GOVERNMENT CONTRACTOR RISK MANAGEMENT
Risk Management is a broad term that can be used to describe any number of methods of avoiding financial and/or physical loss. Some of the different types of Risk Management include: Avoidance, Retention, Risk Transfer, and Insurance. In developing and executing a Risk Management plan, most Government Contractors (GCs) will employ several of these methods at one time or another. Each method presents its own set of issues which should be carefully reviewed and understood.
Perhaps more than any other method outlined above, the Insurance Risk Management method is commonly, and frequently, the most misunderstood. Many companies feel they have adequate protection in place when they do not (there are coverage gaps in their policies); others are unaware of the exclusions contained in some of their existing policies; and many companies are simply paying too much for the insurance they are already purchasing.
HOW ARE GOVERNMENT CONTRACTORS DIFFERENT?
(to an insurance underwriter)
Insurance underwriters are concerned with the following:
Perils – causes of loss (example: fire);
Hazards – conditions that increase perils (example: frayed wiring);
Exposures – being exposed to certain perils (example: an office located next to a foundry would have a higher than normal exposure to the peril of fire); and,
Policy Language – both what is covered and what is excluded
Premium - what is the expected loss ratio for a given class and what is the required premium to offset the anticipated losses?
There are several unique aspects of the world of Government Contracting that justify treating Government Contractors somewhat differently from similar companies whose clients are commercial entities. Performing an identical task, with the same employees and tools of performance (computers, forklifts, etc.), for a Government customer creates a different exposure to risk than if the customer is a commercial entity (banks, hospitals, small businesses, etc.). From the perspective of the insurance and risk management professional, the underwriting, loss control, and claims procedures and philosophies that work with insureds that have commercial customers must sometimes be modified if the customer of an insured is a U.S. Federal Government agency. Unfortunately, many Government Contractors appear to do work that can frighten off an insurance underwriter. (A perception of too many exposures to loss.)
Why is there a material difference in the exposures of Government Contractors? Some of the reasons include:
· The terms and conditions of federal contracts vary from that of commercial contracts, and the contractor may have little, if any, control over that language. Best practices for contract risk management are different in the Government world and, thankfully, better in many instances.
· The law behind federal contracts and the history of litigation over those contracts creates a different legal environment for GCs, as compared to a contractor in a dispute with a commercial customer.
· The ways in which federal programs are funded, and contractors are paid for their performance, can vary from the world of commercial work.
· The federal Government is immune from suits by private parties in a wide variety of circumstances, and contractors performing the work of the federal Government can enjoy that immunity as well (the Government Contractor Defense or “GCD”). The GCD is especially important to understand when underwriting contractors to Federal agencies such as the Dept. of Defense, the Dept. of Homeland Security, intelligence agencies, or NASA.
· Some of the work performed by GCs is rarely, if ever, analogous to commercial work – e.g. designing weapons systems or performing work for intelligence agencies – and can be regarded, at first, as high hazard from an underwriting perspective.
· The competitive environment for GCs can be markedly different than contractors with commercial customers. For example, a GC may compete with another GC to be the prime on a contract, lose the competition, and then be a sub to the winning prime. Government contract awards can be protested by losing bidders in a manner unique from the commercial world.
· The methodologies used by the federal Government to pay GCs, and the standards for record keeping and accounting, can vary from the commercial world.
For all of these reasons, Government Contractors are often assigned a ‘high risk profile’ with resultant higher insurance costs because the nature of their business is misunderstood by most insurance brokers and insurance underwriters. In reality, in many instances, the most typical insurance claims and losses are less likely to occur with Government Contractors than with commercial-based companies. Hence, there is a basis for a lower risk profile, meaning better terms and lower costs.
Timothy J. Hutton, AFSB, CPCU
(703) 220 - 7771
timothyjhutton@gmail.com
tim.hutton@usi.biz
Tuesday, June 30, 2009
State & Local Contracts – Understanding Surety Bond Requirements
In order to succeed in any given business environment, contractors must be uniquely aware of the peculiarities of a given market. The State & Local Government marketplace is no exception to this rule. Within the State & Local Government marketplace, contractors are likely to encounter a contractual requirement that they do not often face in the private marketplace: a surety requirement.
