Variable market conditions have prompted many adjustments and changes in the surety industry. This article provides an update for all lenders and bankers on the current situation, as well as the trends within this group of financial institutions that issue bonds to the construction industry. Contract documents stipulate that surety bonds are used to guarantee project owners that the contractors will perform the work and pay the subcontractors, laborers and suppliers. There are three basic types of contract surety bond:
- The bid bond guarantees that the bid was made in good faith. It also ensures that the contractor is able to get the contract at the quoted price.
- Performance bond protects the owner against financial loss if the contractor does not follow the contract’s terms and conditions.
- The payment bond guarantees that all subcontractors, laborers and suppliers will be paid by the contractor.
Private construction projects are not eligible for surety bonds. The owner must decide if they want to use them. Letters of credit and self-insurance are alternatives to bonding. However, these options do not guarantee 100% performance or payment protection nor guarantee a competent contractor. If a project is to be bonded, it should be specified by the owner in the contract documents. To help the prime contractor manage risk, subcontractors might be required to obtain surety bonds. This is especially true if they are responsible for a crucial part of the job or have a very difficult specialty to restore.
Assureties must always be certain. Although most surety companies are subsidiaries of insurance companies or divisions thereof, both traditional insurance policies and surety bonds can create risk-transfer mechanisms that are synchronized with state insurance departments. Both performance and payment bonds are typically priced according to the amount of the bond being bonded. The premium will be adjusted to reflect any changes in the contract amount. The contract industry’s survival instinct is still vital. Contractors are now more productive, and failures are less common because of the strong economy. The profitable bonding industry attracted new entrants to surety and there was a lot of excess capacity in the surety marketplace. Bond premiums fell as bonding became more competitive.
Premiums The rate of increase in surety bond premiums may have stalled or not depending on a number of factors. Surety companies have increased their pricing to cover increased losses, increased costs for reinsurance and personnel as well as other business expenses. After a short period of adjustment, surety bonds premiums have become more reasonable for the value they provide.
The Risks Both the surety industry and the banker industry have underwritten risk to contractors. Both have made good-time profits during the expansion phase of the cycle, but also suffered losses during the contraction phase. Bankers should focus all their attention on the surety sector due to its ability and willingness to replace risk that has a complementing collision with financial institutions. The lender should consider the risk of the bonding company taking on less construction risk. Both the surety as the banker must assess and monitor their respective risk appetites in the construction industry.
Claims Sureties face a variety of claims, based on the severity of losses during the recovery phase. However, there has been an increase in severity and frequency of claims which is dependent largely upon regional conditions. It is expected that by 2005, all losses will have been eliminated from the system. Bond exposures will only be for projects that are underwritten according to today’s stricter standards. Therefore, loss ratios will improve over the past days.