Jeff C. Carey, MBA, CPCU, AFSB, CRIS
A historical look at the surety industry reveals an emphasis on prequalifying
contractors (principal) on their ability to successfully execute construction
contracts. Over time, sureties have fine-tuned their prequalification process as
project delivery methods have evolved. While standard construction remains their
focus, the emergence of design-build as a proven project delivery system has
changed the nature of the contracts sureties are being asked to support.
A performance bond is the surety product used to guarantee faithful performance
of a construction contract according to its terms and conditions. Traditionally,
these contracts, and therefore the guarantee provided by the performance bond,
were limited to physical construction. Design-build contracts now add the
element of design to coverage under the performance bond. While adding a design
element to the contract appears simple in nature, it can dramatically alter the
information used in the surety prequalification process.
The element of design subjects sureties to risks that are best addressed by
insurance products. Unlike insurance, the premiums paid for surety bonds do not
contain an allocation for anticipated losses. Premiums simply cover the cost of
prequalifying the principal. While surety premiums are higher for design-build
contracts, the added cost covers the expanded underwriting requirements, not
potential losses arising from design errors.
The prequalification process involves reviewing information specific to the
design-builder and the respective design-build contract. The first step is to
outline the type of design-entity (principal) taking on the project and its
contractual relationship. Possibilities include
- Construction firm with internal design team (or vice
versa)
- Design firm subcontracting or joint venturing with a
construction firm (or vice versa).
Regardless of the principal's structure, the same underwriting issues must be
addressed:
- Financial strength—Does the principal have substantial
liquidity and equity to absorb unforeseen problems during the project?
- Historical job performance—Does the principal have a
track record of profitability and strong job performance?
- Experience—What is the principal's experience with
projects of similar scope? Have the two parties worked together before and
was it a successful relationship?
- Reputation—How is the principal viewed by owners,
subcontractors, and vendors?
- Indemnity—Depending on the structure of the principal,
corporate and possibly personal indemnity will be required from one or both
participating entities to support bonding for the project
- Risk management—Has the principal obtained sufficient
insurance coverage to address its respective risks? Specifically, is there
sufficient professional liability coverage to address the design risk
associated with the contract?
Another aspect of the prequalification process involves a detailed review of
the project to be performed. Underwriting issues that must be addressed
regarding the project include, but are not limited to
- Scope of project—What is the nature of the design
called for under the contract?
- Size—What is the size of the project in relation to
the principal's experience?
- Duration—Does the project have a short timeframe?
- Contractual obligations—Damages, length of warranties,
hold harmless clauses, efficiency guarantees?
If, after review
of the information above, a surety is not comfortable with the design-build
contract structure, it may look to remove the design element from coverage under
the bond. Carving out the design element into a separate contract that does not
require a bond is the most common approach. However, regardless of the surety's
stance, this is not always an option. Owners can specifically require the bond
to cover performance of design and construction.
The design-build project delivery system has grown dramatically in popularity in
the last decade, and shows no signs of slowing. As a result, the need for surety
bonds to ensure the performance of these contracts has also grown. In response
to this, the surety industry has positioned itself to address the need. Bonding
smaller, less complex design-build contracts does not present the challenge it
once did. For example, a two-story office building does not present much design
or construction risk. An example on the other end of the spectrum would be a
design-build coal-fired power plant. Not only is it a very large, complex
project, but it must often operate at certain levels of efficiency. These levels
of operating efficiency can be guaranteed within the contract and covered under
a performance bond. Contracts of this nature better represent the challenge the
surety industry is currently trying to address. No two design-build contracts
are alike and each requires special attention. Working with a knowledgeable
surety bond producer and surety underwriter is crucial to gaining surety support
on design-build projects.
Related links
Surety Information Office
National Association of Surety Bond Producers