Colorado Contractors Need to Educate Themselves About the Changing Surety Bond Market

By Lee Hill Marsh

Most contractors have likely heard of surety bonds but may not be familiar with the implications and obligations they carry for everyone involved with them. Required for all construction projects, surety bonding guarantees to a third party that a contractor will fulfill an obligation it has made with the owner.

In the construction industry, this product is primarily used with contractors working on a site according to the specifications of the project owner. It's important to note that surety bonds are not insurance, but rather a guarantee that identifies contractors with the ability, resources and determination to complete the projects for which they have been hired.

If a contractor does not fulfill its bonded obligation, the company hiring that contractor can make a claim demanding that the surety company satisfy the obligation or pay the bond penalty. General contractors also require proof of surety bonding from their subcontractors so they can be reassured of the subcontractor's performance and financial credentials.

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Dramatic Changes

However, the surety industry has changed dramatically in the past three years. Local factors directly impact Colorado-based construction companies' ability to obtain this requirement for public works contractors. National factors such as reinsurance costs, stock market performance and the underwriting results of primary sureties also impact the ability of companies to obtain bid, performance and payment bonds.

In Colorado, smaller contractors sometimes have difficulty obtaining surety bonding before bidding on a project. This is not because they're not capable business operators, but more because the surety-issuing company has seen a trend of smaller companies defaulting on projects, thus raising surety costs even higher.

So smaller contractors are often not able to bid on major projects - which are frequently public works projects. This was especially true during the construction of Denver International Airport.

Obtaining affordable surety bonding became even more challenging after Sept. 11, 2001. Events such as the rapid deceleration of larger construction firms to maintain volume and margin; the collapse of large firms like Enron, Adelphia Communications and K-Mart; and the insurance crisis resulting from Sept. 11 contributed almost overnight to a 180-degree change in insurers' appetites for risk. More importantly, the support of reinsurance companies for surety business declined.

Historically, Colorado companies with bond needs less than $10 million - either single or in the aggregate, offering small- to medium-sized risk - were quite popular. Surety companies servicing this sector of the business never quit their primary role of underwriting to a profit.

However, in the go-go surety environment of 1988-2000, larger companies were thought to be bulletproof. Terms and conditions, especially indemnity, subcontractor bonding and pricing were tossed aside for market share. The "perfect storm" of 2001 reversed that trend.

Stock Market Failure

On a national level, the failure of the stock market to offset unprecedented losses with superior rates of return exacerbated the situation. Before 2000, most surety underwriters had been able to justify their underwriting results and rates of return to the insurance hosts.

With large national firms such as those noted above having tendered contractual responsibility to their sureties - and therefore to the surety backers, the surety reinsurers - the capacity glut overnight turned into a capacity crunch. The estimated number of surety reinsurers has reportedly shrunk from perhaps two dozen to no more than 12 or 14.

Larger construction companies that for decades had been serviced by their underwriters for bonding were told either to look elsewhere for support or to find additional co-surety underwriters as insurance companies suddenly looked at their aggregate exposures for possibly the first time. Pricing, service turnaround and ease of doing business changed.

A Hard Market

Some Colorado contractors are genuinely surprised at the existence of the "hard market." Those contractors with sales volumes of $30 million or less may have seen a 10-20 percent price hike for their bonds over the past 18 months, but many report business as usual.

Most construction shareholders have been asked to support their credit facility with their personal indemnity, which surety underwriters tossed out in the competitive 1990s. Most importantly, most Colorado construction companies have seen more of their bond underwriters in the last 18 months than in the previous five years.

With Colorado expected to see a continued commercial building slowdown, and with housing construction slowing, lenders will again be more fundamental as well.
Because T-REX has absorbed a disproportionate share of the CDOT budget, expect tough sledding with the highway and heavy engineering group, at least in the short term.

As you navigate your way through this economy, be sure to stay close to your surety credit professionals - including brokers, bankers, CPAs, attorneys and business advisers. They may be able to save you the pain of hearing your bond underwriter say:
"We're sorry, but we can't support you on that project."

Minimizing Risk

However, there are some things that construction contractors can do to minimize the risk of not securing surety bonding: