Surety Bonds &Construction Risk

Government of the Northwest Territories Project Management Conference Yellowknife

November 21, 2017

Objectives for Today To explain the surety bonding process in the context of ‘cradle to grave’ project planning and delivery. SAC’s objectives:

1. To provide an overview of how surety works in Canada – and why.

2. To relate the surety process to the risks of larger projects.

3. To learn from you about your perceptions and experience with surety bonding – and other forms of contract risk management

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Inscription found in the Temple of Apollo in Delphi Greece

I – THE SURETY INDUSTRY Surety Companies • SAC members write 95% + of all bonds in

Canada – There are hundreds of sureties listed on

OSFI’s website roster – fewer than 20 are SAC members and they write almost all the bonds

Surety Brokers • Look for SAC member brokers – they are

dedicated to providing superior service

I – Construction Risk

Construction Risk - what we mean Construction Risk = Risk of Contractor Failure. Ongoing global economic uncertainty. Surety Challenge: Uncertainty = more risk Economic factors now seem to be in a

permanent state of flux (e.g.) resource development drives much of the economy but volatility in every resource sector is the new normal (minerals; oil; gas)

The number and severity of contractor failures continues to be a concern across the country

Construction in Canada 2017 Canada will still have strong construction spending: Federal infrastructure commitment stretching over 10 yrs. Saskatchewan remains committed to infrastructure

spending 2015 - Canada was to go to 5th from 9th largest construction

market…how times change! foreign investment was the key; going elsewhere now

Larger and longer projects are a lasting legacy: Challenges to small and mid-sized contractors Challenges regionally – how to protect local contractors

without violating trade agreements (like NWPA)

Unqualified Contractors; the lowest “irresponsible” bidder

Insolvency of Contractor

Contractor default for non-financial reasons: Over Extension Inability to complete Incapacity of key people

Unpaid subs and suppliers resulting in liens

Warranty problems

Why Contractors Fail – some things don’t change

Construction Risk – Recent History From 2011-16, the Surety industry paid out almost $1B

in claims; more than the previous 10 yrs. 2013 a year to forget: Loss ratio = 52% - industry unprofitable; premiums flat

after two years of decline; affects all regions 2014 and 2015 record years: DWP (direct written

premium) closing $580M, loss ratio drops 30%+ 2017: a more positive trend; slight increase in DWP

and loss ratio now around 10% (abnormally low).

Note: The surety industry hitting new all-time highs for the value of contracts underwritten - $75B+

Options to Protect Against Construction Risk: Surety Bonds Performance Bonds Labour & Material Payment Bonds

Liquid Security Irrevocable Letters of Credit Cash/Negotiable instruments on Deposit

Subcontractor Default Insurance (SDI)

II – Surety Bonds What are They?

How do they Work?

Surety is not Insurance

Surety is not Insurance

INSURANCE Losses anticipated 2 party agreement;

Insured & Insurer Premiums actuarially

determined No recourse against

insured in the event of loss

SURETY No losses anticipated 3 party agreement;

Principal, Surety & Obligee

Premiums only a service charge

Recourse against the Principal via indemnity agreement

Surety Bonds: 3 Essential Services Prequalification:

Assurance that the bonded contractor is qualified for the job for which they are contracted.

Ongoing monitoring (and hidden services): Sureties monitor bonded contractors

continuously and can provide assistance if needed ($, technical support, accounting, etc.)

Security: Financial Protection in the event that the bonded

contractor should default on its obligation.

Prequalification

Intensive

Ongoing

Comprehensive

Value Added

Capital

Capacity

Character

Information a Surety Needs

Organization Structure

Key Employee Resumes Business Plan

Backlog Report

Financial Statements References

Contractors Profile

Bank Information (Underwriting Requirements)

What is a Surety ‘Facility’? After undergoing a thorough process of investigation

and discovery, qualified contractors are provided a Surety Facility

The facility is typically provided and reviewed annually; and monitored quarterly or more often Its parameters are set out in aggregate and

individual job limits (e.g.) the surety will back the contractor For a total (aggregate) amount of work at any one

time To a maximum job (contract) size of ‘x’ dollars

Surety pre-qualification isn’t superficial… (Site visit)

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Standard Construction Bonds Before Contract Award – Prequalification Prequalification Letter Bid Bond Consent of Surety

After Contract Award – Contract Security Performance Bond (Covers normal contracts,

spanning 1-2 year construction period.) • Renewable Multi-Year Bonds (For longer term

service contracts, like snow-clearing or refuse collection/recycling.)

