How surety bonds deliver for taxpayers

Foundational value: Surety firms truly want to help insurance agents with clients who need to be bonded.

Surety bonds provide unique and significant value to society. (Credit: Vitalii Vodolazskyi/Adobe Stock)

What exactly are surety bonds?

The Surety and Fidelity Association of America notes: “A surety bond is a written agreement, often required by law, to guarantee performance or payment of another company’s obligation under a separate contract or compliance with a law or regulation.”

A contract surety bond is a tri-party agreement among a principal (such as a general contractor), the surety company, and the obligee (the government agency, private developer, or project owner that is funding a construction project). Typically, the obligee requires the principal to purchase a surety bond as a condition of the contract for the construction project.

Everyone benefits

Surety is probably underappreciated by the public and even some insurance professionals who are otherwise knowledgeable about the insurance business. As a surety professional, it has always been my responsibility to share how surety bonds work and what value they deliver.

There is an underlying beneficiary to every surety bond. Frequently, that’s the American taxpayer. Construction of public infrastructure projects such as highways, bridges, tunnels, buildings, parks and other building projects are funded by tax revenue. For privately funded projects, beneficiaries are the owners and lenders of projects.

There are other beneficiaries. With each performance bond, a payment bond is issued. The payment bond provides a guaranty of payment to the subcontractors, material suppliers and laborers who contribute to public projects. Because these parties cannot place a lien on a public project, the payment bond is a vital backstop to their contribution to public works. The surety sees the performance and payment bond as one obligation.

When a surety company underwrites a bond for a contractor, it’s making a pledge. It’s a public statement that the surety has taken a thorough, dispassionate review of the contractor being engaged for the project. After that review, the surety in essence says: “We’ve looked into each aspect we can think of to determine whether that contractor can complete a contract or not. We believe they can.”

Of course, at times, underwriting discipline requires not issuing a surety bond for the financial protection of all parties. This prequalification process is the backbone and mainstay of surety underwriting.

Stepping in to assist

In spite of the prequalification process, the unforeseen default does happen on occasion. As an example of the value of surety, a contractor defaulted on a bridge construction project in the Southeast. The surety had to step in to engage a completion contractor to get the project done.

Without  the surety bond claims process, the state highway division would have had to rebid the project under a new contract at additional cost beyond what the defaulted contractor had bid. The surety brings its expertise in re-procurement to relet the remaining scope of work to a qualified takeover contractor in a short space of time and at no additional cost to the state highway division. A surety bond saved the taxpayers of North Carolina the financial risk of the project. Surety makes the taxpayers whole.

The value of surety was highlighted by a study, “The economic value of surety bonds,” conducted by EY for the Surety & Fidelity Association of America (SFAA). The key finding: “Bonded portfolios of projects generally outperform non-bonded portfolios of projects.”

The study listed three economic benefits of surety bonds:

Put it another way: Unbonded contractors and unbonded jobs have a higher default rate. That’s because no one with underwriting expertise reviewed the contractor to ask: Can the firm actually complete the project or not? That is the proud job of surety experts: asking that question.

The process of bonding a project is valuable — first with a bid bond (issued to support a contractor in bidding the job) and then with a final performance and payment bonds (issued when work is about to begin).

The fact that a surety company has issued the final bonds means the surety is standing behind that contractor, a meaningful statement to the project owner, the obligee that is requiring the bond.

By reviewing projects, operations and financial statements, the surety industry helps guide contractors to more informed choices.

Helping contractors grow

Most contractors start out as small family-owned operations targeting quarter-million-dollar projects or smaller. They don’t start off landing $5 million jobs. Over time, they gain a foothold with jobs of increasing size, perhaps getting to the half-million or million-dollar level.

The process of applying for a bond helps those growing contractors evolve in their approach to risk management. Moreover, small but growing contractors can turn to surety pros for help as they tackle larger, more complex jobs. Insights from an agent or surety underwriter might lead a contractor to upgrade its financial presentation to financial statements certified by a tax professional. In turn, that might lead to the accounting firm improving the contractor’s internal cost reporting processes. And surety professionals might suggest additional risk management  measures such as requiring subcontractors to provide subcontract bonds as the scope of work grows to greater levels of complexity.

Sureties are valuable partners to contractors as they change and grow over time to meet their challenges and aspirations.

Taxpayer protections in jeopardy

As a surety “cheerleader,” naturally I think more, not fewer, projects should be bonded. But in some states, regulators are trying to increase the threshold for bonds. One threshold being sought in some jurisdictions is half a million dollars. As a taxpayer (and surety professional), it concerns me that the exposure for projects of that size is now being shifted onto taxpayers. I don’t think folks should be happy about that.

Yes, it’s appropriate to have a minimal threshold, but I would argue it’s more rational that as many projects as possible should be bonded.

Independent agents are part of the surety team

Independent agents should realize that surety firms truly want to help agents with their clients who need to be bonded.

One of the pleasures of the surety business is seeing experienced insurance agents bring an opportunity to a surety company, asking: “How can we get this done?” We start the process of providing them information, educating them and helping them solve the surety risk for their client.

Seeing the light come on for that agent, watching them exponentially increase their understanding of surety, is nothing short of satisfying.

John Estes (jestes@orsurety.com) is Branch Manager in Charlotte, N.C. for Old Republic Surety Co. Any opinions expressed here are the author’s own.

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