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.