Labour & Material Payment Bond

Prequalification Letter Not a bond but a letter from a bonding company to

the project owner confirming “bondability”.

Used during the pre-tender phase; (i.e.) before contract terms, scope or pricing details are known.

Non-binding – surety and principal reserve the right to review the details before firm commitment.

Typically refers to the project at hand.

SAC standard form available on SAC website.

Bid Bonds protection from the “lowest irresponsible bidder”

provide assurance that contractor will: enter into the contract provide the required security

typically required in the amount of 10% of tender

if contractor defaults, surety pays the difference between successful bid and second bidder

tender must be accepted within time frame set out in tender documents

seven months to file suit

Consent of Surety Not a bond at all; a letter of commitment from the

Surety to the Obligee to execute performance and/or payment bonds No penal sum set out; payment not an option

Typically, bonds must be required within 30 days

following award No standard (CCDC) form in existence, many

variations in wording

Performance Bonds Guarantees that the Contractor will perform the

contract in accordance with its terms & conditions. To claim on the bond: Contractor must be in default and the default must be

declared Owner must perform their obligations 4 options available to Surety: Remedy the default Complete the Contract Arrange for new contractor to complete Tender Payment

Two years to file suit

Labour &Material Payment Bonds Guarantee that the contractor will pay all direct

subcontractors, suppliers for materials and services provided to bonded project. (Note: “Broad form” bonds are becoming common and protect two tiers) Obligee is trustee on behalf of the claimants Claimant must have written contract with the Principal

(or the Principal’s direct sub-contractor for broad forms) Claimants may only claim for goods and services

supplied to the bonded job Claim must be filed within 120 days of the last day

worked or the date material shipped One year to file suit

Make sure to ask for the L&M Payment Bond!

It’s better when trades and suppliers are paid – especially on publicly funded jobs

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SAC supports CCDC Documents Successful Track Record: legal precedents

have been established – this clarity provides more certainty (less litigation, reduced costs).

Fairness: balance the needs of all parties to the construction process – as all sectors are represented on the

Explicitness: clearly states the rights and obligations of the Principal, Obligee and Surety

Note: The latest CCDC bond forms (the first since 2002) should be released later this year

III – Surety Myths & Misconceptions

Myth #2: A 50% Bonds only provide 50% Protection 50 percent bond gives you 100 percent protection up to the bond amount

Example:

Contract Price = $ 1 million 50 % Performance bond ($500,000) Contract is 50% complete Surety arranges completion for $ 700,000 Surety’s loss is ???

Myths & Misconceptions

Myth #3: Bonds are a “Barrier” (especially to small contractors).

Barrier? Bonding companies need to write bonds.

Sometimes a time problem – for contractors without a surety it takes time to establish a facility.

Some sureties will only bond small contractors, others have small contractor divisions

Small firms will secure bonding for jobs within their realm of expertise

Bonds are only a barrier to unqualified contractors

Myths & Misconceptions

IV – Surety Bonds What Happens when a

Contractor Defaults?

Keep the Surety informed!

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Before a Default is Declared Surety has extensive experience with contracts

and solving construction problems.

Surety has intimate knowledge of the contractor and its operation

Can provide informal assistance to solve problems that can lead to a default

Will convene meeting or teleconference among the parties to address problems.

Assist in formalizing solutions.

Claims When A Contractor Defaults:

Surety will promptly acknowledge notice of default and begin to gather information.

Surety will commence the investigation as soon as possible.

Surety will conclude the investigation as soon as possible.

If requested by the owner, surety will provide periodic written updates on investigation status and best estimates as to completion date.

During and After the Investigation:

Surety will cooperate with the owner to protect work from damage or deterioration.

