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Private developers now requiring surety bonding for construction contracts, as contractor defaults escalate

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Since the end of the Great Recession, many small and midsize contractors have become much more likely to encounter requirements to provide surety bonding as a condition of approval for a construction contract, according to several surety and construction risk management experts.

Already mandated for most types of public contracts, requests for surety bonds have grown increasingly common among private developers seeking to protect their investments, as contractor and subcontractor defaults in the middle market continue to rise amid sluggish recovery in the construction industry, experts said.

Still, even with market conditions firming, experts said small and midsize contractors with consistent performance histories, realistic views of their own capabilities and, most importantly, strong financial footing should be able to leverage the surety market in pursuit of public or private work, experts said.

“There are quite a few surety underwriters that are willing to entertain surety bonds for contractors at the $5 million to $10 million level,” said Erik Johansson, the Irvine, Calif.-based senior vice president of Willis North America's surety practice. “What's probably key at this point in the game is cash on hand and, obviously, that's going to be a challenge to a new entrant into the marketplace.”

During the past three years, fewer project opportunities have led contractors to compete for projects at drastically reduced profit margins than had been the industry norm just a few years ago, experts said, leaving contractors with less operating capital to cover the cost of even routine project delays. The result has been a creeping, yet predictable upswing in the number of construction companies rendered unable — or in some cases, unwilling — to deliver on contracted work, experts said.

“In some situations, subcontractors are just walking off job sites,” said Drew Brach, Grand Rapids, Mich.-based surety practice leader at Marsh Inc. “We had one instance not long ago where the subcontractor didn't even go bankrupt, and it cost the contractor more than $500,000 to replace that company. They just decided that they couldn't make any money on the job, and walked off.”

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Michael Bond, a Washington, D.C.-based executive vice president and head of surety at Zurich Financial Services Inc., said his practice had recorded about 20 contract default claims in excess of $1 million midway through 2012, compared with just three at the same point in 2008, and that “all of them are in the small to midsize sector.”

“It's really because that segment, given the competition and the lagging economic recovery, is still under a lot of stress,” Mr. Bond said. “So now, many of these companies are being asked for the first time maybe to provide a bond, where before they were effectively doing it on the strength of their relationships.”

Unfortunately for contractors, experts said, the rise in defaults and delays claims also has led significant firming in the surety market for midsize contractors, as a majority of issuers have begun to impose much stricter prequalification standards.

“It's certainly becoming a harder market in the midsize contractor range, and in certain lines of construction, sureties are re-evaluating their entire book,” Mr. Johansson said. “Although they might have had some successful contractors without claims in the middle market, they're still really cranking up their requirements in terms of financial reporting and financial analysis.”

Beyond cash flow, credit score, access to future capital and other financial health indicators, sureties are likely to evaluate the potential risk of a contractor's bond application based on the size, scope, location, cost and duration of the proposed project. Also evaluated are previously completed projects, the number of years the company has been in business, pending and previous litigation and insurance claims and management history.

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“From an underwriting perspective, we need to understand that this next deal that they want bonded fits in with their overall business strategy,” Mr. Bond said. “If we see a contractor come in and say they haven't needed bonds in the past but suddenly need one, and the project they want bonded is twice or three times as big as anything they've ever done, and it's in a state they've never worked in before, that raises significant concerns for us. We want to see a proven track record.”

Many sureties have devised other ways of providing small and midsize contractors access to bonding while maintaining a certain degree of insulation from the risk of default, including requests for guarantees of personal indemnity from contractor owners, as opposed to corporate indemnity alone.

“They'll say to the owners of a contracting firm that if they want the bond, and they want their subcontractors bonded as well, then you'll have to give your personal indemnity, or at least some sort of collateral, usually in the form of a letter of credit,” Mr. Brach said. “So there are a number of other underwriting techniques that can be used in order to underwrite the smaller or midsize contractors that aren't doing as well financially as their larger competitors.”