Recent widespread volatility in the financial markets has caused business professionals and consumers across the globe to question basic approaches to risk as their 401(k) and retirement savings dwindle. Oil price fluctuations, the stock market slide, problems in the residential housing sector and commodity price increases have combined to present unique challenges to the surety marketplace. In response, leaders of the surety industry highlight the importance of disciplined surety underwriting as a way to help the construction industry continue to move forward.
The key questions are: What does disciplined underwriting mean in today’s environment, and what are the implications for project owners, construction firms and surety companies?
Discipline
In the surety world, underwriting is the process in which a surety selects customers that qualify for surety bonds. Disciplined underwriting, then, is the process in which a surety offers surety bonds only to customers that meet a prescribed set of underwriting guidelines.
The surety market has three significant parties: the owner, the contractor and the surety. The owner’s main interest is to have a project built by a capable contractor that will comply with the terms of the contract and complete the project on time and on budget. The contractor wants to make a profit by completing the project for the owner and the surety. The surety wants to make a profit for its shareholders by providing surety credit only to contractors it believes will complete the project successfully, thereby preventing underwriting losses.
Risk of Failure
The problem in this scenario is the significant amount of risk involved. Construction is one of the highest risk businesses in the United States. According to BizMiner, of the 850,029 building (non-single-family), heavy/highway, industrial buildings/warehouses, hotel/motel and multifamily home construction and specialty trade contractors operating in 2004, only 649,602 were still in business in 2006—a 23.6 percent failure rate.
Why is there such a high failure rate of construction firms? The Surety & Fidelity Association of America (SFAA) cites five major factors:
- unrealistic growth;
- performance issues;
- character/personal issues;
- accounting issues; and
- management issues.
Some infer that many contractors fail because a preponderance of firms are small and not financially sophisticated. However, FMI Corp. found in its February 2007 study "Causes Behind the Causes of Why Large Contractors Fail," that large contractors fail due to five root causes:
- excessive ego;
- poor strategic leadership;
- too much change;
- loss of discipline; and
- inadequate capitalization.
Left to their own devices and market forces, construction firms will fail at an unacceptable rate because of the amount of inherent risk. This is where disciplined surety underwriting comes into play. Disciplined underwriting analyzes a construction firm and reviews factors such as financial capability, track record, experience, character and business plans. After a thorough review, a disciplined surety underwriting approach will support viable contractors to perform work for owners with reasonable contract terms, preventing losses and failure.
Over/Under-billings
One example of the specific underwriting qualification process in contract surety is the analysis of over-billings and under-billings. The percentage-of-completion basis of accounting is the most preferred and accurate basis for accounting for long-term construction contracts. Under this basis, the income effect is recognized during the construction process. This method typically relies on a contractor’s profit estimates to determine the revenue impact each period.
The key components in the uncompleted-work-on-hand schedule include:
- contract price;
- billings to date;
- costs to date; and
- estimated costs to complete.
Of these components or entries made for each job in progress as of the reporting date, the first three are quantifiable, and the fourth is an estimate. The estimated costs to complete for each job are derived from information provided by the contractor and investigated or considered by the CPA for reasonableness. Thus, a surety should have a sense of how much capital is from jobs that are not yet complete (and subject to projected profitability that may decline over time).
From the analysis of this data on each job, those involved in financial statement preparation will derive:
- costs and estimated earnings in excess of billings, or under-billings (i.e., current assets);
- billings in excess of costs and estimate earnings, or over-billings (i.e., current liabilities); and
- gross profits earned.
Contractors with over-billings generally are considered to be in better financial condition because the project owner is financing the job when the contractor’s costs are less than what the owner has remitted. In this scenario, a disciplined surety underwriter breaks out the over-billings into "profit borrow" and "pure job borrow." The profit borrow is compared to historical profit margins, and the pure job borrow is examined against cash balances because the pure job borrow will be needed to cover future job costs.
Conversely, sureties generally are wary of significant under-billings because these could indicate excessive job costs that may be unbillable, lower than expected profitability or perhaps an unprofitable job. Prudent analysis of over-billings and under-billings helps sureties understand a contractor’s business strategy and its ability to maintain a profitable construction firm.
Benefits
The purpose of surety is to prequalify contractors so only truly qualified contractors receive surety credit to bid and perform a project. Many benefit from a thorough surety prequalification process, including project owners that can utilize qualified, capable contractors for their work. Suppliers and subcontractors benefit because they know that when they deal with bonded contractors, they will be paid for their services.
Additionally, well-qualified contractors know they will compete only with other well-qualified contractors. The surety underwriting process levels the playing field and does not support financially unqualified contractors, ensuring successful construction project completion for all parties, even during a financial crisis.