The perfect storm of inflation, supply-chain disruptions and ongoing labor shortages is adding additional risk factors to construction projects in 2023.
Despite year-over-year growth, the construction industry is still facing a 400,000-plus worker deficit. At the same time, inflation is contributing to the rising cost of construction materials, and supply-chain bottlenecks continue to affect the timely delivery of critical materials and products. These pressure points threaten the profitable completion of construction projects, which has the potential to impact the viability of construction firms.
To stay on track despite economic headwinds, public and private project owners leverage surety bonds. In fact, surety bonds have provided this assurance to the federal government since the enactment of the Miller Act of 1935, which mandates bonds for federal construction projects exceeding $150,000. Many states have a version of the Miller Act commonly referred to as Little Miller Acts.
Like the government contracting space, a key benefit of surety bonds for private owners includes decreased likelihood of default since contractors have been pre-qualified by a surety company and can take comfort that the project will ultimately be completed, even if the bonded contractor is unable to do so on its own.
3 economic protections provided by surety bonds
While their chief goal is to mitigate the risk of a contractor default, surety bonds offer several economic benefits for any bonded project according to the November 2022 Ernst & Young report “The economic value of surety bonds,” prepared for The Surety & Fidelity Association of America (SFAA).
There are three significant ways surety bonds add economic value to private and public construction projects.
- Lower cost of project completion. In the event of a contractor default on a project, the cost to finish it can balloon significantly. In fact, projects with no surety insurance cost 85% more to complete than surety-bonded projects, according to the EY report. Substantial mitigation of completion costs is driven by the expertise of a contractor’s surety. Sureties can help the contractor work through financial hurdles on the back end or they can utilize their vast network of resources to complete the project by other means. More than 90% of respondents to the EY report believe project owners and developers do not have the same high level of expertise and resources as the surety company to get a construction project to completion.
- Lower rate of project default/great timeliness of completion. According to the report, 50% of owners/developers believe projects with surety bonds are more likely to finish on or ahead of schedule, while only 10% say surety-bonded projects are less likely to finish on or ahead of schedule. In addition, nearly five times as many property owners agreed that contractors put a higher priority on surety-bonded projects in the face of financial difficulties, versus those that are unbonded. The construction manager or architect is more likely to be involved in oversight of a bonded project as well, potentially helping to prevent loss.
- Lower contractor pricing. Surety bonding reduces contractor pricing, according to 75% of owners/developers surveyed. This cost reduction is based on confidence that the contractor will meet its requirements for project completion and payment of subcontractors that can only be gained when a third-party is backing the contractor. Furthermore, contractor pricing on surety-bonded projects is, on average, 3.2% below project value.
Bonus protections offered by surety bonds
These economic benefits give project owners peace of mind on individual projects, but the overall greater impact may come from the behind-the-scenes involvement of the surety company itself.
During the underwriting process, surety underwrites the contractor using the three Cs:
- Character: Examines how a construction company interacts with those they do business with, such as their suppliers and subcontractors. It also reviews their credit reports to see if bills are paid in a timely manner, their claims history, and if they are involved in lawsuits. In short, the reputation of the business and its key executives and owners are closely evaluated.
- Capacity: Focuses on the organization’s experience, area of expertise and the type and size of work completed. The surety evaluates the firm’s previous expertise based on scope of work, contract value, location, and the project owners. These factors are then used to evaluate new bond requests.
- Capital/competency: Digs into the financials of the company, including evaluation of current and prior project profitability. Do profits hold from inception to completion? The surety evaluates the balance sheet and determines if companies have the necessary capital to support their business plan. The types of financing and credit access the company has are given a comprehensive review. Finally, the surety will view the company’s financial trends and whether they are pointing up or down.
Sureties also act as consultants and business advisors. With a surety bond, owners and developers gain a higher level of oversight across the project timeline from the underwriting team. Once a contract is executed and a bond is issued, the surety will monitor the project for any significant changes during its lifecycle that could increase risk to the project: Examples of how the surety may work with the contractor during the course of a project include:
- Evaluating project priorities and fostering discussion about adjustments that may need to be made
- Analyzing engineering and architectural plans and mediating any disagreements
- Assisting in managing the contractor/owner relationship
- Helping understand the need for a new strategy should the risks change over the course of the project
- Advising on the significance of any issues that arise and making suggestions on priorities in the new risk landscape
- Working with the contractor to chart a revised approach to resolve any issues before they become claims
Surety bond underwriters and claims professionals often work quietly behind the scenes, keeping the project going in the face of challenges that threaten to halt a project. For example, if a contractor runs into unforeseen financial distress during the project, the surety company may step in (at its discretion) and keep the contractor afloat financially to ensure project completion without incurring loss or the need for another contractor to be sourced.
With a surety bond and a contractor’s surety prequalification, project owners can minimize their risk and manage their budgets. Whether it’s a public agency who routinely engages in the construction and surety procurement process or a private owner looking for a solution to mitigate risk, the EY study provides a compelling, fact-based discussion of the economic value these risk mitigation tools provide.
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