The prospect of increases in bond prices is prompting a creeping unease among contractors. It’s time to confront the issue. Bonds are a key element of many projects; cost increases could have huge implications for a construction company’s bottom line. How likely are 100% bonds to be introduced? And should main contractors be preparing for the worst?
WHAT ARE SURETY BONDS AND WHY ARE THEY IN THE NEWS?
The surety bond has been around in one form or another since biblical times; its purpose is to provide protection for the employer under a contract. The bond itself is a written agreement that transfers the risk of contractor’s default to a third party – the surety. It guarantees to pay the direct loss suffered if a legal or contractual obligation has been breached. Usually, this breach occurs if the party responsible for these obligations becomes insolvent.
In the UK, owners or employers normally request bonds with a value of 10% of the project cost. However, following the unanticipated collapse of Carillion, some surety companies in the UK have been advocating 100% bonds.
This increase would match US construction industry practice. There, under the Miller Act, all federally funded work costing more than USD150, 000 has to be bonded for 100%.
WHY COULD BOND PRICES RISE?
Bond pricing – and the perceived inadequacy of 10% sureties - came to the fore following the liquidation of Carillion. No one anticipated the company’s collapse and with some of its contracts being of a significant amount, 10% of the contract value would not have been sufficient to meet the owner’s loss. Carillion’s everyday bonding needs are not known. However, the service support company provided a lot of performance bonds and offered parent company guarantees (PCGs).
While 100% bonding is feasible, the main hindrance to its implementation is the availability of bonds capacity in the UK, compared with the US. The US has more than 100 licensed surety companies. The UK has only 12, the majority of which have strict criteria about which companies they support. Currently, there is little interest in the SME market. Capacity issues would likely result if 100% bonding was introduced the UK.
BONDING: HOW THE COSTS COMPARE WORLDWIDE
In terms of costs, the US rating structure is unique and fairly complicated. The contract/bond is charged on a sliding scale basis initially for two years and monthly thereafter. In addition, the rate is determined by a number of factors. They include the strength of the surety, the nature of the work being undertaken and the state in which the work is being undertaken. For example, bonds in Texas tend to be more expensive than in Washington.
For the rest of the world, the usual practice is to ask for a 10% bond. But the pricing of any bonds excluding local taxes and other costs is at the discretion of the individual underwriting company.
If 100% bonding was to be introduced into the UK it’s likely there would need to be a fundamental change in the rating structure.
SURETY BONDS AND INSOLVENCY
In the US, the surety has ‘step-in-rights’ to take over the contract following a contractor’s insolvency. Instead of paying a sum of money to the employer, the surety manages the contract completion themselves. Again, the practice outside the US is different in that the surety pays a sum of money to the employer rather than getting involved in finishing a project.
WILL 100% BONDS BECOME THE NORM IN THE UK?
In summary, 100% bonding in the UK is unlikely. However, price is still an issue for larger projects. When PFI was a first introduced, banks often asked for 30%/35% performance bonds. For traditional contracts, the 10% sum will likely remain. However, prices could rise for larger projects, and there will be occasions where the employer might request 15% or 20% bonds.
A specialist construction insurance brokerage can advise further on bonding and related issues, plus all aspects of contractors insurance.
For further information about surety bonds, please contact Simon Lloyd-Evans, Head of Construction Surety at JLT Specialty on +44 (0)20 7528 4229 or email firstname.lastname@example.org.