Month: February 2015

Secret #83: Collateral, the Big Nasty

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There are some excellent bonding companies that help contractors by using collateral to support the underwriting. However, there can be areas of difficulty that pop up. Let’s take a look at the role collateral plays in surety bonding and go over the important elements.

What Is It?
Collateral is a security deposit the bond applicant gives to a surety (bonding company) to gain approval of a bond that is somewhat difficult. The purpose is to lessen the surety’s exposure and make supporting the bond more palatable.

Forms of Collateral
The most common form of collateral is an Irrevocable Letter of Credit (ILOC) issued by a commercial bank. Also called a Standby Letter of Credit, it is based on the credit of the bond applicant, with the surety as the beneficiary.

The ILOC states that, upon demand, the bank will make payment to the beneficiary up to the face amount of the letter.  Such payments are then recorded as a loan to the bond applicant.  If the surety experiences a bond claim or has a loss, they can gain immediate recovery through the ILOC. This protects them from delay or failure of their subrogation (collection) efforts.
gold pile
Other forms of collateral could be cash, a Certificate of Deposit that is assigned to the surety or even real property if it is professionally appraised and free of encumbrance.

Timing
Typically bonding companies require collateral before the performance bond is issued.

When a bid bond is initially required, usually a promise to give collateral is sufficient. The actual instrument is conveyed prior to the performance and payment bond.

Determine the Amount
Surety underwriters will make a decision regarding the amount of collateral required. It is normally a percentage of the related contract amount. Typical collateral amounts range from 20 to 40% of the contract. In unusual cases, the underwriter may require full collateral (equal to the contract amount) in order to issue a P&P bond.

Multiple Bonds
One collateral instrument can support multiple performance bonds  issued in succession, assuming the collateral amount is sufficient.  Let’s look at how this works:

Assume 20% collateral is required on a $500,000 contract, therefore $100,000.

When the second bond for $200,000 is needed, the Work In Process schedule reveals that job #1 is now 50% complete. This could mean that half of the original collateral is available to support the new bond. Is the amount of available collateral enough for the second bond?  (.2 x 200,000 = ?)

Unless there are problems on the first project, the underwriter may calculate that $50,000 is now available, which is more than 20% of the new contract, and therefore sufficient.

If things are going smoothly, this is the manner in which collateral is rolled forward onto new contracts. The transactions are handled internally by the surety – no action required by the contractor.  If the jobs come in rapid succession or a big one is presented, additional collateral may be needed.

Releasing The Collateral
The underwriter will not release the collateral until the surety is exonerated from all bond obligations.  How this is determined is often a subject of discussion.

If only one bond was written, it is worth noting that the underwriter will not give partial releases as the work progresses. In other words, when half the job is finished, half of the collateral is not released. The assumption is that it is impossible to predict the amount of a future claim.  The underwriter does not know how much collateral they can afford to release. To be conservative, they hold the entire amount until the end.

So when is “the end?” When a performance and payment bond is written, the end is not at the end of the project as would seem logical.

The surety is equally obligated under both the payment and performance bond. Their exposure continues for the duration of the lien period (time allowed for suppliers of labor and material to make claim.) This is often 90 days after completion or delivery of the work.

In addition to the lien period, some underwriters hold the collateral in recognition of the maintenance obligation on the performance bond. This can run for one year after acceptance of the work.kid-surprised-face

Contractors should be cautioned that underwriters are in no hurry to give back collateral, particularly if they do not have a continuing relationship with the client. Understandably, their only concern is that they conclude the bond obligation without loss.

Changing Sureties
It can be difficult to conclude a collateral relationship, especially if a series of bonds has been issued. It may be easier to take a new bond from the old collateral market than to move to a non-collateral surety.

The most beneficial use of the collateral funds is with the old surety. Even if the contractor starts obtaining bonds from a new carrier, the collateral dollars remain tied up until the last bond is exonerated. This can be a disincentive to changing markets, even when more beneficial terms are available.