Unlike customers within the private marketplace, many states and local governments are required by local codes/ordinances to require bid and performance guarantees in the form of surety bonds. In order to best understand how to meet these various surety requirements, contractors should become well versed in the language of surety bonding and fully understand why bonds are required and how sureties underwrite surety bonds.
A surety bond is a three party agreement between:
1. Obligee
2. Principal
3. Surety.
In exchange for a fee and a ‘hold-harmless’/indemnity agreement from the Principal to the Surety, the Surety agrees that, in the event of a default on the part of the Principal, the Surety is required to perform the terms of the contract between the Principal and Obligee. Each party to this three party agreement has unique roles, rights, and responsibilities.
Obligee – The Obligee is the entity protected by the Surety bond against loss. The surety bond ‘runs to’ the Obligee and the Obligee has the ability to set the language of the surety bond.
Principal – The Principal is the entity obligated, with the Surety, to the Obligee. The Principal pays the fee for the bond and, via the indemnity agreement, holds the Surety harmless for its failure to perform the terms of the contract.
Surety – The Surety is the entity obligated, with the Principal, to the Obligee. Generally*, the Surety is an unsecured creditor relying only upon the ‘promise to be made whole’ contained in the indemnity agreement. (*Surety does have a security interest in receivables and equipment on bonded jobs.)
The most common surety requirements faced by contractors operating within the State & Local Government Marketplace are bid, performance, and payment bond requirements.
Bid Bond – A surety bond given by a bidder on a contract; it guarantees that the bidder, should they be selected, will enter into the contract and furnish the prescribed performance bond. The bid bond is usually a small percentage of the overall contract.
Performance Bond – A surety bond which guarantees faithful performance of the terms of a written contract. Performance Bond amounts can vary from 100% of contract price to a smaller percentage of the contract price. (Performance bonds frequently incorporate Labor and Material and Maintenance liability.)
Payment/Labor and Material Bond – A surety bond given by a contractor to guarantee payment for the labor and material used in the work which he is obligated to perform under the contract.
As mentioned above, Obligees within the State & Local market are frequently required by law to require surety bonds from contractors bidding on public work. From the Obligee’s standpoint, the benefits of requiring surety bonds are numerous. For example, through the requirement of a bid bond, the Obligee ensures that only qualified bidders will bid the job and, if a low bidder ‘walks away’ from their bid and does not enter into a contract with the Obligee, the Obligee recovers the bid penalty which will cover the costs of rebidding the job. The second benefit enjoyed by the Obligee through the surety requirements is that of prequalification. By requiring bid and performance bonds, the Obligee ‘pushes off’ to the Surety industry, the necessary prequalification work that must be undertaken to ensure that a given contractor has the capacity to perform the given task. In this example, the surety requirements are like ‘hurdles’ put in place by the Obligee; only those contractors able to clear the ‘hurdles’ are deemed capable to work for the Obilgee. Lastly, and perhaps most importantly, through requiring a Performance Bond, the Obligee protects the public from the downside risk of contractor failure. Should a bonded contractor fail to perform the terms of the bonded contract, the Surety is required to perform on behalf of the defaulted Principal. Therefore, the public funds are protected and the project is guaranteed to be completed as contracted.
When underwriting a given contractor, the Surety will examine the contractor’s character, capacity, and capital. (This is commonly referred to as the three C’s of surety underwriting.)
Character – Does the contractor have a good reputation as an upstanding business?
Capacity – Does the contractor have the capacity to perform the contract? Have they done this work before? Have they successfully handled a job of similar size?
Capital – Should the contractor default, is there sufficient capital ($$$) within the company to make the surety whole for the costs they will incur to remedy the contractor’s default?
Insurance policies are underwritten with the expectation that losses will occur and the premium charged for the policy contains a provision for expected these losses. Unlike insurance underwriting, the surety underwrites to a zero loss ratio. If the surety underwriter can not become satisfied with the contractor’s character, capacity or capital, he/she will simply decline to offer surety credit.
In order to establish a bond line with a surety market, contractors should work with an experienced surety agent that will assist them in demonstrating to the surety markets that the contractor has the aforementioned 3 C’s required to gain the surety’s approval. Basic underwriting information required includes several years of CPA prepared financial statements, background materials on the contractor, as well as scope of work/rfp’s for the bonded job(s) in question.
