Bonding - Not Insurance!

Transcription

1 Bonding - Not Insurance!

2 BONDING NOT INSURANCE Robin Federici, CPCU, AAI, ARM, AINS, AIS, CPIW

3 SURETY A written contract surety guarantees can not be done orally One party guarantees another's performance If the party defaults, a third party is indemnified

4 BOND TYPES Two Basic Types: Contract surety bond - guarantees the performance of a bonded contractor Commercial surety bond - guarantees performance in situations that arise from other than contracts

5 PARTIES TO THE BOND Three Parties: Principal (obligor) - the party that is bonded & their performance is guaranteed Obligee will receive the benefits of the bond if the principal defaults Surety is providing the guarantee to the obligee

6 THE BOND Through this agreement, the surety agrees to uphold for the benefit of the obligee the contractual promises (obligations) made by the principal if the principal fails to uphold its promises to the obligee.

7 BOND CHARACTERISTICS 1. Surety must respond 2. Surety vouches for the principal 3. Bond terminates when the obligation is performed 4. Bond penalty 5. Premium 6. Bond must be in writing

8 BOND CHARACTERISTICS Surety must respond: Principal fails to fulfill obligation Surety may either: Fulfill obligation Pay the loss up to the bond penalty BUT... This isn t insurance. The principal must reimburse the surety! This right of reimbursement is granted to the surety by common law subrogation.

9 BOND CHARACTERISTICS Surety vouches for principal: Bonds are issued to principals that can meet the promised obligation Financially healthy to pay expenses while performing & are capable to repay the surety if they default Surety vouching for the principal s: Integrity Capability Trustworthiness Financial Responsibility

10 BOND CHARACTERISTICS Surety vouches for the principal: 3 underwriting C s: Character Capacity Capital

11 SURETY EXPECTS NO LOSSES- 3 Cs OF UNDERWRITING 1. Principals CHARACTER 2. CAPACITY does the principal have the resource (ability & knowledge) to complete the obligation? 3. CAPITAL a thorough financial analysis will determine if the principal has enough funds and credit to finance the project and all other ongoing work. ***Sureties sometime require that the principal post collateral equal to all or part of the bond penalty

12 BOND CHARACTERISTICS If the principal fails to perform & a loss occurs: The surety may be able to reduce the loss by exercising its rights Which include the right to recover its loss payment from the principal Also, the right to recover from other indemnitors through the salvage efforts

13 COLLATERAL A surety may require the posting of collateral equal to or part of the bond penalty: Using collateral may result in a premium credit because it reduces the surety s loss exposure, however The credit is often offset by the higher administration costs (service charge) imposed by the surety for handling the collateral

14 COLLATERAL The surety may require collateral from the principal: Letter of Credit may require certain wording Investment Securities may want a cushion to hedge against possible adverse market reactions CD/Savings Accounts - need an agreement on accrued interest on who will benefit Physically delivered collateral surety executes a collateral agreement

15 COLLATERAL - BTW Collateral is not a panacea: Wont make an unacceptable principal acceptable Posting collateral may cost the surety in time & expense Posting collateral may deprive the principal of needed funds

16 BOND CHARACTERISTICS Termination: The bonds usually terminate when the principal has fulfilled its obligation A bond may guarantee an obligation that extends over many years Some surety bonds can be in force for an indeterminate period Some bonds are cancellable and require that the surety give the obligee notice

17 BOND CHARACTERISTICS Penalty (penal amount): Bond limit of liability Maximum the surety is obligated to pay Some bonds may include payment of court costs or interest on judgment exceeding bond penalty

18 BOND CHARACTERISTICS Premium: Represents the price of the surety s obligation If the premium is not paid the surety can not avoid its obligation Obligee is guaranteed protection

19 BOND CHARACTERISTICS Must be in Writing: As a contract of guaranty promise to be responsible for the debt or default of another a surety bond is subject to the statute of frauds and other common law requirements

20 COMMERCIAL Bond Types License & Permit: Are a means of regulation A source of revenue

21 COMMERCIAL Bond Types License & Permit General Issues: Often the license/permit will not be issued until a bond is furnished to the appropriate public entity Since most are statutory they contain language reflecting the requirements of the underlying statutes Whether the bonds can be cancelled depends on the statute or the bond form cancellation provision

