Considerations that may determine premiums on your next construction bond
Construction bonds are an integral part of any project owner or contractor’s risk management program. For most projects, the cost of a surety bond is a standard line item in the construction cost estimate. Premiums for construction bonds are calculated as a percentage of the bond value, and usually quoted in dollars per thousand: Bond Amount X Rate/1,000. Percentages are typically tiered given the size of the bond and average in the .7 – 2.5% range but can go as high as 3% or more, depending on a variety of factors. So what affects the rate quoted for a construction bond? The short answer is risk.
As a non-traditional insurance product, similar to lending, surety bonds are underwritten. Surety underwriters consider risk factors associated with the bond and with the applicant. The higher the cumulative risk, the higher the rate on the construction bond. A good surety producer can assist with the process to ensure that the contractor is getting the appropriate construction bond at the best rate available.
Surety rate factors associated with the bonded projectType of bond – The most common premium generating construction bonds are performance and payment bonds. There is no premium for Bid Bonds. These bonds, typically issued as a package to protect the obligee/owner of a project, are based on contractor resources, experience and ability to meet the contract requirements.
Amount of bond – A larger bond may carry a lower average blended rate depending on the underlying financial strength of the contractor.
Class of business – There are some specific trades that are viewed as less risk, hence a more favorable premium rate structure due to loss experience. Common examples are paving and roofing contractors.
Size of bonded principal and operation – A small construction company that uses surety bonding less often may pay a higher rate than a large contractor with an established bond history.
Other project considerations – Design/Build projects tend to carry a higher rate. There may also be a surcharge for projects with extended durations and/or warranties exceeding one year.
Surety bond rate factors associated with the applicant
An applicant’s financial strength is the greatest part of the underwriting process when determining risk, and therefore rate. Along with the company or corporate entity, any principal or owner of a construction company with a stake in the operation greater than 10% will be evaluated for personal financial strength. In order of importance, these risk factors largely determine the rate quoted on a surety bond.
Personal credit – Credit history for an owner or owners of a construction firm is a key underwriting consideration for most construction bonds. A good personal credit score indicates strong character, good financial management practices and sureties like that. Contractors with good to excellent credit are generally rewarded with rates under 2%-2.5%, while those with poorer credit scores may see bond rates run closer to the 3% level. For smaller bonds, generally under $500,000, personal credit may be the only financial performance indicator evaluated.
Business Financial Statements – Statements prepared by a CPA familiar with construction accounting practices are viewed more favorably. Especially for larger surety bonds, expect to receive requests for company balance sheets, P&L statements and income statements over one or more accounting cycles. When it comes to the financial strength of a construction business, cash is king. So underwriters will look carefully at things like cash flow statements, WIP schedules, corporate equity, cash on hand and bank line availability to determine if the construction company has the financial ability to perform.
Personal Financial Statements – Similarly, a contractor’s personal net worth is also a factor in determining risk. While underwriters do not always require this, the ability to demonstrate a positive personal net worth with liquidity may be a consideration for acquiring a good rate on larger bonds. In such a case, expect to receive requests from underwriters for proof of personal cash/security account balances.
Industry Experience – Contractor or construction company owner and key personnel resumes that demonstrate long-standing success in a market are a plus. Reputation, particularly in the age of instant digital information, can also play a part in determining surety bond rates. Professional history, bios and production stats posted on sites such as LinkedIn, or social media entries across a variety of platforms, may be reviewed.
For suggestions on ways to improve your bond underwriting risk factors and obtain the best rates available, contact the professionals at Alter Surety Group at (305) 517-3803 or visit www.altersurety.com.
What does your Percentage of Completion data say about your company?
Work in Progress (WIP) is what a construction company or contractor invests in delivering a completed project, including materials, labor and overhead throughout the process of construction and in all stages of a construction contract, right? Well, yes and no. Those are definitely components of a WIP.
In reality, a WIP translates to numbers or, more accurately, an accounting schedule. It is a moniker attached to the balance of costs associated with a project as it moves from one stage to the next. And those numbers end up on a P&L statement and balance sheet, which bankers and sureties consider when setting rates.
For standard construction accounting using a Percentage of Completion (POC) methodology, WIP schedules for each accounting period are required (per GAAP). POC is calculated by dividing actual costs (to date) by estimated total costs. Other POC data tracked include revenues, gross profits and billings.
WIP reporting serves an important function as an early warning system by tracking actual job totals for the completed percentage of the job during and through a specific period, and offering a snapshot of profitability at a specific point. Accurate WIP data reporting can head off cash flow and budget problems, which are extremely important to smaller contractors that perform one contract at a time. Since a timely WIP schedule offers a helicopter view of contract Key Performance Indicators (KPI), it is also an immensely important strategic tool for larger companies with multiple contracts ongoing.
Top Key Performance Indicators for a Construction WIP
For WIP reporting to be useful, the KPIs tracked for actual job totals is critical. Depending on the size of a company and type of construction, your most crucial KPIs may vary. However, a construction company should always know where it stands on each project, at each period, for the following KPIs:
Underbillings – although carried as an asset on a balance sheet, this number can signal profit erosion, unapproved change orders, billing issues or vendor invoicing delays that may result in cash flow problems. And cash flow problems usually equate to increased contractor financing costs.
Overbillings – while this improves cash flow and keeps the contractor from having to dip into his own pocket, it results in a balance sheet liability. That, in and of itself, is not necessarily a negative unless it results in a pattern of “job borrowing.”
Job Borrow – this occurs when billings are more than actual to-date costs incurred AND the difference is more than anticipated total gross profit. If your budgeted gross profit is 12% on a half million-dollar job ($60K) and you’ve billed $300K YTD on $200K of actual costs, you’ve “borrowed” $40K against the job. If that money stays in the construction account, it’s not as big of a problem. But if it goes to pay for other general or administrative expenses, the money won’t be there to finish the job. A company that robs Peter to pay Paul may limit its ability to secure construction bonds with a reputable surety.
Profit Fade/Spike – cost overruns due to sloppy management or poor estimating can cause profit fade, as can inaccurate reporting in prior periods. On the other hand, profit spikes in final reporting periods may indicate that you were too conservative with beginning estimates. Margin history and margins for open jobs should run relatively consistent. Remember, the bank may have made financing decisions based on profit estimates. Accounting could be impacted, and IRS taxes may be affected, too, by profit fade or spike.
Your company’s monthly, quarterly or annual WIP schedule provides profitability insights not only to your CFO and bankers, but also to bonding agents. These statements can affect how sureties view your financial practices and bonding capacity. For more information on understanding the effects of Work in Progress KPIs on construction bonds and limiting other risks, contact the professionals at Alter Surety Group at (305) 517-3803 or visit www.altersurety.com.