The contractors that view their surety as an important member of their ‘team’ will enjoy more success and bond approvals than those that treat the surety as an outsider or a ‘necessary evil’ within the State & Local Government marketplace. Not only will the surety be more responsive to their needs and requests, however, the contractor can and should use a strong surety relationship as a competitive advantage over their competitors that may not be as readily ‘bondable’.
Timothy J. Hutton, CPCU, AFSB
Cell: 703-220-7771
timothyjhutton@gmail.com
Unlike customers within the private marketplace, many states and local governments are required by local codes/ordinances to require bid and performance guarantees in the form of surety bonds. In order to best understand how to meet these various surety requirements, contractors should become well versed in the language of surety bonding and fully understand why bonds are required and how sureties underwrite surety bonds.
A surety bond is a three party agreement between:
1. Obligee
2. Principal
3. Surety.
In exchange for a fee and a ‘hold-harmless’/indemnity agreement from the Principal to the Surety, the Surety agrees that, in the event of a default on the part of the Principal, the Surety is required to perform the terms of the contract between the Principal and Obligee. Each party to this three party agreement has unique roles, rights, and responsibilities.
Obligee – The Obligee is the entity protected by the Surety bond against loss. The surety bond ‘runs to’ the Obligee and the Obligee has the ability to set the language of the surety bond.
Principal – The Principal is the entity obligated, with the Surety, to the Obligee. The Principal pays the fee for the bond and, via the indemnity agreement, holds the Surety harmless for its failure to perform the terms of the contract.
Surety – The Surety is the entity obligated, with the Principal, to the Obligee. Generally*, the Surety is an unsecured creditor relying only upon the ‘promise to be made whole’ contained in the indemnity agreement. (*Surety does have a security interest in receivables and equipment on bonded jobs.)
The most common surety requirements faced by contractors operating within the State & Local Government Marketplace are bid, performance, and payment bond requirements.
Bid Bond – A surety bond given by a bidder on a contract; it guarantees that the bidder, should they be selected, will enter into the contract and furnish the prescribed performance bond. The bid bond is usually a small percentage of the overall contract.
Performance Bond – A surety bond which guarantees faithful performance of the terms of a written contract. Performance Bond amounts can vary from 100% of contract price to a smaller percentage of the contract price. (Performance bonds frequently incorporate Labor and Material and Maintenance liability.)
Payment/Labor and Material Bond – A surety bond given by a contractor to guarantee payment for the labor and material used in the work which he is obligated to perform under the contract.
As mentioned above, Obligees within the State & Local market are frequently required by law to require surety bonds from contractors bidding on public work. From the Obligee’s standpoint, the benefits of requiring surety bonds are numerous. For example, through the requirement of a bid bond, the Obligee ensures that only qualified bidders will bid the job and, if a low bidder ‘walks away’ from their bid and does not enter into a contract with the Obligee, the Obligee recovers the bid penalty which will cover the costs of rebidding the job. The second benefit enjoyed by the Obligee through the surety requirements is that of prequalification. By requiring bid and performance bonds, the Obligee ‘pushes off’ to the Surety industry, the necessary prequalification work that must be undertaken to ensure that a given contractor has the capacity to perform the given task. In this example, the surety requirements are like ‘hurdles’ put in place by the Obligee; only those contractors able to clear the ‘hurdles’ are deemed capable to work for the Obilgee. Lastly, and perhaps most importantly, through requiring a Performance Bond, the Obligee protects the public from the downside risk of contractor failure. Should a bonded contractor fail to perform the terms of the bonded contract, the Surety is required to perform on behalf of the defaulted Principal. Therefore, the public funds are protected and the project is guaranteed to be completed as contracted.
When underwriting a given contractor, the Surety will examine the contractor’s character, capacity, and capital. (This is commonly referred to as the three C’s of surety underwriting.)
Character – Does the contractor have a good reputation as an upstanding business?
Capacity – Does the contractor have the capacity to perform the contract? Have they done this work before? Have they successfully handled a job of similar size?
Capital – Should the contractor default, is there sufficient capital ($$$) within the company to make the surety whole for the costs they will incur to remedy the contractor’s default?
Insurance policies are underwritten with the expectation that losses will occur and the premium charged for the policy contains a provision for expected these losses. Unlike insurance underwriting, the surety underwrites to a zero loss ratio. If the surety underwriter can not become satisfied with the contractor’s character, capacity or capital, he/she will simply decline to offer surety credit.
