Understanding a Surety's Need for CPA Prepared Financial Statements

Unlike insurance, where the insurance buyer exchanges their premium for a transfer of their risk to the insurance market, in the Surety world, there is no transfer of risk. When/if a surety loss occurs, the surety, via the indemnification agreement that was signed prior to bond issuance, is repaid for any loss paid on behalf of their bonded principal.

In much the same way that suretyship is different than insurance, surety underwriters behave differently than their insurance underwriting counterparts. Surety underwriters are primarily concerned with making sure that their bonded principal has sufficient net worth to repay any losses the Surety may incur. With every underwriting decision, surety underwriters are constantly looking at the downside risk of their extension of surety credit and they are looking to verify the net worth/liquidity of their principal. If the surety underwriter can not verify/rely on the net worth of their principal, they will simply decline to extend surety credit.

Since the contractor’s financial statements are the surety underwriter’s primary underwriting tool when it comes to measuring net worth/financial resources of their principal, the surety usually demands that the contractor supply them with CPA prepared financial statements. Depending on the size of the work program required by the contractor, the surety may request either compiled, reviewed, or audited financial statements.

Financial statements which are prepared directly by the contractor or by the contractor’s accounting system are referred to as “internal” financial statements and they are generally unacceptable to most surety underwriters. The reason for this is that internal financial statements do not provide the surety with the necessary independent third party valuation contained in CPA reviewed or audited financial statements. (CPA prepared compiled financial statements are generally equated with “internal” financial statements since, in a compiled set of financial statements, the CPA firm simply recreates the statements given to them by the contractor without verifying/checking balances.)

The importance of CPA prepared financial statements is not limited to the surety underwriter’s analysis and verification of net worth. In addition to this, a good CPA prepared set of financials will include a Work In Progress, or “WIP”, schedule that ties in to the financial statements. The WIP schedule is very important to the surety underwriter as it allows them to track things such as underbillings, overbillings, profit fade/gain, and pure job borrow. The WIP gives the surety underwriter a predictive tool to analyze future performance, future gross margin, and cash flow in the contractor’s remaining uncompleted work.

To draw a mining analogy; if a contractor seeks surety credit in the same way that a miner seeks gold, the miner must use a pick and shovel to get to the gold and, in the same way, the contractor must use CPA prepared financial statements to get to his gold = surety credit.

Tim Hutton, CPCU, AFSB
timothyjhutton@gmail.com
703 220 7771 mobile

Employee Dishonesty Insurance - Ensure Your Policy's Limit of Liability is Sufficient!

As a former underwriter of this line of coverage, I can attest that, when losses occurred, the limit in force at the time of the loss was frequently insufficient to cover the entire loss. As a broker, when I meet with prospects, I frequently find that they have never considered the sufficiency of their Employee Dishonesty Insurance limit of liability. When I bring to their attention how affordable a dramatically increased limit is, most opt to buy a larger limit of liability.

Employee Dishonesty Insurance (also referred to as ‘Fidelity Insurance’ or a ‘Fidelity Bond’) is an important part of any risk management program. The prevalence of these claims is widespread and, in a weak economy, these claims tend to increase. When these types of losses occur, they are frequently caused by long time “trusted” employees and they can be very substantial; even big enough to drive a company out of business. (In fact, the U.S. Chamber of Commerce reports that 1/3 of business failures can be traced to an occurrence of employee theft.)

>Besides buying an adequate limit of liability, there are many steps an employer can take to limit their exposure to an employee dishonesty loss…I’ll save those for another blog post!

Even with the best internal control structure in place, employee dishonesty losses do occur. Make sure that your limit of liability is sufficient! Ask your agent/broker to provide you with optional quotes for increased limits of liability…you will be surprised at how reasonably priced this line of coverage can be, and, with a higher limit in place, you are better protected should a loss occur.

Tim Hutton, CPCU, AFSB
timothyjhutton@gmail.com
703 220 7771 mobile