Guest Author: Michael D. Lapre, SVP Surety Operations for NFP
For those unfamiliar with the term ‘bonding capacity’, it refers to the maximum level of security credit that any insurance company or surety company would be willing to offer a contractor who is applying for a bond. There are generally two ways that bonding capacity is expressed, the first of which is a single job limit, and the second being an aggregate limit.
A single job limit is related to the largest dollar value project that any surety company would be willing to back, whereas the aggregate limit refers to the maximum level of contract backlog that any contractor can be supported for. As one example, a contractor who had a $10 million single/$30 million aggregate limit, might reasonably expect that any bond requested of a surety for up to $10 million would be pre-approved. This course is assuming that the contract backlog which the company has at the time of bidding is $20 million or less.
Any job which would push the contracting company over the $30 million limit would have to be reviewed by the surety company before being approved. As can be seen from this scenario, the single and aggregate limits are not intended to be absolute restrictions on a contractor, but serve as convenient guidelines beyond which a review would be called for. The primary factors affecting bonding capacity are described below.
One of the primary factors which has an impact on a company’s bonding capacity is whether it shows a profit or not for a certain period of time prior to applying for a bond. A company which is unprofitable for a single year isn’t really a problem for a surety company, but a contractor who shows losses for several years running would definitely raise a red flag and call for a serious review. Any contractor applying for a surety bond would be well advised to control overhead costs and to build up a cash reserve, so as to ensure profitability before applying for a bond.
Surety companies will also pay close attention to the net worth of any bond applicant, and will almost always discount assets which are deemed to have a high level of risk, such as inventory or aged receivables. Surety companies also evaluate the distribution of assets in a company, because this can be a strong indicator of how functional it can be in the business landscape. A company whose assets are completely tied up in equipment for example, could not easily compete with rivals if their credit lines and cash reserve were depleted. Companies with strong level of working capital are always given preferential treatment in terms of bonding capacity, as opposed to those having relatively low levels of working capital.
Cash flow is another major component of establishing a high level of bonding capacity, especially since the majority of surety losses are directly attributable to a contractor’s cash flow shortage, and eventual failure. When contractors have sufficient cash flow to complete a job, the likelihood is that there will be no claims made against the bond, whereas a cash flow shortage is very likely to lead to unfinished project work. When this happens, it becomes the responsibility of a surety company to step in and either retain another contractor to finish the work, or to pay off subcontractors and other individuals working on the project.
One other factor which has a major impact on bonding capacity is the level of work in process that a company has, as well as how accurate those WIP estimates really are. When WIP estimates are inaccurate, a contractor can frequently experience ups and downs in job profitability, which will wreak havoc with financial statements. This will also cause a surety company to lose confidence in a contractor’s ability to estimate work-related factors, and that would downgrade their bonding capacity. This stands to reason, since no surety company wants to support a specific contractor showing a solid financial statement, and then have a flood of losses showing up immediately afterward. This situation will almost always result in a downgrade of bonding capacity, and very likely a corresponding reduction in the contractor’s overall bond-worthiness as well.
Under-billing and over-billing
Most construction companies are obliged to recognize income in terms of percentage of completion. This is a calculation which determines if a specific contractor has under-billed or over-billed on any given project undertaken. Over-billing generally means the contractor is using the owner’s working capital rather than his own, and it’s considered a sign of good cash management. However, a struggling contractor can resort to over-billing as a means of acquiring cash on one job to fund overruns or losses on another job.
In an under-billing situation, the contractor will usually not have billed the owner enough, relative to the completion percentage. This could mean that a job is not as profitable as it was projected to be, and the original gross profit was overstated. Regardless of the cause, under-billing is generally not a good sign of cash management, and when under-billings reach the level of 25% of working capital, it becomes a red flag to surety companies, which will always result in a reduced bonding capacity.
About the Author:
MICHAEL D. LAPRE
SVP, Surety Operations
Mike established a Surety & Specialty Commercial Lines Insurance Agency known as Lapre Insurance & Surety, in 1984. The Surety program expanded to a national level in 1996, at which time Mike became licensed in all 50 states. Now with NFP, Mike oversees the bonding department. NFP operates nationally and represents many of the Nation’s top Insurance Carriers. We specialize in construction bonds.