Broker Q&A: Surety Bonding in the Construction Industry

A Surety Bond is a guarantee, provided by a financial institution, guaranteeing that contractual obligations will be met. If these obligations are not met, then there is a sum of money available to the employer to ensure the contract is completed.

Unlike an insurance policy, a bond is an agreement between three parties – the contractor, the employer (who is the beneficiary of the bond) and the bondsman. Also, insurance policies can be cancelled whereas most bonds cannot. It is there to provide certainty and a protection to the employer. Bonds are prevalent in the construction industry due to the costs involved in replacing a contractor if the original contractor fails to perform, most typically because of insolvency.

The most common type of bond is the ‘Performance Bond’ which, in the UK, is typically for 10% of the contract amount and is used to guarantee completion of the contract.

Other bonds in the industry are ‘Advance Payment Bonds’ which are used when a large sum of money is paid up front to help mobilise the contract and will provide the employer with the comfort that this money will be used appropriately as per the contractual terms. These bonds are typically anywhere from 10-30% depending on the sum advanced. A ‘Retention Bond’ is also often used as a way to release the monies held on retention until the contract is completed. The bond enables the employer to release the retentions thereby freeing up valuable working capital to the contractor.

Larger contractors, typically in the FTSE250, can also access other forms of bonds to replace letters of credit which may be used to guarantee pension deficit contributions or insurance deductibles.

This is really a two-stage process. First and foremost a bond ‘facility’ must be set up. This is an uncommitted line of credit that contractors can then utilise to apply for their individual bond requirements. To set a facility up and then to keep it live, the surety underwriters will need to undertake a full financial assessment and due diligence of the contractor (and the group which it may belong to). Underwriters will need to review the latest annual and management accounts, cash flow forecast, work in progress reports, bank facility and they are also likely to require a meeting at least once a year with the group FD or Head of Treasury.

Once the facility is set up and the counter indemnity is in place (more about that later), the underwriters will need to assess each and every new bond application. Underwriters are looking to see that the new contract fits within the contractors ‘sweet spot’ and that they are not taking on something they won’t be able to handle. Size of the contract, estimated duration and the bond wording are key. They will also often want to review the contract to check there is nothing too onerous or obligations that should be excluded under the bond.

Bonds offered by the bank are usually fully secured against the company assets and have a direct impact on a contractors’ working capital facility. The wordings can be onerous, on-demand, with no room for negotiation leaving the contractor potentially exposed in the event of a claim with little defence regardless of how the contract is performing.

By contrast, a bond from the insurance market is ‘off balance sheet’ and is usually not secured beyond a group counter indemnity.

The bond wording issued by an insurance company is usually ‘conditional’ whereby the employer needs to demonstrate that it has suffered damages as a result of contractor default before a claim is successful, ensuring the contractor retains the benefit of the contractual terms and conditions that it negotiated before signing the contract. Pricing is surprisingly similar with insurance companies being very competitive even though they often do not have the same security as the banks.

The counter indemnity is the form of security required by the insurance company which enables them to issue bonds for the contractor. Essentially, this is a document issued by the contractor (or the group of companies the contractor belongs to), promising to hold the bondsman harmless in the event of a claim or potential claim. The aim of the bondsman is to ensure that it ranks alongside other unsecured creditors in the event of contractor default and has a right to recourse in the event of a claim. As mentioned previously, banks have a much stronger indemnity by having charges over group assets and the ability to pay claims with immediate recourse.

Going direct to an insurance company can work if they provide plenty of capacity and if the contractor is sure they are offering the best price whilst also being commercial with decisions around bond wording. However, utilising a specialist surety broker such as Gallagher’s provides market oversight and a view of the entire regulated surety market. Gallagher’s surety team has a vast and in-depth knowledge of the surety market plus relationships with key underwriters and decision makers to ensure our clients have the necessary capacity and suitable terms available, to help clients when tendering for contracts. We also help our clients manage their capacity effectively and provide assistance and advice on bond and indemnity wordings.

It is certainly not an easy time to be a surety underwriter. The Coronavirus crisis could not have come at a worse time for many sureties on the back of a dismal 2019 and will fuel uncertainty for months ahead. Additional questions are being asked around order book, project delays and the resulting impact on cash flow. Underwriters had still been feeling the effects from Carillion’s demise in 2018 and the resulting struggles of contractors in the supply chain. Sureties (and banks) have also been hit hard by several large travel bond claims, in particular Thomas Cook, as companies across all sectors struggle with cash flow and liquidity. On a more positive note, there have been some new entrants to the surety market which should help provide some much needed capacity. As banks tighten their belts and restrict credit limits there has never been a better time to appoint a specialist surety broker to ensure adequate bonding capacity is available when tendering or negotiating new contracts.