Solvency Of The Surety
If the surety goes out of business, the collateral funds should be in a separate, protected account.  However, there have been cases where collateral markets shut down, causing great anxiety for their bond clients.  When additional parties become involved such as the state insurance department and a bankruptcy court, it can only add to the delay in processing a collateral release.

Money Tied Up
Bonding companies realize that completion of the work may be more difficult when they deprive the contractor of a liquid asset. The cash that is given as collateral, or that backs the ILOC, is out of circulation for the contractor.  However, they continue to be the owner of the cash. The asset is still shown on their financial statement and to that extent may help in future bonding and banking relationships.  Cash that has been pledged or dedicated in his matter is identified as “restricted cash” on the balance sheet.

In Conclusion
Collateral may be a necessity in some cases. There are contractors whose business financial statement looks weak, but they have other resources. For them, collateral is not a burden. And it may be the best solution available.

Other companies are distressed and can ill afford to give up liquid assets.  They need them to conduct company business. In these cases the underwriters may ask themselves “Will the collateral requirement make it difficult or impossible for the contractor to perform the project?”

Big Nasties: 

  • Coming up with the collateral
  • Operating without this asset available (if you really need it to survive, the surety will probably not release it!)
  • Getting the collateral released promptly
  • Graduating to a non-collateral surety

Underwriters must determine the prudence of requiring collateral and the amount.

Contractors must weigh the risk / reward of using this method.

Secret #82: Who’s On First? Understand Surety Bonding Terms

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Need a bond?  Talk to the Pros!  856-304-7348  www.BondingPros.com

Brokers protected.  Contractors welcomed.

The world of surety bonding may seem mysterious and complex. Let’s face it, it’s not like insurance. It’s actually more similar to banking. No wonder the subject is not well understood by the very people who need to know.

abbott-and-costelloIn this article we will cover some of the basics such as who the parties are and what they do so the subject does not seem so foreign.

Who is the “insured”?  The insured is the party buying insurance. Therefore, in bonding there is no insured, instead there is a “principal.”  This is the party whose actions the bond concerns.   If your construction company needs a bond, it is the principal, the bond applicant.

The intermediary who assists you with your bonding need may be a bond producer, a bonding agent, or an insurance agent. In every case, the person is licensed by the state to process surety bond transactions.

The firm the agent works for is called an insurance agency or bonding agency. This entity provides the channel between the principal (bond applicant) and the surety, the bonding company, the provider of the bond and party holding the risk.

In the world of bonding, the term “company” is used to describe the bonding company. The agent and the agency would not be referred to as “the company” even if the name of the firm was the ABC Local Insurance Company Inc.

A reference to the paper relates to the bonding company.  “Whose paper is the agency using?” This means “Who is the bonding company?”

Since the bonding company holds the exposure on the bond, it is their employee who makes the decision to approve or decline it.  This person is called a surety underwriter or bond underwriter.

It is true that insurance agencies may employ individuals with underwriting expertise, and their title may be “underwriter.” They may even have some element of decision-making authority that has been delegated to them by the bonding company (referred to as “having the pen.”)  But the fact remains that the ultimate seat of authority is the bonding company not the agency.  It is worth knowing that when a bonding agent speaks with authority about what can or cannot be done.  In reality, they must still ask the underwriter for permission. They always answer to the bonding company on all transactions that involve the surety.

When a contractor is asked “Who is your bonding company?” sometimes they give the name of their bonding agency. Now you know the difference!

Other areas of confusion: The owner of the construction company is not the applicant for bid and performance bonds. In the eyes of the surety, the construction company is the applicant because it is the entity named on the bonds.

It is true that sureties expect company owners to stand behind the transactions by providing personal indemnity. However, the underwriting process (decision-making) is primarily focused on the company, its history and capabilities. The personal factors surrounding the business owner are secondary.

We do not intend to diminish the importance of the bonding agent. The agent plays a critical role in gathering, shaping, and presenting the file for review by the underwriter – and they guide the process forward as bonds are needed. When you utilize a bonding specialist for your surety needs, you gain the expertise of an industry insider who understands the underwriting process and how to present your account in a fair and effective manner for the mutual benefit of the applicant and the bonding company.

