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Contractor prequalification is not a project owner’s primary function. While the owner is responsible for orchestrating the bid and payment process, it should delegate the prequalification process to licensed reputable sureties as part of its overall risk avoidance practices.

No matter how large a contractor is or how long it has been in business, the possibility of failure persists. Each phase of a project requires several independent parties working together to ensure success.

Three basic factors lead to subcontractor failure.
  1. Poor management, such as inadequate accounting, financial and project management systems; changes in ownership, management, personnel or business strategy; rapid over-expansion in volume or into new geographies; or poor owner or project selection.
  2. Labor and materials shortages or unrecoverable cost escalations.
  3. Uncontrollable factors, such as weather problems; economic downturns; changes in jobsite conditions; the death, illness or departure of a key employee; or another project owner failing to pay.
Most project owners that engage in prequalification practices typically check credit reports such as Dunn & Bradstreet, talk to familiar subcontractors or suppliers for references, and then apply the results of an in-house, financially derived, ratio formula to reach a “prequalified work program” number. This prequalification process is rudimentary compared with the in-depth process used by sureties:
  • Thorough analysis of the company’s financial condition. This includes through examination of financial documentation and work-in-process. Depending on the surety program request, the results of the financial analysis can readily determine whether the contractor has the appropriate financial horsepower to undertake the proposed project, particularly if project difficulties appear.
  • Thorough analysis of the contractor’s prior work history and work-in-progress. This includes reference checking with subcontractors, suppliers and project owners. The surety will investigate the nature of the project under consideration and the applicable contract terms to ensure the contractor has the appropriate experience to complete the project on time and within budget. 
  • Evaluation of the contractor’s organization and management structure. The surety will examine the firm’s employment history, track record, educational background, objectives and attitude toward risk, as well as character and reputation of key employees. Management continuity is reviewed in the event key employees pass away or become incapacitated to ensure the business will continue and, most importantly, complete all remaining work on hand.
  • Review of the firm’s management and control systems. Can the contractor determine the status of its contracts and translate this information into a financial display? Is its internal cost system being used and, if so, how, by whom and with what frequency? Can the firm’s management team identify problems early and take steps to resolve those problems without delaying the project or exceeding the original budget?
  • Examination of the contracting firm’s history of bidding jobs that reflect its skill set at the right price. Does the firm properly control activities on the jobsite, such as labor productivity, material costs, equipment utilization and job component scheduling? 
As illustrated, surety prequalification is a rigorous, specialized process by which the surety assesses the contractor and supports its judgment by issuing performance and payment bonds. Performance bonds assure the contractor is qualified to perform the work and protect the project owner from financial risk should the contractor default. Payment bonds assure that specified laborers and suppliers associated with the project will be paid.

While the primary benefit of the surety’s prequalification is transferring contractor default risk to the surety company, it should be noted that surety bonds are not traditional insurance products. Unlike alternatives to surety products, surety bonds provide the project owner with complete transfer of project default, not simply a cash payment that leaves issues of contractor replacement and supplier payment in the hands of the project owner. In general terms, a surety will not extend itself based on the perception of a contracting firm’s potential, but rather it will extend credit based on the contracting firm’s past accomplishments.

Beyond having surety professionals involved with the overall process of successful contract completion, other benefits to prequalified and bonded contractors include:
  • increased assurance of having contractors complete their contracts on time and within budget;
  • a shield from paying twice for the same work items if the contractor fails to pay subcontractors and suppliers; and
  • increased likelihood that a financially troubled contractor will complete its bonded jobs because business and personal assets are on the line via corporate and personal indemnity requirements from surety companies.
Because there are so many surety companies in the marketplace, project owners should investigate the quality of a contractor’s surety as part of its risk assessment process. Several sources rate insurance companies, including A.M. Best, Standard & Poor’s, Moody’s, Fitch Ratings and Weiss Ratings. An additional resource is the U.S. Department of Treasury’s T-List. Surety agents also can be an excellent source on how to mitigate contractor risk.

With so many resources available to project owners—and with the primary emphasis on contractor prequalification through a reputable surety—contractor default mitigation becomes a manageable process, which greatly enhances the chance of successful project completion. 

Bob Staples is senior vice president of surety for Allied World North America. For more information, email robert.staples@awac.com.

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