Handling Surety Claims

A surety bond is effectively a guarantee — quite different from an insurance policy. A surety bond involves three parties: the surety (insurance company), principal (contractor) and obligee (owner).

Many different types of surety bonds exist, but two produce about 95 per cent of all losses, Ted Baker, president of Baker, Bertrand, Chass & Goguen Claim Services Limited, told delegates at the Canadian Independent Adjusters’ Association’s annual conference in Montreal. A performance bond guarantees the performance of the principal contractor to an obligee owner. The labour and material payment bond, often referred to simply as a payment bond, is a guarantee that the subcontractors and creditors of the principal will be paid in the event of a default of the principal. “Behind both bonds is a construction contract,” Baker said. “That’s really what the bonds are attached to: They are guaranteeing the performance of your contractor in a contract to build buildings, to build things.”

Underwriting a surety bond

The underwriting of a surety bond is very subjective and completely up to the underwriter, because it is not actuarially driven, Baker said. An underwriter would look at the three C’s of suretyship: character, capacity and capital.

All of these factors are important, but the most important factor is the financial strength of the contractor, Baker pointed out. The underwriter must evaluate the contractor on those three C’s and then say either say ‘Yes, I support this,’ or ‘No, I do not.’

“Once you get in bed — and that’s not literally — with your contractor, the underwriter is in for a ride because he cannot stop issuing bonds,” Baker said. “A contractor that is bonded is getting work at a certain level. If you take the bonding away from him he won’t get work at that level. He won’t get the cash flow. So once you write a few bonds you’re with him. It takes an underwriter with big ones to bite the bullet and say no more.”

One basic premise of suretyship is that there’s supposed to be no losses. The whole idea is there is a backup when a bond is written for somebody. In theory, if the underwriter has a loss and has to pay, he can go to the principal and recover the cost. However that never works, because by then the principal is gone, Baker said. “I am standing here, 42 years in the business, as living proof that there are lots of losses.”

Handling a surety loss

Baker got a call in July 1993 from a surety underwriter about a problem with a general contractor. Matthews Construction, based in Mississauga, Ont., was the third-largest general contractor at that time. It had 104 bonded contracts and $300 million in work on hand. “They were in trouble,” Baker said. “The call I love. You’ve got to love this call because you know it’s going to get you six years’ work.”

Over the next three months Baker and his company analyzed the financial statements, looked at all the company’s jobs and came to the conclusion that for Matthews to survive, the company needed about $200 million in new work in the next 12 months at a 10 per cent margin just to service the debt. “Well that’s impossible,” Baker said. “You can’t get $200 million in new work in the next year unless you bid everything at a loss, which doesn’t help cause you might have cash flow but at the end of the day you’re bankrupt. And he never had 10 per cent margin in his life.”

During this time, the underwriter suspected the contractor was going to fail, but not want to be cited as the of the failure. The underwriter, therefore wrote three new large contracts, two for jobs the firm had never previously handled.

Basically, the underwriter lucked out, Baker noted. The bank decided it had had enough of Matthews’ financial condition and put in a receiver.

“We had prepared for this,” Baker said. “We had developed a game plan, because what are you going to do with 60 active jobs across Canada and about five in Texas? How do you handle all that?”

Matthews was going out of business; since it was a default, the surety is on the hook, Baker said.

Looking at the three C’s — character, capacity and capital — it was decided that the first two C’s were present in Matthews’ case: There was nothing wrong with Matthews’ work and there was nothing wrong with the superintendents, staff or the projects themselves. The only problem was the third C — the company was broke.

The surety on a performance bond has three basic options. One is to remedy the default and give money to the contractor, but there’s no limit on the bond then. Second, the bonding company can finish the job itself. Third, the jobs can be re-tendered. Since re-tendering 60 jobs would take years, it was decided the bonding company would finish the jobs.

Five separate companies were established. The superintendents from Matthews Construction took over ownership and these companies finished the jobs. The payment bond was used to cover the debt; subtrades and suppliers were paid immediately to finish the job at the original subcontract price.

One of the bank’s primary pieces of security is the receivable — i.e. work that’s been done on the job but not paid by the owners. “Those receivables were about $25 million,” Baker said. “We beat the bank to the receivables”

By having a good claim-handling strategy and experienced staff, a potential $100 million loss exposure was reduced to just under $20 million, and all bonded projects were finished on time.