Risky Business

Risky Business

In an uncertain economic climate, surety providers require more and better bonding capacity from electrical subcontractors

In the face of steady declines in the annual value of total put-in-place construction, the surety industry's aggregate direct-loss ratio fell to record lows from 2006 to 2008, according to the Surety & Fidelity Association of America (S&FAA), Washington, D.C. Propped up by contractor backlogs extending 11 months, the industry's aggregate direct-loss ratio reached a record low of 12.7% in 2008. Furthermore, although preliminary data for 2009 reveals direct losses nearly double those of the previous year, at an aggregate 19.3% they remained well below the 30% loss ratio considered the “break-even” point (click here to see Fig. 1). “Relatively speaking, the surety market continues to do reasonably well in terms of total premium written,” says Tim Sznewajs, principal, Investment Banking, FMI, Raleigh, N.C., and co-author of the recently released report, “Surety Firms Weigh in on Construction Markets and Contractors: FMI Surety Providers Survey.”

Yet, despite the performance of the last few years, many surety industry representatives are bracing themselves to handle increased defaults throughout this year and into 2011. “The surety industry is anticipating that financially its clients will be showing less profit to losses and are expecting claims,” says J. Spencer Miller, president of the National Association of Surety Bond Producers (NASBP), Washington, D.C., and president of Schwartz Brothers Insurance Agency, Inc., Chicago. “It just doesn't know where or to what extent yet.”

Tipping point

A surety bond secures 100% of the subcontract amount. Surety providers protect projects from default by providing bonds to subcontractors that pass a rigorous prequalification screening process and maintain the capacity to perform the work to be bonded. Currently, that capacity is being compromised by several circumstances created by project delays and cancelations, which, through budget shortfalls and stricter standards for credit, are estimated to be occurring at four to five times the normal rate.

Contractors are reporting backlogs diminished by as many as four months to FMI's Nonresidential Construction Index (NRCI) for the first quarter of 2010. In addition, rising material costs and depressed output prices continue to contribute to lower profit margins, adding to the likelihood of default for some contracting firms. “Increased competition in the marketplace and the lower margins at which work is being performed put financial stresses on the subcontracting firms, which ultimately lead to additional challenges in terms of getting work completed, based on cash flow and failures of businesses,” says Sznewajs. “What that ultimately means is that a lot more people are going to make a lot less money, thereby increasing the likelihood that some of them go out of business.”

The results from the FMI survey of surety providers echo this sentiment. Only 25% of respondents believe their clients — the contractors — are “well-positioned” to succeed in the marketplace over the next three to five years. Overall, respondents felt that contractors didn't act quickly enough to adapt their firms to the new economic climate. Three common items were cited by respondents as their main concern about contracting firms: lowering overhead to make up for loss of revenue, staying within their areas of expertise, and taking on too much risk by bidding too low. “Hopefully, for the sake of their own survival, firms have already made significant cuts to their employee base to manage overhead,” says Sznewajs. “If you've got those overhead issues hanging around, then you're going to have challenges in terms of turning a profit and ultimately being able to survive into the recovery.”

Justifiably, the circumstances that jeopardize a subcontractor's profits, and thereby possibly reduce its bonding coverage, prompt owners to require more surety bonding capacity. Therefore, even under circumstances in which there are fewer projects to bid, more will require surety bonding — even in the private sector. “From the owners' standpoint, they want to take advantage of the reduced cost to build their projects,” says Sznewajs. “But they know those lower prices will also put additional financial stress on contractors, so they're willing to pay that extra premium to have a surety bond involved in the project.”

Stricter lending standards may also require owners to seek surety bonding. “Across the entire industry, there is a greater willingness to require a surety bond because of the uncertainty in the broader economy and a perception that contractors perhaps are not as financially sound as they were a couple of years ago,” says Sznewajs. “So lenders and owners are willing to pay that extra premium to have a surety bond involved in the project to give them the assurance their project will be completed.”

As a result, surety providers have begun re-examining their clients' bonding capacities. More than half of the survey's respondents expect their clients to have a more difficult time obtaining bonding one year from now (Fig. 2) — and to still have difficulty obtaining bonding two years from now (Fig. 3). According to the survey respondents, merely surviving the downturn will not be sufficient to maintain bonding capacity. Firms must keep up with important management responsibilities, such as management succession and leadership development, along with providing up-to-date financial statements, backlog data, and bank letters regarding credit. “What this can mean for construction firms is that those that already have bond capabilities will be seeking to expand them, and contractors that have never had to provide bonds before are now being asked to do so,” says Miller. “But at the same time, they may be having less than desirable results.”

