Surety bonds – a crucial part of any development
I’ll wager that few in the property industry know much about surety bonds, but no development could take place without this specialist service. To find out more, I met Paul Farrar, General Manager with Advent Risk Management and a recognised expert in the area.
There are two main types of surety bonds. Under a building contract, the main contractor is usually required to produce a performance bond. This covers the employer for the additional cost of completing a project, if the contractor fails to do so. If the contractor fails, the employer usually re-tenders the job, and the extra cost of completing it, including increased building costs and fees, are paid by the insurer, under the bond value. Bonds generally cover between 10 and 15pc of the original contract price, which is the usual range of loss.
The recent history of the surety bond market in Ireland is interesting. Some insurers suffered losses estimated at approximately €100m, arising from the failure of several large Irish contractors. Much of these losses were suffered by UK insurers, who promptly exited the market. They were then replaced by other overseas insurers, who also suffered losses and subsequently withdrew. Paul Farrar puts those losses partially down to the difficulty in assessing local risk from a long distance.
Seeing an opportunity, Farrar and others worked with Advent Insurance DAC, now a leading player in the sector, and one which has written bonds for projects with a value of over €1bn this year.
Farrar told me that they assess the risk attached to the contractor, under the headings of ‘character, capital and capacity’. Questions asked include: ‘does the contractor have the resources to complete this project, and, have they built this type of building before, or are they over-stretching themselves?’. According to Farrar, if a contractor passes the scrutiny of a professional-surety underwriter, then there should be very few defaults.
That said, Farrar told me that they assume one major loss every five to seven years. Advent has had one claim in the last five years, and Farrar says that diversity of risk is part of the insurer’s strategy. Advent Insurance DAC ‘lay off ’ about half of their risk, with international investment-grade reinsurers.
Conversely, a contractor should ideally have some form of payment guarantee from the employer, although, as Farrar points out, this is not written into the building contract, and it’s ‘caveat emptor’.
“The contractor has to assess the employer,” he told me. “For example, is it an Irish shelfcompany, funded by a hedge fund in New York, through a bank in London?” Some contractors are good at this according to Farrar, but others are “going in blind” and “not everyone has learned the lessons of the past”.
A weakness in the system, Farrar suggests, is that building contracts don’t require the passing of any credit test, a minimum worth, or a minimum credit rating, and this is leading to contracts being awarded to companies which do not always have the capacity to complete them.
The second type of bond in the market is a development bond, which is a surety provided by a developer, in favour of a local authority, to cover costs in the event that the developer fails to complete works required under conditions in a planning permission. This typically covers areas such as roads, lighting and drainage. Again, Farrar tells me there is a lot of money tied up under these bonds. From my experience, developers often complain that local authorities are slow to release these bonds, whilst the developer is covering maintenance and risk. Conversely, local authorities have been caught out, where they released bonds and then discovered that works had not been completed.
Paul Farrar believes most companies could do more to improve their credit rating.
“The weaker your credit rating, the more expensive it is to get bonding, and the greater the pressure on your cash-flow,” he says.