Insurance Surety Programs

Originally published
Originally published: 5/1/2008

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 time frame to secure the bond meant more money out of pocket. We were not able toget 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 acomprehensive, 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(know 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 contemplatedin the premiums. The cost associated with the surety bond is actually a premium for the pre-qualificationof the hvacr contractor for the obligee by a third-party guarantor, the surety. Given that no losses are built intothe 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 wellas the shareholders, so that they can pursue recovery from those indemnitors in the event of a loss.The surety under writer 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.

Underwriting— The Blueprint

In order to establish a credit decision on a given account,the surety will underwrite the case by focusingon the three Cs of surety underwriting.

Character: The surety will pull personal credit reportson the shareholders, business credit reports onthe 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 ofthe 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 financialanalysis of the shareholders will be done. Current bankline-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: workingcapital, net worth, debt to equity, and profitability. Avast majority of the surety industry focuses their underwritingaround 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 consistenthistory 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 hvacrcontractor will be requested. The underwriter will callthe owners and verify performance and timeliness oncompleted and on going projects, as well as investigate the size, scope and percentage of materials versus laboron 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 arecircumstances that allow them to become comfortablewith a larger increase, such as repetitive exposures likeidentical 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.

Compiling The Proper Components

In order to secure the optimal surety program foryour 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 prudentto add a contingency amount into their bid. Thesame 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 selectgroup of professionals can be as good as your top estimatorin helping you secure additional profitable work.These professionals include:Accountants: There are many Certified PublicAccountants (CPAs) in the phonebook. However, thereis a small group of CPAs that have practices that specializein construction accounting. Most CPAs tend tofocus too much on the tax ramifications and not enoughon the importance of the hvacr contractor’s financialpresentation and the additional profits that may be attainedvia an expanded bond program due to your taxmanagementdecisions. Further, many are in favor oftheir clients having compiled financials prepared. Veryfew sureties will accept a compiled financial statementbecause by definition they are merely the representationof the company management’s internal financialsput into the proper format of balance sheet and incomestatement, thus carrying very little credibility with anunsecured creditor, the surety.CPAs that focus on construction understand theseneeds. They will prepare a reviewed or audited financialin accordance with Generally Accepted AccountingPrincipals (GAAP) for your hvacr company on a percentageof completion basis, with full disclosure footnotesand supplemental work in progress and completedjob schedules that encompass all accounting periodsfor a given contract. A quality presentation from aconstruction specialist CPA will improve your positionwith any surety.Bankers: Given the cyclical nature of the constructionindustry, it is important to have a banker thatunderstands your business and the industry that youoperate within. When times are good, a lot of banksbegin to solicit hvacr contractors. But in order to havea true partner in your bank, be sure that they will be there when times are tough. There area few banks that have departments thatspecifi cally work on lines for constructioncompanies. Those with long trackrecords are always your best choice.Even if you have suffi cient cash fl owand reserves that allow you to avoid bankfi nancing, it is still a good idea to establisha line with a construction-focusedbank. Sureties look for the contractorto have a line in reserve, just in case.Further, it is easy to get money when youdo not need it, but tough when you do. Ifyou have a sudden period of growth or areceivable issue develops, an unused linewill be a real help.Attorneys: From reviewing contractsto assisting with project issues and developingyour subcontract agreements,a good attorney is an important component.Almost every project has someissue or disagreement with the owner,construction manager, general contractor,supplier, or government authority.Given the fact that you will likely be indemnifyingthe surety, many times theywill look for you and your attorney toprovide their defense. Therefore, youwill benefi t from an industry-focusedlaw fi rm that is familiar with the uniqueissues that arise when a surety claimbecomes a possibility. A quick, conciseresponse will ultimately save your companymoney. If the surety must supplythe defense, you may not have as muchcontrol over the expense associated withdefending claims.surety Agents: Many insuranceagents try to handle the surety needs oftheir clients. Surety is a very specializedarea within the insurance industry andmost agents are not qualifi ed to handlethe surety needs of the hvacr industry.The National Association of SuretyBond Producers is an organizationwhose members must meet specifi c criteriafor membership. These memberstypically employ people who worked assurety underwriters that assist the contractorsin preparing the proper forms,making the appropriate fi nancial decisionsand working with the CPA, bankerand attorney to develop a package thatwill optimize the hvacr contractor’sbond program. Further, the professionalsurety agent also will fi nd the appropriatesurety underwriter to fi t the specifi cneeds and profi le of your company. Notall markets are a good fi t. A surety professionalwill have a large group of marketsso that if things change in your profile, they will be able to provide a newmarket that will meet your needs.A quality surety agent will be able toassist you in fi nding qualifi ed professionalsin the other areas of focus. Whenselecting the surety agent, inquire aboutmarkets that they represent, annualsurety premiums written, formal suretytraining, individual experience, andnumber of surety professionals on staff.It is important that they have a numberof qualifi ed professionals so that if anunforeseen incident occurs, you will nothave a change in service or a decline inexpertise.All of these professionals can workwith you to build an appropriate continuityplan for your hvacr company. Buysellagreements, key-man life insuranceand completion agreements with projectmanagers are some of the expectationsof the surety underwriter.Just like selecting quality manufacturersfor the components on one of yourhvacr installations, evaluate each professionalto be sure that you choose the onethat will work best for your organization.Be sure that they have a department thatspecializes in your industry, ask for referencesand verify the amount, as well asproportion of annual revenues that arederived from your industry.Once you put together the appropriateteam, build the blueprint and establishan appropriate bond program, yourdecisions will control the effectivenessof the program. If you invest in yourbusiness by leaving in profi ts and payingtaxes, the underwriting base willgrow, which will allow the program tobe expanded and thus improve the bottomline. Think of it as return on equity,which will likely exceed most investmentvehicles available. When you wantlarger projects, upgrade the fi nancialsto an audit and improve the quality ofyour continuity plan, which will makeyou more attractive to the larger suretycompanies. You may qualify for betterrates, as well. Approach this just as youdo when you look at a set of specifi cationsso that the blueprint, componentsand controls are integrated to maximizethe surety program for your hvacr constructioncompany. 

Kyp L. Ross is the president of ClevelandbasedDawson Insurance Inc., which is anindependent agency that focuses on the placementof surety and insurance programs forthe construction industry. You can contacthim at or440-333-9000, ext. 526.

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