Insuring Peace of Mind
Surety bonds: Sleep-at-night coverage for when the job must get done
By Tracy Barbour

urety bonds are an essential but often misunderstood insurance product used by companies that serve both the public and private sectors. Surety bonds are a distinct type of insurance designed to ensure a project is completed based on the terms of the contract. More specifically, a surety bond is a three-party agreement in which a surety (bonding company) promises to pay an obligee (the project owner or whoever is requiring the bond) if a principal (the contractor or whoever needs the bond) does not satisfy their contractual obligation.

Essentially, bonding companies vouch for principals, promising to fulfill their commitment if they go out of business, declare bankruptcy, or fail to deliver for any other reason. “When you do a bond, you’re putting up a certain amount of your assets to say you’re going to be able to finish the job,” says Dave Adams, partner and senior account executive at RISQ Consulting. “If you’re not able to do it, the bonding company will come in and take over.”

So, for example, if a contractor has bonded a construction project in Midtown Anchorage and can only complete half the job, the bonding company will step in and finalize the project. Then the company will go after the contractor and liquidate enough of their assets to finish the job.

Of course, the hope is that this type of scenario will not ensue because bonding companies prefer not to take over jobs. “The underwriters at the bonding company underwrite the client’s financial status, so they have a pretty good understanding of the principal’s financial position,” Adams explains. “And if they do not meet the requirements, they will not bond them.”

Dave Adams
RISQ Consulting
Similarly, Guy Armfield, principal at Parker, Smith & Feek, says bonding companies do not expect to have a loss—unlike with regular insurance. He likens a surety bond to “sleep-at-night coverage” that provides a financial hedge for the project owner. “If I am the owner of a project and I absolutely must know that the project will be finished, I will require a surety bond,” he explains.

But if a principal fails to satisfy a contract, then the surety company is forced to take action—and the remedy is more costly. The surety will have to spend 30 to 50 percent more to complete the project. “Nobody wins when there’s a surety claim,” Armfield says.

The Role of Surety Bonds
There are two basic types of surety bonds: contract and commercial. Contract bonds—commonly referred to as construction bonds—include bid, performance, and payment bonds. A contract bid bond ensures a contractor will adhere to the agreed-upon price. A performance bond guarantees that the contractor is qualified to perform the contract. And a payment bond promises the contractor will pay any subcontractors, laborers, and suppliers that work on the project.

Commercial bonds, which are often used to support certain laws, include license and permit, fidelity, fiduciary, public official, and court bonds. These types of bonds are typically obtained by companies and individuals who require bonding due to legal issues, government regulations or requirements that may take the place of insurance, or letters of credit.

Surety bonds play a unique role in business activities, Armfield says. Performance and payment bonds are project-specific and are generally required on construction projects where the owner of the project is using public funds to pay for the work. License and permit bonds relate to compliance with Alaska state or municipal statutes and are required by many types of businesses other than just construction contractors.

“Both of these types of bonds are intended to protect the interests of the general public by creating a financial incentive for businesses to comply with the laws governing their activities and/or perform the obligations of their contracts,” says Armfield, who specializes in surety bonds for general and specialty contractors and Alaska Native corporations.

Who Typically Requires a Bond
The construction industry is one of the largest users of surety bonds, according to Armfield. And there are a few reasons why: Due to the Miller Act, all federally funded construction projects require the prime contractor to provide performance and payment bonds equal to 100 percent of their contract price. State-enacted “Little Miller Acts” call for similar requirements on all state-funded construction work. Additionally, the practice of prime contractors requiring subcontractors to provide bonds is commonplace in construction.

“Construction certainly makes up the lion’s share of all surety bond company premiums, with the number ranging from 60 to 70 percent, depending upon the year,” Armfield says. “And the percentage is probably higher in Alaska.”

He adds, “Outside of construction, most bonds are connected to any manner of business that may need permits, licenses, appeals of court decisions, and financial guarantees of private contracts such as leases.”

Armfield says 99 percent of the companies that write surety bonds use a network of independent brokers to interface with the customer. Alaska has a bevy of surety brokers who are adept at helping clients in this area, including firms like Parker, Smith & Feek, RISQ Consulting, Business Insurance Associates, and Liberty Mutual Surety.

