Risk

Positioning Your Firm for Maximum Surety Credit

Whether a small, medium or large contractor, there are important factors to keep in mind that will increase a company’s chances of keeping and growing its surety credit.
By Andrew Dickson
April 13, 2021
Topics
Risk

We have lived through an unprecedented year—one that has dramatically changed personal and professional lives. The surety industry is no exception. Employees are now working remotely, and more scrutiny of surety underwriting is required from the reinsurance community. This flows down to the insurance companies and ultimately to agents and contractors.

Whether a small, medium or large contractor, there are important factors to keep in mind that will increase a company’s chances of keeping and growing its surety credit. More than ever, professional surety companies are employing underwriting fundamentals. These include detailed analyses of the “three Cs”: capacity, capital and character.

CAPACITY

Capacity boils down to a firm’s potential ability to complete the job on which it is bidding. The surety company will review prior experience with similarly-sized jobs. Many surety losses have come from so-called “stretching” on a job, which makes sureties hesitant to underwrite a project much larger than anything a contractor has done previously. For example, if a firm’s largest prior job was $5 million—and it is now bidding on a $25 million project—it will set off a multitude of surety alarm bells.

Instead, contractors should slowly increase size and graduate to larger jobs. Surety underwriters have all heard the story that the job is just “more of the same work.” However, one needs to always take a step back and understand what is involved. If the job seems abnormally large on paper, it will likely be too large in practice. Larger subcontractors should also be bonded.

Another large risk factor is entering a new geographical area or construction industry. For example, contractors that bid on a job in a state in which they have no experience are typically labeled as risky. Each state has its own rules, regulations, labor force and other idiosyncrasies. Every job must be thoroughly researched, and contractors should be prepared to explain to the agent and surety team why it would be successful. A contractor suddenly looking to jump industries, such as a heavy/highway contractor considering a power plant build, would be another example.

These types of changes or “new” items are red flags to a surety company, so as a best practice, construction firms should stick to their core business.
In the past, owners have severely harmed well-run, stable construction businesses with irresponsible ventures into commercial real estate development or another non-core area.

CAPITAL

When it comes to capital, surety companies want to know that there is a sufficient financial cushion in the balance sheet to weather any unforeseen circumstances. Cash is very important and can help tremendously when waiting for payments on jobs. It is also important to have a bank line of credit available to help with liquidity, if needed.

During 2020, many construction firms received PPP money that helped liquidity—as long as it was used for the correct purpose. The surety will review the amount that a contractor has outstanding on the line, coupled with the amount of interest-bearing debt on the balance sheet—less is better. Today’s interest rates are at historic lows, and it is wise to stress test debt obligations utilizing higher rates to understand the additional future cash flow needs.

Further, surety companies look at distributions and how much money is withdrawn from the construction company each year. Excessive distributions are detrimental, reducing the equity balance and limiting surety capacity. It is recommended that construction partners enlist a construction-specific CPA.

CHARACTER

With respect to character, surety underwriters value honesty and integrity. They will review how a company is run and how its leaders have handled setbacks in the past. There will always be problems or issues to manage, but how a firm has responded to such problems is indicative of its ability to handle projects successfully.

Also, communication is vital in the relationship with an agent and surety company. Being honest about job performance and updating the surety regularly will help the contractor and its agent build trust and credibility, which will pay dividends in the event there is an issue in the future.

As it relates to small- and medium-sized contractors, sureties traditionally secure personal indemnity from the owners of the construction firm. This is a very positive sign of commitment to the surety company, and is highly valued by underwriters. In the past, an owner’s refusal to provide personal guarantees was a red flag, making the surety underwriter ask, “If you don’t want to back up your own company why should we?”

THE FOURTH “C”: CONTINUITY

Though not one of the “three Cs,” this article would be incomplete without emphasizing another “C”: continuity. It seems that continuity analysis within the surety underwriting process has decreased in the past few years. Contractors with more than 20 years of experience have failed because the owner was either unable to work or, sadly, passed away, and no one was available to continue their success. This is an avoidable tragedy.

Sureties must counsel their clients on continuity planning. This is especially relevant given the ongoing nature of the COVID-19 pandemic. It is of utmost importance for construction firms to create a continuity plan with the help of an agent, surety company, CPA, banker or attorney. Options include buy-sell agreements, keyman life insurance, work completion agreements with key employees tied to a payout or bonus, or a combination.

Sticking with strengths, keeping the company capitalized with ample liquidity and communicating frequently with an agent and surety company are key factors to ensure maximum surety credit. Professional surety companies will give more credit to well-run and liquidity-rich companies, in addition to differentiating between the good and bad characters.

Character really is the key element—always take the high road and do the right thing. Your bottom line will thank you.

by Andrew Dickson

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