In order to establish a bond line with a surety market, contractors should work with an experienced surety agent that will assist them in demonstrating to the surety markets that the contractor has the aforementioned 3 C’s required to gain the surety’s approval. Basic underwriting information required includes several years of CPA prepared financial statements, background materials on the contractor, as well as scope of work/rfp’s for the bonded job(s) in question.
The contractors that view their surety as an important member of their ‘team’ will enjoy more success and bond approvals than those that treat the surety as an outsider or a ‘necessary evil’ within the State & Local Government marketplace. Not only will the surety be more responsive to their needs and requests, however, the contractor can and should use a strong surety relationship as a competitive advantage over their competitors that may not be as readily ‘bondable’.
Timothy J. Hutton, CPCU, AFSB
Cell: 703-220-7771
timothyjhutton@gmail.com
Understanding International Surety Bond Requirements
While widely recognized and utilized in the United States, internationally, suretyship has a mixed reputation. Based mainly on a given foreign country's heritage/exposure to western influence, suretyship may or may not be utilized and/or accepted internationally. For U.S. Government Contractors and Technology companies working abroad, gaining a better understanding of the peculiarities of international suretyship can greatly assist them should they encounter these surety requirements.
Before we can discuss the peculiarities of International Surety Bonding, we must first have a basic understanding of suretyship and its related terminology.
A surety bond is a three party agreement between:
1. Obligee
2. Principal
3. Surety.
In exchange for a fee and a ‘hold-harmless’/indemnity agreement from the Principal to the Surety, the Surety agrees that, in the event of a default on the part of the Principal, the Surety is required to perform the terms of the contract between the Principal and Obligee. Each party to this three party agreement has unique roles, rights, and responsibilities.
Obligee – The Obligee is the entity protected by the Surety bond against loss. The surety bond ‘runs to’ the Obligee and the Obligee has the ability to set the language of the surety bond.
Principal – The Principal is the entity obligated, with the Surety, to the Obligee. The Principal pays the fee for the bond and, via the indemnity agreement, holds the Surety harmless for its failure to perform the terms of the contract.
Surety – The Surety is the entity obligated, with the Principal, to the Obligee. Generally*, the Surety is an unsecured creditor relying only upon the ‘promise to be made whole’ contained in the indemnity agreement. (*Surety does have a security interest in receivables and equipment on bonded jobs.)
International surety requirements can be loosely categorized into two distinct categories each with their own attributes.
1. Surety bonds required by a U.S. Contractor working abroad for a U.S. Obligee
Of the two categories, these types of "international" bonds are the easier of the two to obtain. While the work covered by these types of bonds can be construed as international, to most surety underwriters, they will view this as domestic work that just happens to be occurring overseas. This view is due to the fact that, given the Obligee is a U.S. entity, the surety underwriter can safely assume that the Obligee will readily accept a bond issued by a U.S. domiciled surety and also readily accept the jurisdiction of the U.S. Courts should a claim/issue arise. The surety is concerned with the acceptability of "U.S. paper" because the surety takes on additional costs and bureaucratic hurdles when a 'fronting arrangement' has to be established prior to bond issuance. Additionally, jurisdiction is a key risk factor in the surety's underwriting decision. Generally, most U.S. domiciled sureties will not allow their bonds to be governed by the courts of another nation.
As we will see below, when the Obligee is a foreign entity, these assurances/underwriting assumptions can not be readily established.
2. Surety bonds required by a foreign Obligee
When a foreign Obligee requires a surety bond of a U.S. Contractor, the first 'bridge' that must be crossed, is one of semantics. To many foreign Obligees, the terms "bond guarantee" and "performance bond" can be and are used interchangeably with the terms "bank guarantee" and "letter of credit". Given that the classic three party surety bond is not as widely used or well known in most of the world, many foreign Obligees ask for a "bond" when the really want a "letter of credit" or a "bank guarantee"!
Secondly, as we discussed above, many foreign Obligees will only accept bonds from sureties that are domiciled in their own country. To meet this requirement, the U.S. surety must:
a. have a pre-established relationship with the given foreign surety market or
b. go to the extra expense of establishing such a 'fronting' arrangement.
