Expert Commentary

Project Risk Assessment

For the bond underwriter, risk assessment is made in relative—not absolute—standards. Rolf Neuschaefer discusses project risk factors that may apply.


October 2002

As we all know, life has changed and become a bit more difficult since September 11. This fact is also evident in contract surety underwriting. Because of significant deterioration in underwriting results, bond underwriters are examining more closely both the performance and the financial risks of a proposed project. To help you navigate through this process, we will review some of the risk factors that surety underwriters may examine in their project risk assessment (PRA).

PRA Is Relative

For the bond underwriter, risk assessment is not made in absolute standards but in relative standards. To illustrate this point, one cannot, for example, state that a $5 million net worth is good or bad without placing it in context. Does the contractor perform as a general, a prime trade contractor or subcontractor? What is the makeup and amount of the contractor’s backlog?

A general building contractor with a $50 million backlog would likely be viewed as well financed while the same contractor with a $100 million backlog might be viewed as being marginally capitalized. There are, of course, many other factors, but this serves to illustrate that the assessment of most risk factors are relative to something else.

Prior Experience

When it comes to PRA, probably the first question asked will be: what is the contractor’s experience in building this type project? It is not simply a question if they have completed a project of similar dollar value. Is the project under consideration truly comparable to the earlier completed project?

A $5 million negotiated medical office building built in the suburbs may not be comparable or relevant to a $5 million bus terminal for the public transit authority where the site location is difficult and time for completion is limited. The point is that the contractor will need to be able to demonstrate that its current construction team has, in fact, satisfactorily completed similar projects under similar or more severe conditions.

Dollar Value

While the dollar value of the proposed project is certainly a risk factor, it cannot be viewed in a vacuum. Consider a sewer project where the cost of the pipe is included. If you compare it against a like size project where the cost of the pipe is excluded, you would have entirely different risk parameters.

Likewise, you might have a large project such as an airport, where there are bid packages for various structures. A $10 million bid package which is part of a $100 million overall project would not be comparable to a single project valued at $10 million. The amount of the bid or contract is, of course, evaluated relative to the job size and work program parameters that have been set for the account, but it must also be considered in the context of other factors that may be relevant.

Construction Financing

While it may seem elementary, a basic question that the contractor should have confirmed well before bidding a job is: does the owner have all the money to pay for the construction work? This issue, of course, seems much more applicable to private work than public work. It is nonetheless also relevant to know the source of construction funding on public work. If the sewer contractor, for example, has to wait for the sale of bonds before he can receive a contract award, he may have a low bid outstanding for some time which ties-up his bonding line.

Most states, if not all, have voided as a matter of public policy so-called pay-if-paid provisions in contracts. Therefore, even if an owner does not pay the general contractor, the general would still be responsible to pay the subcontractor for work performed pursuant to their subcontract. Therefore, it is critical that the contractor confirm availability and source of construction financing prior to bidding any work.

Geographic Location

Where is the project located? Is it within the contractor’s normal operating territory? The surety underwriter will look very closely if the project is in a new market. From a PRA this would be a very critical consideration. There are myriad of concerns when the contractor enters a new market. There is the legal and political climate to consider. Working in a new and unfamiliar market creates new and added risks because the contractor would be dealing with people with whom they have no working relationship. When the contractor moves out of territory, it increases overhead as it will likely entail added travel expense, hiring of new people, renting office space, etc.

If the contractor encounters operational difficulties, it may prove very costly and time consuming to remedy the problems. Given the current bonding marketplace, only contractors with significant financial resources and managerial sophistication will likely be able to persuade the surety to allow them to pursue work in a new geographic territory.

Site Conditions

The surety will want to know about the site location where the project is located. Building a road or sewer in a mostly rural, unpopulated area would be entirely different than constructing the same in a congested, urban area. The surety will want to know about such things as access to the site, storage for materials, and whether special job site security will be required.