OK, now it’s time for one of our famous Pop Quizzes!  Choose the most appropriate word in each case:

  1. When Elmer the contractor realized he would need a bond, he got right on the phone and called his (Principal / Agent).
  2. Morty the underwriter had a few more questions and sent them to the (Surety / Bond Producer).
  3. The (Surety / Bonding Agency) was not willing to hold any additional risk on the account.
  4. Surety bonds (are / are not) insurance policies.
  5. LaFawnduh, the (Underwriter / Agent), knew it was time to arrange for a new surety.
  6. Thor, the Bonding Specialist, only used quality (Pens / Paper).

7. Bonus Question (Extra credit!): When all else failed, Moonbeam knew it was time to file a bond claim with the (Carrier / Insured).

Answers:

  1. Agent
  2. Bond Producer
  3. Surety
  4. are not
  5. Agent
  6. Paper
  7. Carrier

Secret #81: The Path to Profitable Contracts

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Secrets of Bonding is brought to you by Bonding Pros

Need a bond?  Talk to the Pros!  856-304-7348  www.BondingPros.com

Brokers protected.  Contractors welcomed.

Profits.  Is there anything more important for the success of a company?

path_to_riches This critical factor determines if bills can be paid, if growth is achieved – it is the very essence of survivability.

Ask any business owner and they’ll tell you they make every effort to protect their profit margin.  They are careful about choosing the right contracts, vendors, and employees.  When construction companies pursue competitively bid projects (municipal, state and federal), they meticulously calculate the cost estimate to assure a healthy profit upon completion.

For many firms, competitively bid work is their bread and butter. The plain truth is that such jobs are difficult to win.  All the proposers want the revenues but only the lowest bidder wins. The others get nothing for their effort. In this lean and mean environment, contractors must calculate the minimum profit that is sustainable for their firm.  With so much at stake, good management practices require a diligent effort to protect the company’s financial interests.

Everything we’ve said so far probably seems obvious.  No one would dispute the importance of protecting the life blood of a company’s future. However, over the course of our years bonding contractors, the reality may be slightly different…

Fallacy #1: “If I bid it right, the job will be successful.”  This seems like a good strategy.  But what’s wrong with it?

The problem is that a project estimate is just that, an estimate. The contractor may be confident that all labor and material costs are correct. The company may have successfully completed similar projects. But unpredictable factors such as weather, variances in productivity and outside factors like a subcontractor’s performance can all contribute to the financial success or failure of the job.

Fallacy #2: “If the architect approves my monthly pay requisitions, the job must be on track.”

This fails to consider that the architect is the owner’s representative. The architect wants a completed project even if there is no profit left for the contractor!  It is not the architect’s (or project owner’s) job to protect the contractor from taking a beating.

Fallacy #3: “When I get to the end of the project that’s when I find out about the profits.”

The problem here is the lack of oversight during the life of the job, when the outcome may still be managed.

Bonding companies intend to support well-managed, financially successful construction firms. One very important element is the analysis and management of incomplete contracts.  This process must be performed during the life of the projects.

To be successful, this oversight process depends on three elements:

  1. The accumulation of project specific cost data (labor and material utilized).
  2. The data must be analyzed with sufficient frequency (such as monthly).
  3. The remaining “Costs-to-Complete” must be periodically re-estimated based on actual contract performance.  This means not relying on the accuracy of the original project estimate but instead reviewing the actual labor and material cost experience.  When this is compared to the original estimate, enlightened predictions can be made regarding the ultimate profitability.

By following these three steps, construction companies can effectively predict their revised profit estimate and manage open contracts during their life – while there is still time to affect the outcome.

We can say with certainty, all well-managed construction companies utilize such procedures.  Equally, all surety underwriters expect to see this management approach and can readily detect if it is not being utilized.

Contractors must use these procedures to protect profitability and assure their future success.