Although many surety providers claim to offer fast, online surety bonding capacity, this isn't something a subcontractor needing bonding for the first time should rush. The bonding process lasts for as long as the surety firm is providing bonds to the subcontractor. Therefore, subcontractors and surety providers often try to foster long-lasting relationships. This is advantageous to the subcontractor in that the firm will have to go through the prequalification process only once and limits access to proprietary financial information and business plans by outside companies. In addition, a surety familiar with a subcontractor's business will be able to guide the firm toward successful projects and away from ones likely to stretch its resources too far.

“Companies that presently have bonds need to stay in constant communication with their agent,” says Miller. “If you need a bond for the first time, find a professional surety agent to assist you in guiding you through that process.”

Miller recommends contacting NASBP at (202) 686-3700 or www.nasbp.org to locate professional surety agents. The NASBP website includes a “Find A Producer” feature that lists experienced surety agents. Under the current economic conditions, which are expected to continue until 2011 or 2012, firms in need of bonding should start researching surety firms now. “That contact should come sooner rather than later,” Miller says. “You don't want to ask for a bond tomorrow when you've never had one.”

Public access

In the United States, contract surety bonds are required on all federal construction projects through the Miller Act, which requires a contractor on a federal project to post two bonds: a performance bond and a labor and material payment bond. The Miller Act payment bond covers subcontractors and suppliers of material that have direct contracts with the prime contractor. These are called first-tier claimants.

Subcontractors and material suppliers who have contracts with a subcontractor, but not those who have contracts with a supplier, are also covered and are called second-tier claimants. Anyone further down the contract chain is considered too remote and cannot assert a claim against a Miller Act payment bond posted by the contractor. A corporate surety company issuing these bonds must be listed as a qualified surety by the U.S. Department of the Treasury. The list is available at www.fms.treas.gov/c570/c570.html. Many U.S. states have adopted the Miller Act, which when used at their level are called “Little Miller Acts.”

Under current circumstances, these laws create additional bonding challenges for subcontractors seeking to bid and win government contracts. While privately funded construction projects have largely been put on hold or canceled, construction put-in-place for public projects has been steadily climbing (Fig. 4 on page C14). “To date, those markets have held up and been stronger than the private markets, where surety bonding is not as prevalent,” says Sznewajs.

There has definitely been an increase in the number of bidders on government projects, says John Jordan, CCIFP, CFO at Reston, Va.-based engineering and construction company Truland Systems Corp., which has more than 60 years of experience in government building. “There are many contractors that are desperately looking for work and are bidding on jobs that they normally would not,” he says. “There's a perception that government work is purely a low-bid situation, and that's not really the case. There are barriers to entry. There are experience and surety requirements that not every contractor can meet.”

To maintain its surety capacity, Truland meets with its bond provider at least quarterly. Meetings are more frequent when the company is preparing to bid on a large project. “They are needed by us in order for us to do our business, but we value their input,” says Jordan. “We want their critical opinion of what we're doing, and we take that to heart. If there's something we can do better based on their feedback, we certainly attempt to do it. We look to them as a partner.”

The American Recovery and Reinvestment Act (ARRA) of 2009 includes $81 billion for electrical infrastructure projects, such as power and lighting work on highway, rail, and bridge construction and renovation. ARRA also provides aother $50 billion for renewable and energy-efficiency projects, including photovoltaic (PV), solar thermal, and wind energy installations. Of the $11 billion allocated to bring the nation's power grid up-to-date, it is estimated that $7 billion could go to contracts for electrical construction. Additionally, estimates claim 20% of the $7 billion to be used for renovation and repairs to federal buildings throughout the country would involve contracts for electrical work.

The key to participating in these projects has been speed. Thus, any firm already able to be bonded would be considered over ones just starting the process. Also, there are complications involved in government projects that an uninitiated firm may not be aware. “There are a lot of requirements that go along with working for the government that aren't in place for private owners,” says Sznewajs. “There are legal and financial disclosures and other bureaucratic steps you have to take in order to meet the criteria to do public work. And if you've never done that before, it can be costly to implement and problematic to put in place, especially if you're working in an environment where you're trying to cut costs or manage overhead on lower margins. To have to incur those costs to go into those markets is not something a firm should be taking lightly.”

Joint security

Government contracts are getting bigger. Work that was once performed under as many as a dozen contracts might now be performed under one large one. In some cases, this may disqualify smaller firms. “If a 10-person electrical contractor wants to work on a government contract, bond companies have to ask how it's going to do it,” says Miller. “Somebody has to put together all the compliance paperwork. Do you hire somebody to do it before you have the work? Do you get work not knowing what you're getting into? That's the dilemma.”

To help answer these questions, the U.S. Small Business Administration (SBA) Surety Bond Guarantee (SBG) program and others try to guide small firms through the process (Program Helps Small and Disadvantaged Businesses Become Bond-Ready). To contact the SBA Office of Surety Bond Guarantees, go to www.sba.gov/OSG or call (202) 205-6540.

