Originally published: 05.01.08 by
Maximizing your surety program will create a sound continuity plan for your company
Erring on the side of caution is a good thing when it comes to surety bonds. Indeed, we recently worked with an hvacr client to place their first bond. While they had the experience and capital to qualify, the short timeframe to secure the bond meant more money out of pocket. We were not able to get all of the upgrades implemented to secure a preferred rate. They got the job, the bond and an inflated invoice. Had they started the process sooner — before they needed the bond— they could have enjoyed a much lower rate.
All hvacr contractors are familiar with evaluating the prints, plans and specifications in order to build a comprehensive, profitable estimate for a project. Once you secure the contract, you must install the proper components and controls to meet the owner’s expectations. You should approach your surety relationship with the same insight and understanding.
Unlike insurance, which is a two-party contract between the hvacr contractor and their insurance carrier where losses are contemplated in the premiums, surety is a three-party contract among the hvacr contractor (known as the principal— the primary party that will be performing a contractual obligation), the owner (known as the obligee— the recipient of the obligation), and the surety, who ensures that the principal’s obligations were preformed and where no losses are contemplated in the premiums. The cost associated with the surety bond is actually a premium for the pre-qualification of the hvacr contractor for the obligee by a third-party guarantor, the surety. Given that no losses are built into the premium, the surety underwriter must be thorough in their investigation in order to avoid any unforeseen financial failures by the hvacr contractor. Further, they typically require the indemnity of the company, as well as the shareholders, so that they can pursue recovery from those indemnitors in the event of a loss.
The surety underwriter will want a plan in place to be certain that in the event one or more shareholders become disabled or pass away, a clear and properly funded transition will take place without incident on any outstanding contracts.
In order to establish a credit decision on a given account, the surety will underwrite the case by focusing on the three Cs of surety underwriting.
Character: The surety will pull personal credit reports on the shareholders, business credit reports on the entity and make calls to the banker and suppliers. They will look for strong credit scores, a history of prompt payment of bills and input on the way that relationships have been handled by the management of the hvacr contractor. If you are aware of any deficiencies on your credit reports or payment history, address these proactively to avoid any issues.
Capital: A thorough analysis of at least three years of corporate financials and a current personal financial analysis of the shareholders will be done. Current bank line-of-credit documents will be reviewed in order to establish the amount and terms of the debt facility available. The underwriter will establish the account’s specific positions for the key financial ratios: working capital, net worth, debt to equity, and profitability. A vast majority of the surety industry focuses their underwriting around working capital, with a small group more focused on the net worth of the contractor. When developing the working capital and net-worth figures, the surety will make adjustments, such as eliminating prepaid items, amounts due from affiliates and accounts receivable over 90 days. Most look for clients with a debt-to-equity level less than 3 to 1 and a consistent history of profitability is a must. A good rule of thumb for an overall program that will be extended is 10 to 15 times the level of working capital or net worth, depending on the underwriter’s focus.
Capacity: A list of the past projects of the hvacr contractor will be requested. The underwriter will call the owners and verify performance and timeliness on completed and ongoing projects, as well as investigate the size, scope and percentage of materials versus labor on the projects. The underwriter also will look at the profit figures for each of the projects to establish any trend that may exist in a size or type of given project. The surety will usually look at projects up to twice the largest project completed in the past, unless there are circumstances that allow them to become comfortable with a larger increase, such as repetitive exposures like identical installations but more units.
After the above processes are complete, the underwriter will develop a single project size and an aggregate program, along with a rate for your company.
In order to secure the optimal surety program for your hvacr operations, it is important to provide a good blueprint for the surety underwriter. When your hvacr estimators see an area of ambiguity on a they are prudent to add a contingency amount into their bid. The same is true when an underwriter sees things that are not in line with surety industry standards. Therefore, you must be sure that items are clear and easily understood for the underwriter. In order to do this, a select group of professionals can be as good as your top estimator in helping you secure additional profitable work. These professionals include:
Accountants: There are many Certified Public Accountants (CPAs) in the phonebook. However, there is a small group of CPAs that have practices that specialize in construction accounting. Most CPAs tend to focus too much on the tax ramifications and not enough on the importance of the hvacr contractor’s financial presentation and the additional profits that may be attained via an expanded bond program due to your tax-management decisions. Further, many are in favor of their clients having compiled financials prepared. Very few sureties will accept a compiled financial statement because by definition they are merely the representation of the company management’s internal financials put into the proper format of balance sheet and income statement, thus carrying very little credibility with an unsecured creditor, the surety.
