort level requires contractors to appreciate the importance of establishing a relationship with their surety producers in which information and ideas are freely exchanged.

Xcelecom's Conroy says contractors that treat their surety bond producers as members of the company's team of virtual management consultants, along with the likes of accountants, bankers, attorneys, and insurers, can position themselves to reap considerable dividends.

“By establishing good face-to-face relations with both the broker and the surety entity, and filing quarterly or even monthly financial reports with them so they're always up to speed with what's going on in our company, we find that we can build up goodwill,” Conroy says. “Being up-front and establishing a level of candor with them builds trust that we think will make it a lot easier for us to sit down with them and talk frankly about our situation should tougher times arise.”

By focusing on building relationships with competent sureties, rather than looking at them as merely sources of bonds, contractors can tap into valuable knowledge and expertise. Since sureties want to work with strong contractors, they should be motivated to share insights and ideas gleaned from their work with other contractors.

Ed Heine, executive vice president of Payne Financial Group, a Missoula, Mont., construction surety bond producer, and president of the National Association of Surety Bond Producers, says contractors can reap valuable benefits from the right surety producer relationship.

“Hire a good agent that understands the surety process, just like you hire accountants, insurance agents, and bankers who understand the construction business, and you're positioned to develop a good surety relationship that should help enhance the profitability and overall performance of your company,” Heine says. “They can help you be a better businessman.”

Tuned into risk management, of course, sureties can play an important role in helping keep contractors focused and, if necessary, restrained. While a contractor might have laudably lofty goals for expansion, for instance, a level-headed surety charged with making sure the company retains its bonding capacity might counsel caution. In that sense, sureties can play a devil's advocate role when the scent of growth becomes so enticing it threatens stability.

“Sureties are always looking for red flags,” says David Mendes, senior director of communications and education for American Subcontractors Association, Alexandria, Va. “Many contractors, for example, want large backlogs. But that can create financial performance problems. If you get overextended you may have to hire large numbers of people and that can lead to cash flow problems, which affects bondability. Sureties like stability.”

While that's always been the case, it's even more so in today's tighter surety bond market. After taking their eye off the ball during the last construction boom and suffering major losses in some cases, sureties are getting back to the basics in an effort to identify solid, bondable electrical contractors. The surety industry's guiding “three Cs” of contractor evaluation — character, competence, and capacity — are definitely back in vogue.

After all, says Morse Electric's Scott, sureties are the ones left holding the bag if a contractor fails to live up to a contract.

“From their viewpoint, if you default they have to finish the job,” he says. “Ultimately, they have no idea how to construct the job you've taken on, and they don't want to have to know.”

Zind is a freelance writer based in Prairie Village, Kan.

Flagging Risk

When scrutinizing contractors, surety bond producers and underwriters are looking for signs of risk. While the list can be long, here are some key factors they're taking into account when looking at a contractor's business today:

Consistent profitability

While the construction business ebbs and flows, financially stable contractors manage to stay profitable. Sureties view a long history of profitability as evidence that contractors can see their way through most project difficulties or a general business slowdown.

Strong, stable management/ownership

A seasoned management staff, combined with ownership that has significant equity, are confidence builders for risk-averse sureties. As more sureties look for personal ownership indemnification in the event of default, signs of commitment at the top are essential.

Sound business plans

Contractors that can provide a road map of where they're headed and why demonstrate focus and control. A contractor that has a plan and can show that they've stuck to it can help alleviate concerns that they'll make risky forays into untested markets.

Professionally prepared financial statements

Sureties want to be able to accurately assess a contractor's financial condition. The gold standard is an outside, CPA-led audit. Contractors that have a long-term relationship with a financial adviser who knows the contracting and construction industry definitely have a leg up.

Contingency plans

Every company has a breaking point; sureties want to know where that is. A contractor's ability to demonstrate how it would deal with a financial crisis or a soured job, however unlikely, can play into risk assessment. For instance, if more labor is suddenly needed to handle a job, how will the contractor address it?

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