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Surety underwriters evaluate three Cs to assess the overall risk of supporting surety credit: character, capacity and capital.

Character includes the contractor’s reputation in the marketplace, integrity and the general manner by which the contractor conducts its business. Capacity refers to the contractor’s organizational and technical ability to profitably complete its projects. Capital refers to the contractor’s financial capability to complete its projects.

Loss & Obligations

A surety loss generally occurs when contractors fail to meet their contractual responsibility to complete their bonded projects (known in the insurance industry as a performance bond claim) or fail to pay their obligations on bonded projects (known as a payment bond claim). The owner—or “obligee”—of the project and/or vendors and subcontractors providing material and/or services incorporated in the bonded project, (collectively referred to as “claimants”) contact a surety.

The surety must respond to these performance or payment claims and, after careful evaluation, may need to disburse funds to meet obligations in accordance with the bond. The disbursement of funds is known as “surety loss.”

Contractors sign a general indemnity agreement (GIA), which includes a guarantee to hold sureties harmless should a loss incur. This GIA is generally signed by the contractor, their affiliates, the owners and spouses of the contractor, as well as perhaps even third parties. Collectively, this group of people is referred to as “indemnitors.”

When called upon to meet performance bond obligations, sureties generally have three available options.

  1. The surety may take over the project from the obligee and relet the project to another contractor to complete the work. In this instance, sureties receive the project’s proceeds from the owner and pay the replacement contractor to finish the work.
  2. The surety may agree that the work may be completed by a replacement contractor. In this instance, the surety will pay the obligee the difference between the original contractor’s remaining contract balance and the replacement contractor’s price to complete the work.
  3. The surety may provide financing to the incumbent contractor to complete the work.

Of the options, the first two generally result in the surety understanding potential exposure in short order, known as “circling their liability.” This, however, usually involves competitive bids.

Maximizing Recoveries

Contractors today generally have robust backlogs, are facing qualified labor shortages and may be addressing COVID-19 related issues. Because of these challenges, construction bids are extraordinarily excessive compared to similar situations just a few years ago.

Alternatively, financing generally results with sureties not circling their liability, but can result in far less exposure than the first two options.

Therefore, when sureties are called upon to meet performance bond obligations, this is the time for contractors to continue exhibiting the three Cs. These characteristics were likely already examined during the underwriting process. But now the three Cs are especially important, as contractors coordinate with the surety’s claims team, typically including construction, financial and legal disciplines.

The prime objectives of surety claims teams are to minimize loss and maximize recoveries. Remember that surety losses are to be reimbursed under the GIA. What is good for the surety is generally good for contractors and indemnitors.

Who should know the project(s) better than anyone else? Obviously, the incumbent bonded contractor should know best, due to their current experience on the job with the owner, track record of working with suppliers and subcontractors, in addition to intimate knowledge of its own organizational capabilities. Unlike a replacement contractor, the incumbent bonded contractor will not charge a mark-up to the surety on its own completion costs. Contractors should assist the claims team by welcoming them into their businesses, sharing all available records and providing access to systems and personnel. Contractors should be transparent team players, so the claims teams can make informed decisions.

Cost-Effective Finance

In today’s environment, financing can prove to be the most cost effective results, but contractors should know there will be adjustments made to their normal means of operation which should be embraced to achieve the surety’s (and therefore indemnitors’) objective of minimizing loss. 
There will, of course, be agreements addressing financing. Contractors will be asked to direct payments from owners to separate accounts for each bonded project, controlled by the surety.

Then, the surety will deposit its funds into these accounts to make up the shortfall between proceeds received from the owners and costs to complete the projects, pay project related bills and other costs. Disbursements will generally be reviewed and approved by the surety. Overhead and other expenses not directly related to the bonded projects will be evaluated by the surety and reviewed with contractors. Measures will be implemented to retain personnel or potentially acquire additional personnel. Agreements may need to be reached with the contractor’s bank. Sureties will require detailed financial, operational and job reports on a regular basis. Sureties will also hold periodic meetings, similar to a Board of Directors meeting. Sources of capital covered by the GIA will be identified and, perhaps, liquidated to assist with financing the completion of the projects.

The ultimate goal of providing financial assistance is to minimize surety loss and therefore indemnity obligations. By demonstrating strong character, capacity and capital, maintaining transparency and cooperating with the surety’s claims unit, that goal can often be achieved. Remember the three Cs!

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