David Hartman, Director, Analytics, IFIC Surety; and Michelle Savage, VP, Communication, XBRL US
In 2017, direct premiums written by sureties rose to $6.2 billion, from $5.9 billion in the prior year, according to the Surety & Fidelity Association of America (SFAA). The most recent industry loss ratio reported by SFAA is 15.5% (from 2016). Conversely, the most recently reported (2017) loss and premium data in the property/casualty business, reported by the Insurance Information Institute, suggests a loss ratio of over 60%.
The numbers show that most contractors do an excellent job meeting their obligations. However, in the complex and often unpredictable world of contracting, things can go wrong. Jobs are underbid. Cash flow becomes stretched. Weather does not always cooperate. Accidents happen. Deliveries get delayed. Critical permits get held up. Materials cost more than expected.
When a project is bonded, the surety must be prepared to answer the call in the event that a subcontractor or vendor complains about not having been paid; or a project owner is concerned that job performance is not up to snuff, or that the project will not be completed on time or within budget.
Data standards can help ease that process by making more actionable, timely, functional data available for the in-depth analysis that must be conducted whenever a claims call comes in.
What does the surety bond promise?
A surety bond is a contract between three parties: the Obligee: the party who is the recipient of an obligation; the Principal: the primary party who will perform the contractual obligation; and the Surety: who assures the obligee that the principal can perform the task. The surety bond represents a promise by the surety to pay up to a certain amount if the principal fails to meet some obligation, such as not completing a job on time or within budget, failing to pay subcontractors and material suppliers timely, or performing faulty or shoddy work. Unlike an insurance policy, losses paid against a surety bond are expected to be reimbursed by the principal. Sureties generally require an indemnity agreement to be signed by the principal, along with potentially other entities or individuals, to prescribe numerous rights of the surety.
How do sureties monitor the contractors they bond?
Once a bond is written, the financial health of the contractor continues to be monitored. Periodically, at quarterly or six-month intervals, financial information, including the Work-in-Process (WIP) report, is submitted to the surety by the principal.
How are claims initiated and processed?
When there is a problem with a project, the surety may be alerted by a subcontractor or a material supplier, or by the obligee. Periodically, the principal may reach out to the surety to advise of ongoing cash flow issues that may be hindering project completion.
The surety responds by requesting documentation about the issue from the materials supplier or subcontractor. They also contact the principal, often through their bond agent, to let them know there is a problem. In some cases, the surety might request a meeting to assess the financials which is allowed under a common clause in most indemnity agreements. This clause allows the surety to conduct a “books and records review”, gaining access to a myriad of documents, instruments, papers, books of account, financial statements, tax records, files and data, and other documents used in, or associated with, the business.
Commonly requested items would include the most recent internally generated income statement and balance sheet, plus an updated WIP report. The surety might also ask for the most recent payment application for bonded projects, the Accounts Payable (A/P) and Accounts Receivable (A/R) schedules by job, a bank agreement if the contractor has a line of credit, plus verification of bank statements, and other documents.
Data extracted from these documents serve as important inputs to the surety claims processor’s financial model, which help the surety understand issues that reflect on the financial health of the contractor such as:
- What does the contractor have in Accounts Receivable by job?
- What is the level of retainage for each job? (the portion of the agreed upon contract price deliberately withheld until the work is substantially complete to assure that a principal or subcontractor will satisfy its obligations and complete a construction project)
- What work remains to be performed?
- What is the remaining cost to complete?
- Are there any potential claims or liquidated damages that may be assessed against the principal?
Data to answer these critical questions may be pulled from the WIP report, the principal’s financial statements, the A/P and A/R schedules, the payment applications, and other documents collected.
One very manual time drain for the surety can be the importing of the WIP data which must often be manually keyed into the analyst’s financial model. WIP data for a principal’s operations can take hours to enter into the claims model, depending on the number of jobs, and whether the analysis includes both bonded and non-bonded jobs. Additionally, because of the time-sensitive nature of the claims investigation, the manual rekeying is generally performed by a financial analyst. Manual data entry is a waste of time and company money, has the potential for human error in transposition of the numbers, and takes time that could be invested in analysis rather than data entry.
At the same time the financial analysis is underway, the surety’s claims attorneys start a dialogue with the obligee and the principal. The team may be expanded to include a staff (or consulting) engineer or project manager who can best assess what work still needs to be performed on the project. The goal of the team (attorney, financial analyst, engineer/project manager), is to estimate the potential losses to the surety under various assumptions by comparing money expected to be collected, to money expected to be spent over the remaining life of the project.
To calculate these estimates on the revenue side, accounts receivable, retainage, remaining contract balance, and potential affirmative claims are assessed. On the cost side, the team sums up the accounts payable by job, the cost to complete, and any liquidated damages that are expected to be assessed. This allows the surety to identify the potential magnitude of any losses going forward. The team also evaluates other resources the contractor may have. Do they have a line of credit with a bank? What kind of financial network do they have that can be called upon for help? This analysis is important to setting reserves and ultimately making the right decisions about the account.
With the data and analysis in hand, the claims team has discussions with internal underwriting, with the contractor’s bond agents, and then schedules a meeting with the principal.
How could standards improve claims processing?
The hours-long process conducted today to extract revenue, cost and profit data from a WIP report and financials could potentially be reduced to a matter of minutes through adopted data standards. Analysts would have more time available to review and assess the implications of the numbers, rather than spending so much time on data entry. That would ultimately help all parties involved:
- The principal (contractor) would gain from having problems identified and resolved faster, improving their relationship with the obligee, and subcontractors and materials suppliers they will likely need to continue working with, and/or will likely want to call upon for future projects.
- The obligee would have the problem rectified and their project would move forward faster.
- Subcontractors and materials suppliers would receive more timely payment for services rendered.
- The surety would be able to eliminate the inefficient process of manual data processing, a task today performed by highly skilled staff.
The XBRL US Surety Working Group has created an initial release of a Work in Process Taxonomy, with digitized terms created to represent costs, revenues, and profits of individual contractor projects. The group has also developed a draft taxonomy release to represent Contractor Financials, specifically the income statement and balance sheet. These taxonomies can be easily mapped into a surety carriers internal financial system so that they can accept standardized, structured data reports for the WIP and contractor financial statements.
Processing surety bond claims is yet another example of how financial data standards can make the surety industry more efficient and effective at delivering their promise to project owners.