However, Armfield says, the number of surety companies actively seeking to provide bonds is limited. This is especially true in Alaska where there are only six to eight firms that write surety. A surety bond is such a specialized product, and there is, ultimately, a smaller pool of individuals who are qualified to be part of the underwriting. Plus, surety companies face the possibility of significant losses that can wipe out decades of profit. “Not everybody has the profits or the appetite for the risk,” he says.

In addition, some surety bonds may be harder to secure than others. Armfield explains: “In the case of license and permit bonds, many surety companies view these as modest credit risks, and there are multiple facilities in place to secure these bonds with relative ease. Performance and payment bonds are a more complicated product to secure and lend themselves to long-term relationships between contractors and a surety.”

In both cases, there is an underwriting process that takes place with various levels of financial and operational information being evaluated, in some cases, quite extensively.

However, some businesses use surety bonds for reasons where the underwriting may not be as challenging, according to Chris Pobieglo, president of Anchorage-based Business Insurance Associates. For instance, almost anyone can obtain a notary bond; there is literally no underwriting that goes into that. Another example is an ERISA surety bond that requires posting a bond with a minimum payout equal to 10 percent of the assets in a company’s retirement plan.

“The underwriting guidelines can vary greatly depending on the level of risk. Tax liability bonds, for example, are riskier,” Pobieglo says. “Often folks are already behind on their taxes when they are required to provide a tax liability bond.”

The Bonding Process
Since a surety bond is essentially a type of credit extension, it involves an underwriting process in which the principal is closely scrutinized. Underwriters typically evaluate the contractor in three main areas: capital (liquidity, debt, and profitability), capacity (experience and capabilities), and character (reputation).

The financial documents required for bonding will vary somewhat between surety companies. And the process of securing a surety bond is shaped by a variety of factors.

While there are an increasing number of alternative procurement methods, the most common is a standard design/bid/build project, according to Travis Remick, regional underwriting officer for Liberty Mutual Surety’s Western region. Using the design/bid/build project delivery method as an example, the project owner will work with an architect or engineer to develop the scope of the project and then release a set of plans to the public for bids. Contractors who want to pursue the project will need to submit a bid, which the project owner will require to be secured with a bid bond.

The contractor will then submit a bid request to the surety agent, who will forward it to the surety partner for review and underwriting. The complexity of the underwriting process varies depending on the size of the request and how usual or unusual the project is for the contractor, Remick says.

For more routine job requests, the underwriter may simply want to confirm that the scope, size, and location are within the contractor’s ongoing experience and capabilities. For a relatively small percentage of projects that involve large or unusual jobs, the bonding process can be much more involved.

The surety company wants to understand as much as possible about the contractor and project, including the contractor’s interest in the project, an overall project breakdown, key risks, primary mitigating factors, key cash flow considerations, who will manage the job and their experience with the scope, how much additional work the contractor wants to pursue if successful, and any unusual contract provisions. The in-depth assessment is entirely appropriate, given the exposure the surety company assumes when issuing a bond. “No one is going to issue that type of guarantee without doing their due diligence,” Remick says.

“Construction certainly makes up the lion’s share of all surety bond company premiums, with the number ranging from 60 to 70 percent, depending upon the year. And the percentage is probably higher in Alaska.”
Guy Armfield, Principal, Parker, Smith & Feek
Guy Armfield
Parker, Smith & Feek
Once the bond bid is approved, the contractor submits a bid for the project, along with the bid security. After the project is awarded, the contractor is required to post a performance and payment bond. This effectively guarantees all the contractor’s obligations under the contract for an amount equal to that of the contract. Typically the underwriter will review the bid results in between the bid date and project award. Then assuming everything is in order, performance and payment bonds will be approved and issued.

So how long does all of that take? It depends. It can take less than a day for an account that has an established surety relationship and ongoing surety needs. “This assumes there is an active relationship and active communication between the contractor, the surety agent, and the surety company,” Remick says.

The process can run significantly longer for a contractor who needs a bond for the first time or does not have an active surety relationship. To properly underwrite an account, the surety company requires a lot of documents and information. If the contractor has that information readily available, the process can take less than a week. But it could require more time if some of the information needs to be prepared, if there are any underwriting challenges, or if the surety requires a meeting prior to providing a final determination.