CPAs that focus on construction understand these needs. They will prepare a reviewed or audited financial in accordance with Generally Accepted Accounting Principals (GAAP) for your hvacr company on a percentage of completion basis, with full disclosure footnotes and supplemental work in progress and completed job schedules that encompass all accounting periods for a given contract. A quality presentation from a construction specialist CPA will improve your position with any surety.
Bankers: Given the cyclical nature of the construction industry, it is important to have a banker that understands your business and the industry that you operate within. When times are good, a lot of banks begin to solicit hvacr contractors. But in order to have a true partner in your bank, be sure that they will be there when times are tough. There are a few banks that have departments that specifically work on lines for construction companies. Those with long track records are always your best choice.
Even if you have sufficient cash flow and reserves that allow you to avoid bank financing, it is still a good idea to establish a line with a construction-focused bank. Sureties look for the contractor to have a line in reserve, just in case. Further, it is easy to get money when you do not need it, but tough when you do. If you have a sudden period of growth or a receivable issue develops, an unused line will be a real help.
Attorneys: From reviewing contracts to assisting with project issues and developing your subcontract agreements, a good attorney is an important component. Almost every project has some issue or disagreement with the owner, construction manager, general contractor, supplier, or government authority. Given the fact that you will likely be indemnifying the surety, many times they will look for you and your attorney to provide their defense. Therefore, you will benefit from an industry-focused law firm that is familiar with the unique issues that arise when a surety claim becomes a possibility. A quick, concise response will ultimately save your company money. If the surety must supply the defense, you may not have as much control over the expense associated with defending claims.
Surety Agents: Many insurance agents try to handle the surety needs of their clients. Surety is a very specialized area within the insurance industry and most agents are not qualified to handle the surety needs of the hvacr industry. The National Association of Surety Bond Producers is an organization whose members must meet specific criteria for membership. These members typically employ people who worked as surety underwriters that assist the contractors in preparing the proper forms, making the appropriate financial decisions and working with the CPA, banker and attorney to develop a package that will optimize the hvacr contractor’s bond program. Further, the professional surety agent also will find the appropriate surety underwriter to fit the specific needs and profile of your company. Not all markets are a good fit. A surety professional will have a large group of markets so that if things change in your profile, they will be able to provide a new market that will meet your needs.
A quality surety agent will be able to assist you in finding qualified professionals in the other areas of focus. When selecting the surety agent, inquire about markets that they represent, annual surety premiums written, formal surety training, individual experience, and number of surety professionals on staff. It is important that they have a number of qualified professionals so that if an unforeseen incident occurs, you will not have a change in service or a decline in expertise.
All of these professionals can work with you to build an appropriate continuity plan for your hvacr company. Buy-sell agreements, key-man life insurance and completion agreements with project managers are some of the expectations of the surety underwriter.
Just like selecting quality manufacturers for the components on one of your hvacr installations, evaluate each professional to be sure that you choose the one that will work best for your organization. Be sure that they have a department that specializes in your industry, ask for references and verify the amount, as well as proportion of annual revenues that are derived from your industry.
Once you put together the appropriate team, build the blueprint and establish an appropriate bond program, your decisions will control the effectiveness of the program. If you invest in your business by leaving in profits and paying taxes, the underwriting base will grow, which will allow the program to be expanded and thus improve the bottom line. Think of it as return on equity, which will likely exceed most investment vehicles available. When you want larger projects, upgrade the financials to an audit and improve the quality of your continuity plan, which will make you more attractive to the larger surety companies. You may qualify for better rates, as well. Approach this just as you do when you look at a set of specifications so that the blueprint, components and controls are integrated to maximize the surety program for your hvacr construction company.
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