Surety companies prequalify contractors to guarantee the company has the capital, capacity and character to complete the project. The surety will use its money, up to the amount of the bond, to make the owner of the construction project whole if the contractor does not perform or does not pay its suppliers or subcontractors. To offer that guarantee and stand behind the contractor, a good surety underwriter will understand the complexities of construction accounting and use a thorough underwriting process.

Construction is one of the riskiest of all industries, with a reported one in four failure rate. A surety bond is a three-party risk transfer agreement that shifts the burden of construction risk from the project owner to the surety company. The surety bond assures the owner that a prequalified contractor will perform a specific contract.

The three primary types of construction surety bonds are bid bonds, performance bonds and payment bonds. A bid bond assures the owner that the bid was submitted in good faith and that the contractor submitting the bid has been properly vetted by an independent party and is qualified to successfully complete the project. The performance bond provides the owner with protection from financial loss in the event of a contractor default. The payment bond assures the owner that, at completion, the project will be free of liens by guaranteeing the contractor will pay covered subcontractors and suppliers throughout the project. 

Surety Bonds Vs. Traditional Insurance Policies
Project owners and contractors sometimes confuse a surety bond with a traditional insurance policy. While they both are provided by insurance companies and are licensed and regulated by state insurance departments, surety is a unique form of insurance in which the surety company’s financial resources back the contractor’s commitment to enter into a contract with an owner. While traditional insurance and surety premiums are actuarially based and take losses into consideration, traditional insurance works by pooling risk. Surety bonds shift the risk from the project owner to the surety, and the premium for a surety bond also serves as a fee for prequalification services.

Unlike other types of insurance policies in which losses are expected, surety bonds are designed to prevent losses, even though significant losses do occur. Surety companies accept a tremendous amount of construction risk and receive a small amount of bond premium in return (usually 0.5 percent to 3 percent of the contract price). This model demands that a surety bond underwriter use a thorough analysis process to prequalify a contractor’s financial strength and work experience.  

The Underwriting Process
To prequalify a contractor, an underwriter must use current and historical data to forecast future results. An underwriter will look at a contractor’s historical financial success, balance sheet composition, length of time in business, prior work experience, management team and character references. An underwriter will want to review the contractor’s personal and business financial statements, as well as obtain references from the contractor’s banker, suppliers and previously completed project partners. 

An underwriter typically focuses on working capital and net worth to determine if the contractor can manage short-term assets and cash flow in a way that satisfies its future debt while also building a net worth reserve in case of future problems. If a contractor manages working capital successfully, net worth will increase over time, allowing the contractor to grow operations and generate future profits. 

Personal indemnity also plays a significant role in the underwriting process, as it can offer additional reserves during difficult times. The personal financial statement of the construction company’s owner may provide further proof of past financial successes, as well as insight into the owner’s risk tolerance. 

Reviewing credit reports and speaking with a contractor’s banker, materials suppliers and the owners of previously completed projects will highlight the contractor’s character and help the underwriter determine a contractor’s borrowing power and past work experience. With the surety company absorbing such a high level of construction risk, it’s extremely important for the contractor to show its underwriter that the contractor will stand behind its work and correct any issues that arise. 

Being thorough is essential to underwriting. It would be a disservice to the contractor and the project’s subcontractors, suppliers and owners if an underwriter were less than thorough. When the contractor supplies a project owner with a surety bond, it is not a meaningless piece of paper. A surety bond from a reputable company means the contractor is a good risk and the project owner’s money is protected. Contractors that utilize professional surety agents and surety underwriters as trusted consultants will stand out from the rest as successful, profitable and trustworthy. 


Keenan Lehmann is assistant vice president of contract underwriting for Merchants Bonding Company, Austin, Texas. For more information, email klehmann@merchantsbonding.com or visit www.merchantsbonding.com.