However, an easier entry to government work can come from teaming. A prime contractor/subcontractor relationship or joint venture can be beneficial to both the large business and the small business. The smaller company receives access to the experience of the large business in performing a government contract and the large business' assistance in bonding the project. At the same time, the large company is able to develop a capable partner that it can use for future business ventures. Also, through these arrangements, the firms may be able to mesh their complementary services. Truland often partners with small or disadvantaged business firms and suppliers looking to break into the public arena. “We have provided bonds for both general contractors and electrical contractors on projects,” says Jordan, who explains that recently the company was working on a fire alarm project in which it provided surety bonding for the general contractor. The general contractor, a start-up, minority-owned business, wasn't able to provide the bond for the total job, so Truland provided the bond for the total project, including the general contractor's portion, which was only about 10% of the value. Truland's work amounted to about 90% of the project value, and it worked with its bonding agent to provide 100% of the bond for the total job. “That way, the small business was able to take the project,” says Jordan. “It doesn't happen like that on every job, but it's not uncommon.”

The surety industry is very supportive of teaming and joint ventures, says Sznewajs. “As long as the risk allocation is clear and there's an understanding as to what balance sheet ultimately is guaranteeing the surety credit that the surety firms are putting forward,” he says. “Of course, they offer an additional opportunity to place surety bonds in a declining market.”

Truland also performs projects as a design/builder, employing several engineers and maintaining a business unit dedicated to this delivery model. The most recent of these were two projects at Fort Lee, Va., installing the electrical system for a masters-level college classroom for the Army Logistics University and for a training location for artillery maintenance at Fort Lee Central Campus. “Truland has done design build throughout our history, so when we began our relationship with our surety 17 years ago, that was part of our profile,” says Jordan. “As design build caught on in the federal marketplace and the size of the design build projects grew, there was a bit more exposure for our surety. But because of our relationship with them and our business reason for it, plus the proper staff, they were comfortable with our pursuit of large federal design-build projects.”

In the current economic climate, alternate project delivery methods, such as design-build and integrated project delivery (IPD), are becoming popular on public projects to save time and money, but they are proving problematic to the surety industry. Without any legal precedent, the industry doesn't know how to provide insurance products. Instead, the methods rely on an integrated form of agreement (IFOA) adopted by the Lean Construction Institute. “Non-traditional delivery methods pose unique challenges to owners, designers, and contractors in terms of how risk is allocated amongst those parties,” says Sznewajs. “The surety industry has done a good job of supporting alternative delivery methods to date, but I don't think necessarily everything has been figured out in this usage of surety.”

Although the preplanning and coordination that comes with IPD is advantageous for all involved, it will not do away with the need for bonding, says Jordan. “Having that total project completely coordinated makes for a much smoother project,” he says. “But I don't think surety bonding will ever be eliminated. ”

Sidebar: Program Helps Small and Disadvantaged Businesses Become Bond-Ready

The U.S. Department of Transportation (DOT) Office of Small and Disadvantaged Business Utilization (OSDBU) recently signed a Memorandum of Agreement with the Surety & Fidelity Association of America (SFAA), Washington, D.C., to assist with the development and implementation of its Bonding Education Program (BEP). The program, based on SFAA's Model Contractor Development Program (MCDP), will apply the MCDP approach in a pilot effort, using the DOT network of Small Business Transportation Resource Centers (SBTRCs) to provide education, placement, and technical assistance to help small and disadvantaged businesses become bond-ready and meet requirements to bid on and win transportation-related construction and services contracts.

“We think this program will go a long way to provide the type of targeted assistance that small businesses competing in the transportation industry need right now,” says Brandon Neal, DOT/OSDBU director. “It will really help level the playing field for smaller companies eager to compete.”

The BEP features a series of educational workshops in which participants learn how surety bonding relates to all aspects of their business operations and specific approaches and techniques that result in a successful bond application. Training focuses on business planning, banking and finance, construction accounting and financial management, bonding and insurance, claims and dispute resolution, marketing, estimating and bidding, and project management and field operations. The program also employs a bond-readiness component, consisting of one-on-one interactions with surety bond producers, underwriters, and other professionals who work with participants to help assemble the materials and information necessary for a complete bond application. These professionals also work with participants to address any omissions or deficiencies that might deter the successful underwriting of a bond.

“We are excited to launch this bonding initiative in partnership with the DOT,” says Lynn M. Schubert, SFAA president. “This program is another reflection of the surety industry's commitment to helping small and minority- and woman-owned businesses obtain surety bonds or increase their bonding capacity.”

Three pilot initiatives have been launched in select cities, to be followed by a fully vetted nationwide program in the fall.

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