All seems calm at the moment but surety companies are bracing for losses in the next 3 years. While 2000-2004 were loser years, sureties have experienced record profitability from 2005 to present. The culination was in 2008 where the industry as a whole had only a 10% loss ratio! Current looses are about 30% but still at a profitable level. The US trend looks to be that GC's are requiring more bonds of their subcontractors and when private work returns many of those jobs will be bonded. In light of the current economic conditions, sureties will begin to scrutinize operations closely and assess whenever they can continue to offer credit for future projects.
Bonds are typically looked at as unsecured credit. The bank has first position liens on all collateral from hard assets to accounts receivable and contractor's equipment. Unlike traditional insurance that charges a premium commiserate with expected losses, the surety's 1-2% fee is a charge for underwriting. They theoretically underwrite to a zero loss ratio and do not expect to ever have to pay a claim.
Being privy to loss data from their vast base of contractors, patterns emerge and losses can be attributed to a few basic things:
• Cash Flow deficiency and insufficiency Working Capital
• Working out of Territory
• Diversion of funds to "non-project" purposes
• Taking a job that's over 2 times your greatest job-to-date
Bond companies tend to look at a company's balance sheet from a liquidation value standpoint. That being said, let's talk about one of the most important items surety underwriters analyze – Working Capital. Working Capital is such a critical number because it's a measure of how much available cash the contractor has to pay it's workers, buy supplies and the ability to withstand the timing differences between sending out an invoice and getting the cash back in the bank. Working capital is defined simply as Current Assets minus Current Liabilities. Underwriters will not count everything on your balance sheet as a current asset. They classify current assets as cash, liquid investments, collectable A / R, 50% of your inventory, any under-billings (Under-billing's CAN be a red flag and signal an unapproved changed orders or work that will not turn into billable items) , cash value of a life insurance policy and the current portion of a note (loan) due back to the company.
Any pre-paid expenses or intangible assets will not be counted in the equation. The difference of that equation should be 10% of your "cost to complete" which can be found on your WIP (work in Progress) schedule. Cost to Complete is that number that says if you had to write a check to cover the cost of each one of your jobs right now (bonded and un-bonded) what would that number be? If your "cost to complete" was $ 1,200,000.00 then ideally the company should have $ 120,000.00 in working capital. That also equates to a single bond limit of about $ 1,200,000.00 – $ 1,500,000.00 (still using the 10% rule). For general contractors and heavy equipment contractors that number may go down to 5% because the GC and the excavator have a much smaller payroll burden on a $ 1,000,000.00 job than an electrical contractor who has a much higher salary for that same $ 1,000,000.00 job.
On a related note – the Small Business Administration (SBA) has a surety guarantee program much like their popular 504 loan guarantee package. Essentially they act as a re-insurer (80%) to the surety company issuing the bond. The bond is written on the insurance company's paper and the owner or GC is not privy to the guarantee of the SBA that is in the background. The beauty of this program is that the SBA will count any unused line of credit funds into the above working capital equation and do not care to much about net worth or some of the other ratios surety companies are looking for. This can be a very useful tool in today's environment where working capital is light but you may have some room on your line. For example if you need a $ 2,000,000.00 (which is the program's limit as of today) bond then you would need to show $ 200,000.00 in working capital which can include the unused balance on your line! There is a fee in addition to normal surety fees that goes to the SBA but its well worth it if you need that bond and are having trouble getting it through traditional channels.