If there will be any significant underground work performed—e.g., foundations, sewers, subterranean structures—the PRA will focus on soil conditions and the existence of underground improvements that may interfere or will need to be relocated, such as utilities. Also, are there any toxic or hazardous materials on the site and how will they be addressed? Differences in site conditions can make two seemingly identical projects as different as night and day.

Availability of Labor

The surety will want to be assured that the contractor has adequate project management and labor available to complete the project successfully. Obviously, the more labor intensive the work, the more critical will be the labor component of the project. Most contracts with cost overruns result from inadequate estimates for the labor time required to complete the work or misjudging the productivity of the available work force. Availability of qualified labor is critical and oftentimes is more of an issue when construction activity is robust.

Will the project labor be union or nonunion and are there jurisdictional or strike issues pending? Likewise, many contractors have learned the hard way that you should not take on a major project unless you have a qualified project manager and superintendent available on staff. Advertising to hire key project management people after you acquire a large job may result in poor contract performance and significant financial loss.

Availability of Subcontractors

Equally critical is the availability of qualified subcontractors. Most of the time, general contractors will seek to work with a select group of subcontractors where they know their track record. On competitively bid fixed-price projects, that is far more difficult because the general contractor is under pressure to utilize the lowest subcontract bid in order to enhance his own chance for being the low bidder.

Since the general is responsible to the owner for overall job performance, any failure by any of the subcontractors to satisfactorily perform their work and/or pay all of their labor and materials will become the general’s burden. The surety in their PRA will inquire which of the subcontractors will provide performance and payment bonds in favor of the general. Given the more difficult surety marketplace, you may expect an increased requirement to bond back subcontractors.

Availability of Materials

The PRA will also focus on the availability of critical materials and equipment to complete the work. Some specialized equipment/machinery to be installed may need substantial lead-time and may have only a single or limited source. Availability of construction equipment is more of an issue for civil/highway type contracts than general building contracts.

While currently not an issue, I have seen where, because of oil shortages, the availability and cost of diesel fuel or bituminous material was a significant PRA issue. Given that our economy is much more global today than in years past, one has to also consider the possibility that a critical item manufactured/produced in a foreign country may not be available on time for a variety of reasons.

Contractual Provisions

The surety as part of the PRA will also want to focus on various contractual provisions. What are the payment provisions, retention, time for completion, liquidated penalties, changed conditions clause, hold-harmless/indemnification provisions, and insurance requirements? Most contracts include a 1-year warranty requirement against defective workmanship and materials. Does the contract include any extended warranty or so-called efficiency of operations guarantees?

Obviously, all contract provisions are important and the contractor should fully understand the provisions of the contract he will execute. Likewise, the surety will want to review the proposed final bond forms, unless they are industry standard forms such as Associated General Contractors of America (AGC) or American Institute of Architects (AIA). The time to address concerns with any contract or bond forms is prior to execution.

Bid Evaluation

Before approving and executing final bonds, the surety will want to review the bids and determine if there is any adverse bid spread. Historically, a bid spread of 10 percent or more between the first and second low bidder was cause for further review. A good contractor will reexamine his bid and compare it with the competitors’ bids to determine if the bid was complete and satisfactory.

Bid spread in itself is meaningless and does not guarantee the contractor will make or lose money on a job. It is simply a factor to consider prior to executing final contracts and furnishing final bonds. It is far better to walk away from a bad/erroneous bid than to attempt completion and lose your shirt.

Conclusion

Given the more difficult marketplace today for surety performance bonds, you can improve your chances for a favorable underwriting decision if you are prepared to demonstrate that you have considered and satisfactorily addressed the foregoing project risk factors as they may apply.


Opinions expressed in Expert Commentary articles are those of the author and are not necessarily held by the author's employer or IRMI. Expert Commentary articles and other IRMI Online content do not purport to provide legal, accounting, or other professional advice or opinion. If such advice is needed, consult with your attorney, accountant, or other qualified adviser.

Like This Article?

IRMI Update

Dive into thought-provoking industry commentary every other week, including links to free articles from industry experts. Discover practical risk management tips, insight on important case law and be the first to receive important news regarding IRMI products and events.

Learn More