Expectedly, both a.) and b.) above add layers of cost to the surety which can diminish their interest in supporting the deal. Last, foreign Obligees frequently require that any bond they accept, must be governed by their domestic court system. Of course, this opens the U.S. surety to unknown risks, costs, etc. and also serves to diminish the U.S. surety's interest in supporting a given bond request.
Summary
When operating internationally, U.S. Government Contractors must be ready to meet the often complicated requirements of international suretyship. However, by utilizing the services of an experienced surety broker, these requirements can be planned for, managed, and achieved so the ultimate success of the contract is assured.
Timothy J. Hutton, AFSB, CPCU
Cell: 703-220-7771
timothyjhutton@gmail.com
Before we can discuss the peculiarities of International Surety Bonding, we must first have a basic understanding of suretyship and its related terminology.
A surety bond is a three party agreement between:
1. Obligee
2. Principal
3. Surety.
In exchange for a fee and a ‘hold-harmless’/indemnity agreement from the Principal to the Surety, the Surety agrees that, in the event of a default on the part of the Principal, the Surety is required to perform the terms of the contract between the Principal and Obligee. Each party to this three party agreement has unique roles, rights, and responsibilities.
Obligee – The Obligee is the entity protected by the Surety bond against loss. The surety bond ‘runs to’ the Obligee and the Obligee has the ability to set the language of the surety bond.
Principal – The Principal is the entity obligated, with the Surety, to the Obligee. The Principal pays the fee for the bond and, via the indemnity agreement, holds the Surety harmless for its failure to perform the terms of the contract.
Surety – The Surety is the entity obligated, with the Principal, to the Obligee. Generally*, the Surety is an unsecured creditor relying only upon the ‘promise to be made whole’ contained in the indemnity agreement. (*Surety does have a security interest in receivables and equipment on bonded jobs.)
International surety requirements can be loosely categorized into two distinct categories each with their own attributes.
1. Surety bonds required by a U.S. Contractor working abroad for a U.S. Obligee
Of the two categories, these types of "international" bonds are the easier of the two to obtain. While the work covered by these types of bonds can be construed as international, to most surety underwriters, they will view this as domestic work that just happens to be occurring overseas. This view is due to the fact that, given the Obligee is a U.S. entity, the surety underwriter can safely assume that the Obligee will readily accept a bond issued by a U.S. domiciled surety and also readily accept the jurisdiction of the U.S. Courts should a claim/issue arise. The surety is concerned with the acceptability of "U.S. paper" because the surety takes on additional costs and bureaucratic hurdles when a 'fronting arrangement' has to be established prior to bond issuance. Additionally, jurisdiction is a key risk factor in the surety's underwriting decision. Generally, most U.S. domiciled sureties will not allow their bonds to be governed by the courts of another nation.
As we will see below, when the Obligee is a foreign entity, these assurances/underwriting assumptions can not be readily established.
2. Surety bonds required by a foreign Obligee
When a foreign Obligee requires a surety bond of a U.S. Contractor, the first 'bridge' that must be crossed, is one of semantics. To many foreign Obligees, the terms "bond guarantee" and "performance bond" can be and are used interchangeably with the terms "bank guarantee" and "letter of credit". Given that the classic three party surety bond is not as widely used or well known in most of the world, many foreign Obligees ask for a "bond" when the really want a "letter of credit" or a "bank guarantee"!
Secondly, as we discussed above, many foreign Obligees will only accept bonds from sureties that are domiciled in their own country. To meet this requirement, the U.S. surety must:
a. have a pre-established relationship with the given foreign surety market or
b. go to the extra expense of establishing such a 'fronting' arrangement.
Expectedly, both a.) and b.) above add layers of cost to the surety which can diminish their interest in supporting the deal. Last, foreign Obligees frequently require that any bond they accept, must be governed by their domestic court system. Of course, this opens the U.S. surety to unknown risks, costs, etc. and also serves to diminish the U.S. surety's interest in supporting a given bond request.
Summary
When operating internationally, U.S. Government Contractors must be ready to meet the often complicated requirements of international suretyship. However, by utilizing the services of an experienced surety broker, these requirements can be planned for, managed, and achieved so the ultimate success of the contract is assured.
Timothy J. Hutton, AFSB, CPCU
Cell: 703-220-7771
timothyjhutton@gmail.com
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