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A performance bond underwriting process of any kind has two main goals:
- Assessing the risk of the contractor incurring claims if approved for a performance bond, and
- Assessing the financial risk to the bond’s guarantor in the event of claims against the bond.
The results of this underwriting assessment determine whether an applicant is approved for a performance bond and, if so, how much the contractor will pay for the bond.
How Performance Bonds Work
These underwriting goals are derived from the way that performance bonds work in the construction industry.
First, understand that performance bonds provide financial protection for the project owner (the “obligee”) requiring the bond, not for the contractor. A performance bond is a pledge by the contractor (the bond’s “principal”) to complete the work specified in the construction contract in accordance with the law, and the terms of the contract and of the surety bond agreement. Any violation by the principal that causes a financial loss for the obligee can result in the obligee filing a claim against the bond.
For example, a contractor may become insolvent and default on the contract, or fail to complete the job to the obligee’s satisfaction for some other reason. In such cases, the obligee can seek to recover monetary damages or have the bond’s guarantor (the “surety”) get the job completed at no additional cost to the obligee.
Second, although the principal is legally obligated to pay any claim the surety finds to be valid, the surety guarantees that valid claims will be paid. To honor that guarantee, the surety will often extend credit to the principal for the purpose of paying a claim. To expedite resolution of the matter, the surety will pay the claim initially, on behalf of the principal, thus creating a debt that the principal subsequently must repay to the surety. The premium rate the principal will pay for a performance bond will reflect the underwriting assessment of the overall risk, along with the risk of the surety having to take legal action against the principal if that becomes necessary to recover the amount of the claim.
The Basis of a Performance Bond Underwriting Process
Any contractor applying for a performance bond will need to provide certain information and documentation to the surety for underwriting purposes.
Contractor’s Background and Legal Status
When first establishing a relationship with a surety and/or applying for a performance bond, a contractor will need to specify:
- The type of legal entity (e.g., sole proprietorship, partnership, limited corporation, C-corporation, S-corporation)
- Ownership of the contracting business
- Location and geographic territory
- Relative percentage of work for public and private project owners
- Relative percentage of work as prime contractor vs. subcontracting
- Percentage of work requiring bonding
- How subcontractors are selected
- Typical job size and duration
Recent Job History
Performance bond underwriters typically will want the details about the contractor’s largest recently completed jobs, including:
- Contract price
- Final gross profit margin
- Completion date
- Any job losses
Be prepared to provide an organizational chart and such details as:
- Key management personnel and their ownership interests in the company
- Copies of management agreements
- Resumes showing qualifications of key management personnel
- Current responsibilities for estimating, project management, contract negotiation, field operations, personnel management, administration, etc.
- Continuity plan, life insurance policies, etc. to ensure smooth transition if there is a transfer of ownership
Business Plan and Financials
There is a list of financial documents and information the underwriters may want to review to do a thorough underwriting risk evaluation, including:
- The past 3 years of CPA or internally prepared financial statements (balance sheet and P&L reports)
- Personal financial statement
- Current work-in-progress, accounts receivable aging summary and other pertinent financial information
How Much Do Performance Bonds Cost?
The surety’s underwriters will evaluate the risk associated with establishing a new relationship with a contractor, granting additional credit to an existing client relative to the amount of credit requested. The premium rate assigned will reflect the degree of perceived risk. Low risk typically earns a contractor a low premium rate, perhaps as low as 0.75% to 1%. A contractor who presents a higher degree of risk will be assigned a higher premium rate to help mitigate the risk to the surety, potentially as high as 2.5% to 3%.
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