22 COMMERCIAL Bond Types License Bonds Many businesses need a license to operate Surplus Lines Brokers Electricians Plumbers HVAC Contractors Grocery Stores Hairdressers

23 COMMERCIAL Bond Types Permit Bonds: Often they are needed as a prerequisite for performing special functions that are incidental to business operations, such as: Permit to use public park for a social event Permit for a sign or canopy to extend over public property

24 COMMERCIAL Bond Types Public Official (Non-Federal) : Duties vary by position All, however, must act in good faith & obligated to faithfully discharge their duties to best of their ability When they hold public funds they have a duty to honestly account for & turn them over to their successors

25 COMMERCIAL Bond Types Public Official (Non-Federal) : They are held personally accountable for losses, shortages, and damages to public property Some are also held accountable for the acts or omissions of those that are their subordinates

26 COMMERCIAL Bond Types Public Official Two Types: Honesty: carry out their duties Faithful Performance: held liable if they fail to faithfully protect the public interest

27 COMMERCIAL Bond Types Public Official - examples: Honesty: The treasurer will account for the money he/she holds Faithful Performance: The treasurer could be held liable if tax collections were deposited in a non-interest bearing account rather than in investments that would increase revenue

28 COMMERCIAL Bond Types Public Official - examples: Administrative Handling Public Funds Involved with members of the public

29 COMMERCIAL Bond Types Public Official - examples: Two bonds that are considered hazardous : Those that handle their duties carelessly: Administrative: Town managers, commissioners, assessors, and town clerks Handling Public Funds: Tax collectors and state treasurers Those involved with members of the public: Deputies, marshals, constables, sheriffs & public notaries

30 COMMERCIAL Bond Types Court: Guarantee that the principal will perform duties as outlined by law or the court Some bonds guarantee that the principal will demonstrate financial responsibility for another s benefit until a court decision is reached Usually are non-cancelable & continuous

31 COURT BONDS Judicial arise out of litigation & required by the court Posted by the party seeking or appealing a remedy Obligee = the court for the benefit of the other party Fiduciary - arising out of CCC of another parties property Remain in force until: Applicable proceedings are completed The principal and surety are released by the court

32 COMMERCIAL Bond Types MISCELLANEOUS A class of bonds that do not fit any specific bond category Because of the specific nature of each bond obligation, each individual bond form must be reviewed Review the bond form to check for possible onerous provisions that may be objected to by the surety or principal

33 Bond Types CONTRACT Two broad purposes: 1. Vouch for the principals ability to perform 2. Guarantee either performance or indemnification if the principal defaults

34 CONTRACT Bond Types CONTRACT BONDS Bid Bond - If awarded the bid, will enter into the contract & will furnish all required bonds Performance Bond - Project will be completed on time and as outlined in the contract including within the agreed price Payment Bond - Bills for labor & material will be paid Maintenance Bond -Contractor will correct faulty work & replace defective material for a specified period of time

35 BONDS FINANCIAL PICTURE The surety will require time to adequately review the financial picture of the contractor before they commit to issuing a bond(s) The surety will require that a variety of financial reports are provided during the underwriting process

36 BONDS FINANCIAL PICTURE The types of financial documents that most will require include: Expense & income in excess of billings Billings in excess of expenses and income Ageing of accounts receivable and payable Earned income Schedule of general and administrative expenses Gross profit and loss

37 BONDS CONTRACTORS ACCOUNTING METHODS Completed Contract Method Percentage of Completion Method

38 CONTRACTORS ACCOUNTING METHODS Completed Contract Method: If at the end of the business fiscal year of a company work on a contract remains incomplete, no revenue, expenses, and profit on that contract is recognized in the current year on the income statement; all costs and billings are accumulated in respective balance sheet accounts.

39 CONTRACTORS ACCOUNTING METHODS Completed Contract Method: Generally this method of accounting may be used by contractors averaging less than $10 million in annual revenues if it is initially elected as their tax accounting method.

40 CONTRACTORS ACCOUNTING METHODS Advantage Completed Contract Method: This method includes a tax advantage. No taxes are due until the income is recognized on the income statement. Defers a large tax bill on large projects allowing the contractor temporary use of these unpaid tax dollars Disadvantage Financial statements due not accurately reflect the financial effects of work

41 CONTRACTORS ACCOUNTING METHODS Percentage of Completion Method Generally the required method of larger construction companies Attempts to recognize revenues and gross profit in the applicable periods of construction The degree of completion (the percentage-ofcompletion) is typically estimated by dividing the total construction costs incurred to date by the total estimated costs of the contract, or job.

