What are surety bond risk factors?
The fundamental reason for the use of surety bonds in the construction sector is the risky nature of this industry. There are many reasons why construction contractors can experience problems leading to insolvency, rendering them incapable of fulfilling contractual commitments. It's important to realize that the majority of construction companies are small- or medium-sized businesses that are vulnerable to the many risk factors inherent to the construction industry. Here are a few examples:
- One or more errors in quoting a construction project, leading to a bid that is too low to complete the construction contract
- Poor project management resulting in inadequate monitoring of unforeseen construction costs, which in turn prevent the contractor from taking timely corrective measures
- Unexpected complications when carrying out the contract, such as soil conditions that are much more problematic than foreseen in the geotechnical study data
- Atmospheric conditions that can cause costly delays
- Prolonged strikes, if the contract does not provide for compensation in these situations
- Unavailability of material or tradespersons
- Incomplete or inaccurate estimates that can lead to additional costs that are difficult to recover
- Construction site conditions requiring construction methods that differ from those specified in the estimate and are more costly
- The client's insolvency owing to inadequate financing of the project or other projects experiencing difficulties
- Subcontractor insolvency and excess costs necessary for replacing them
- Problems if the bank decides to suspend or reduce the operating line of credit
- Illness or death of the principal shareholder or key person in the construction company
- Bad investments in sectors outside construction
- Disputes, unresolved notices of change, lack of cooperation among the contractor, engineer, architect and client.
Any of these reasons—and others—could lead to the insolvency of a construction contractor and cause default of a project. Many of these situations are beyond the contractor's control. This is why it is prudent for clients to protect themselves against the financial consequences of contractor default by insisting the contractor be bonded by an insurance company.
The consequences for clients
The consequences of contractor default resulting from insolvency are numerous for clients. Here are a few examples:
- If the uncompleted contract involves a building in the private sector, registering a hypothec will prevent the developer from receiving further construction loan disbursements.
- Various delays in the construction schedule of residential or commercial complexes can discourage potential buyers and tenants
- Unpaid subcontractors and suppliers can block the owner's efforts to have the work completed if they do not receive guarantees that their overdue accounts will be paid
- The costs of having the construction contract completed can become exorbitant and destroy the project's viability; they can even cause the owner's insolvency
- If the construction project is for industrial use, the schedule delay caused by the contractor's insolvency can lead to considerable costs in unrealized gains owing to the delay in getting the industrial complex into production
It is therefore useful for clients to remember that bonding contractors can minimize the risks of contractor default by having the contractor undergo a prequalification process. Surety bonds thus offer significant financial protection in the event of contractor default as well as requiring the bonding company to assume the administrative burden of making the arrangements to complete the work and settle the overdue accounts of subcontractors and suppliers. Clients, who are the obligees of the surety bond, therefore transfer to the bonding company a significant portion of their business risk associated with management of the project.