After a recent discussion with a contractor who was expanding their business into the Municipal focus, it came to my attention how appropriate it would be to have a discussion of “bonds” in relation to my own experience in banking and insurance. The reason I feel it is so appropriate is that my focus on Risk Management delves into the areas of risk, identification of your risk, transfer mechanisms to reduce your risk, etc.
By “bond”, I don’t mean to refer to debt instruments that one might invest into or have issued as a source of capital but Construction Bonding or Surety that includes Bid Bonds, Performance Bonds, Labour & Material Payment, Maintenance, etc. This is a legal “guarantee” from the surety company but not every insurance company issues surety instruments and any business should be assured that the surety company is expert in this area. My own preference (this is personal preference) is to have an “A” rated carrier or better (as provided by firms like AM Best, Standard & Poor’s, Moody’s, etc.). Those rating agencies review closely the financial capabilities of the firms issuing a guarantee and, if you’re relying on another party to “guarantee” payment, does it not make sense to know they will be in business to meet all the terms and conditions of the risk transfer mechanism?
Insurance is a legal contract (a “policy”) that transfers risk of a loss to a third party (the insurance company, for simplicity sake) who will reimburse you for a financial loss that has been detailed in your written contract. Contracts can be used for various types of risk reduction but insurance is a specific type that permits reimbursement following a loss. Other types of contracts that might mean a reduced need for insurance include an Indemnification Agreement, a Lease or an Insurance Certificate where you may be named as an Additional Insured, etc.
In Banking, a Line of Credit is an Agreement between you and a Lender that permits your business to draw down against a pre-arranged approved limit of funds for various reasons. The Line has to be repaid, within certain conditions, and brings many legal requirements with it. Unfortunately, many businesses don’t pay close enough attention to all the legal terms within their “agreements” with the bank and, often, when needing to make a draw will be unable due to the demands of the lender. I have seen many businesses expect to draw upon their Line and be told “NO”.
What about a Surety Instrument? A “surety” is difficult to explain without trying to draw comparisons that are better understood. A Line of Credit is an agreement between you and the bank and an insurance policy is an indemnification agreement between you and the insurance company to repay for a loss upon pre-agreed conditions. A surety is an agreement between you, the bonding company and another party. It provides for pre-qualifying, project monitoring, security, etc. to the party contracting to a contractor and guarantees you will meet the commitments you promised and that were ultimately accepted by the other party to your contract.
A government, whether municipal or any other level, will require as part of the Request for Proposal (RFP) process that contractors “bid” for a job. Following the review of all bids approval of one bid is made. What if the contractor is unable to meet the agreed-upon conditions following winning their bid? This is the reason that contractors request a surety or a Bid Bond because the Bank might offer a Line of Credit for “X” dollars but may not advance funds as needed. Contractors are likely to need a Bid Bond for Sewer and Watermain Construction, Roadwork, etc. but what about guaranteeing their “performance” after they do win any bid? Well, another surety instrument is the Performance Bond which will guarantee to the government agency the completion of the construction project. Any agency asking for “bids” on a project will also require guarantee of performance following the awarding of any contract. Usually, the Bid Bond and the Performance Bond go hand-in-hand because what good is it to anyone to request a Bid Bond but not qualify for a Performance Bond, right?
The financial requirements, in requesting a surety bond, will be quite similar to asking a bank for a line of credit – preparing an application, submitting personal and corporate financial information, disclosing details you might prefer not to tell anyone but still must. The time frame will be similar in the processing and approval of the request and surety companies must also have strong financial statements with expert underwriters so don’t think it is any easier or very different from dealing with a bank. As for your insurance broker/partner, yes, I do use the word “partner”, please ensure it is someone you trust with this very private financial information and someone who understands and relates to both you and the underwriter. This is one area in which I do have difficulty because too many competitors lack this expertise but are still successful in placing business due to the “trust” placed in them. Privacy of information, now, is almost a given due to legal requirements but do those individuals understand your finances and can they work with you to your satisfaction?
I hope I have given a general idea of what you should know concerning what a surety bond is and how it can be used to your benefit. If not, please feel free to contact me on Twitter @WRiskManager
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