42 CONTRACTORS ACCOUNTING METHODS Percentage of Completion Method Advantage More accurately reflects the contractors financial condition Disadvantage Relies on the contractors ability to estimate the cost to complete the project Only produces an accurate picture when the income and expenses are reasonably dependable

43 BONDS FINANCIAL STATEMENTS Audited by an independent CPA Review Statements Compilation Statements

44 BONDS Audited by an independent CPA Financial statements are prepared and certified by a Certified Public Accountant (the auditor). The CPA certifies that the financial statements meet the requirements of the U.S. GAAP. An auditor can have an unqualified opinion - agrees with how the company prepared the statements, or a qualified opinion - states which aspects of the statements he/she does not agree with.

45 BONDS REVIEW STATEMENTS Reviewed Statements require that the CPA perform inquiry and analytical procedures A report is issued stating that a review has been performed in accordance with AICPA professional standards The CPA is not aware of any material modifications required for the statements to be in conformity with GAAP This is known as the expression of "limited assurance."

46 BONDS COMPILATION STATEMENT Represents the most basic level of CPA service the CPA must comply with certain basic requirements of professional standards: knowledge of the client's industry and Have read the financial statements to determine whether there are any obvious departures from generally accepted accounting principles

47 BONDS Personal Indemnity Agreements A contractor may provide these signed agreements to strengthen the financial health of a contracting firm. They may make the account more agreeable to the underwriter

48 BONDS Personal Indemnity Agreements Contractors wealth must be easily verifiable Sureties want a contractor with liquidity Liquidity is the key liquid assets are those that are easily convertible to cash

49 BONDS Personal Indemnity Agreements Acceptable liquid assets include: Good quality stock Savings accounts Bonds Accounts receivable

50 BONDS Parent Indemnity Agreements Often required in addition to Personal Indemnity agreement The parent company, of the principal, provides assurance to the surety that they will be held financially responsible if the principal defaults

51 BONDS Contract Status Reports When the contractor does not use the Percentage of Completion Method for accounting purposes. These reports are known as: Work-on-hand reports Work-in-progress reports Uncompleted contract reports

52 BONDS Contract Status Reports Key component is the cost to complete: The cost to complete process determines the percentage of completion for uncompleted projects The cost to complete is based on a comparison of the actual costs incurred with total estimated cost.

53 BONDS Contract Status Reports These Contract Status Reports may include: A description of the contract The contract price Original estimated gross profit (loss) Current estimated gross profit (loss) Billings to date Direct costs incurred to date Excess of billings over costs Excess of costs over billings Current estimate of direct cost-to-complete Estimated date of completion

54 BONDS BACKGROUND INVESTIGATION Since the surety is guaranteeing the contractor is capable of fulfilling the contractual obligation, an investigation of the contractors past is critical to the underwriting process

55 BONDS CREDIT ANALYSIS Written credit analysis of the contractor s qualifications should be clear, concise, and comprehensive It should indicate the strengths and weaknesses relative to each item reported

56 BONDS CREDIT ANALYSIS A history of the company Information on the organization Management history & knowledge Any outside member of the firm s management team accountants, attorneys, bankers, etc. The type of work the contractor has done in the past and the present Their performance record on past obligations

57 BONDS CREDIT ANALYSIS Financial performance and current condition Five year financial trend Bidding history Current work projects Desired work projects Future work prospects Trade and bank credit relationships

58 BONDS OTHER INFORMATION It may be necessary to sell an underwriter on a contractor To that end, the underwriter may require more comprehensive information to make an informed decision

59 BONDS OTHER INFORMATION Business plan Type of work currently performed How this work is obtained Where the contractor operates What are the future growth and profit goals

60 BONDS OTHER INFORMATION Description of jobs: What was the largest job recently completed. This would include contact information on the project owner, general contractor, etc. The contract price The date completed The gross profit

61 BONDS OTHER INFORMATION Perpetuation plans if the owner or key employees died or were disabled References from subcontractors and suppliers Evidence of lines of credit Letters of recommendation Indemnity agreements Job site visits

62 ROBIN FEDERICI, CPCU, AAI, ARM, AINS, AIS, CPIW