Ultimately, the relationship between the contractor, surety agent, and surety company will have a significant impact on the bonding process.

Compliance and Renewal
In terms of compliance, responsibilities vary for the different parties involved with surety bonds. For instance, employers generally have to maintain workers’ compensation insurance for licensing purposes, but that’s a standard requirement that many companies must meet, Adams says. And sometimes on contractor’s bonds there are covenants that require the principal to keep certain financial ratios. “This is normally on a contractor’s payment or performance bond and usually relates to much larger bonds,” he says.

In addition, Pobieglo says, brokers must be compliant with underwriting requests in terms of what each surety company requires. Likewise the bonding company must comply with the requirements of the state. There are also areas where principals must comply. “The state requires a contractor’s license bond or a motor vehicle dealer bond,” he says. “If you are working in the right-of-way, you have to post a bond that ensures you will return the right-of-way to its previous condition.”

To remain current, some principals may need to renew their surety bond. Licensing and permit bonds usually renew every year, Adams says. However, bid, payment, or performance bonds typically don’t renew. Instead, the bonding line might be renewed. The bonding line signifies that a principal—especially a contractor—is worth a certain amount of money to complete the job.

Ultimately, the bonding line will depend on the principal’s financial position, current projects, and other criteria. “Bonding companies look at how much cash you have on hand, your business assets, personal assets, your percentage of work completed, your jobs you have pending,” Adams says.

Some bonds automatically renew. They don’t have an expiration date printed on the bond form, so the bond is considered to be continuous, Pobieglo explains. In this case, the principal would simply need to pay the renewal premium. Or if the principal wanted to cancel, that could be arranged as well. “In Alaska, every contractor has to have a contractor’s license bond posted,” he says. “Once the bond is renewed, then we send out a certificate to the state, showing that the contractor has had its bond renewed.”

However, gaming license operators must be issued a new bond every year because the bond form has an expiration date. These types of bond renewals may require some level of underwriting where the client may have to submit financial statements and a new credit report. “We know ahead of time, as the broker, whether financial statements are required for the renewal,” Pobieglo says. “We notify our clients ninety days ahead of time that they have a renewal coming up.”

Incidentally, construction bonds are written for a specific project and are usually not renewable.

The Pros of Using Alaska-Focused Brokers
There are distinct benefits to working with an Alaska-based surety bond broker versus an outside firm that is unfamiliar with the state. Local brokers can provide insight into the logistical aspects that impact projects here that an Outside firm doesn’t have. A big consideration is the scheduling of work because the seasons are so different in Alaska. “We know a lot of material suppliers, subcontractors, so there are cases where we may be able to head off problems and help our clients because we have a lot of relationships here,” Pobieglo says.

In addition, surety brokers can help their clients effectively comply with state-specific conditions. This can include any bonds required at the federal, state, and local levels. Bonding specifications fluctuate from state to state, so it is critical for brokers to know the exact requirements their clients must satisfy, Pobieglo says.

“In Alaska, every contractor has to have a contractor’s license bond posted. Once the bond is renewed, then we send out a certificate to the state, showing that the contractor has had its bond renewed.”
Chris Pobieglo, President, Business Insurance Associates
Chris Pobieglo
Business Insurance Associates
Adams agrees that an Alaska-focused surety broker has a valuable understanding of the environment and challenges that companies must navigate to complete projects. And this knowledge can be especially advantageous for construction contractors.

He explains: “Part of it is knowing the contractors—and knowing the businesses here, what they build, and how they build… There are things that local surety companies are more cognizant of.”

Armfield also feels that it’s essential for principals to establish a relationship with a professional surety broker and firm that understands their business. This lends an obvious advantage to a firm that actively serves the Alaska marketplace.

And with the surety market firming, principals only get one chance to make a first impression. “Surety companies rely more than ever upon their broker to know the business climate and advise them of reputational and economic elements of a client and market,” he says. “The average underwriter who is not based in Alaska needs more help from their broker to understand the client and the marketplace in order to maximize surety credit. This is where a surety broker that has spent years cultivating knowledge and relationships in the Alaska market can be of a big advantage.”