Surety will work with the owner to: Identify and implement a solution. Minimize delays, keep the job going and

protect the rights of all parties. Pay valid labour and material payment

bond claims as promptly as possible to ensure continuity of subs and suppliers.

Claims

How the Project Owner can help Comply with bond & contract terms! (e.g.

proper notifications, payments and certifications)

Communicate: keep surety appraised of problems and provide default notice promptly.

Cooperate: Ensure surety has access to knowledgeable staff and relevant documents.

Keep expectations realistic.

By the way…claims are expensive

SAC estimates that an average construction contract loss is on the order of 50% of contract value; and over half that amount is paid out under the L&M Payment bond.

This is based on a study done by BBBG, a major surety claims management company, some years ago

VI - Other Forms of Contract Security

Liquid Security (ILoCs)

Yield cash; not performance

Provide no prequalification assurance

Available in smaller; perhaps insufficient amounts (5% to 10%) Recall, a typical default: 50% of contract value

Upon default – you ‘own the problem’ No surety support to bring in replacement

contractor(s) or to assist with resolving the myriad issues around payment, scheduling, monitoring, etc.

Liquid Security (ILoCs) cont’d…

Some other considerations when using ILoCs:

Deplete a contractor’s borrowing power and can bring on the very problem they seek to avoid

Provide no dedicated payment protection for subs or suppliers This is a growing issue everywhere,

especially for public/quasi-public agencies Can be especially problematic in rural and

remote area

Subcontractor Default Insurance

Introduced in 1996 to protect very large general contractors from subcontractor default. Indemnity product – compensates the GC for loss incurred Significant deductibles and co-payment Only available to the largest GCs (in-house construction

admin experience and strong cash flow) – but even they are new to underwriting NOT designed to protect owners from risks associated

with default of prime contractor Note that one of the largest public procurers in Alberta

has specified that subs must be given the option to post bonds if the GC wants to put the job under SDI (Subguard)

VII – e-Bonding

Did someone mention “paperless” ??!!!

Issues and Challenges Commercial Legal Technological SAC has worked to define and explain the

issues & challenges over the past seven years or more

Electronic Delivery of Bonds

E-Bonding For years e-tendering and e-bonding was the

train that never ‘left the station’

However, this has changed, with e-tendering and e-bonding spreading rapidly in the West, and at the federal level (DCC)

Three e-bonding suppliers are active now: Mobile Bonds, Xenix, and Infinite Source (for users of Bid Central in BC, and CoolNet in AB)

VIII – New & Improved… What’s the Latest in the World

of Surety Bonds?

New Surety Products – The Business Case Surety bonds have been around forever – but they are being asked to respond to new procurement methods and changing needs of owners

The surety industry has a well earned reputation as conservative and cautious Underwriting new and different risks requires new

knowledge and data – which is often lacking

Remember the unique surety value proposition: it always strive to provide true performance security; i.e. providing owners with a completed project in the event of default (including payment protection for subs and suppliers)

The case for new products – cont’d…

As well, there are new realities for owners and contractors (e.g.)

Owners want more control in default situations (schedules, replacement contractors)

Lenders need assurance that big projects won’t be held up due to a default of a key trade or supplier

Some contracts (like road maintenance) need to be much longer – five years or more is common

SAC Code of Best Practices (2016)

Sets out standards of professionalism for a surety’s response to a performance bond claim.

Provides Obligees with a guide to what it can expect when claiming under a performance bond.

Incorporates enhanced process bond form principles: Prompt Resolution Pre- and post-default meetings at the call of the

owner Standards of professional conduct in claims

handling

SURETY ONLINE LEARNING CENTRE The Surety Online Learning Centre accessible from

SAC website; www.suretycanada.com.

Five learning modules that introduce the basics of surety bonds and the suretyship process

Learn at your own pace.

Ideal for review or for colleagues who can’t attend a “live” information session.

It’s FREE

Contact Us Bob Sloat, Director Business Development, Western Canada Phone: 778-995-6585 / 403-612-4070 email: bsloat@suretycanada.com or visit our www.suretycanada.com website: