ANDREW NUGENT explains how bonds have become an everyday consideration for those involved in construction.
Bonds have been a component part of construction contracts for decades and indeed are prerequisites for public works. Bondsmen were those mysterious characters in the background who provided the guarantees but whom most of us never met. How times have changed! The reality of the most severe contraction of the construction industry in the history of the State is that bonds have now entered the everyday lexicon of the building industry.
Performance bonds, retention bonds, bid bonds, maintenance bonds and the like are all types of surety bonds where essentially three or more parties come together to transfer risk away from one of those parties, i.e., the employer or beneficiary. A performance bond, which is the most common type of bond in the Irish market, is essentially a guarantee provided by the surety (insurance company) in favour of the employer (beneficiary) that a project will be performed according to the terms and conditions of the contract.
Performance bonds have traditionally been effected for various amounts of the contract sum in accordance with recommended thresholds. Under public works contracts, these thresholds are:
It is worth noting that these requirement levels are not too dissimilar to those recommended in The Liaison Committee Code of Practice 2006.
The main sureties in the market have traditionally been our main banks, multinational insurance companies – Allianz, Euler Hermes, HCC International, Aviva, Construction Guarantee – and other smaller boutique providers, who (with the banks) have recently exited the stage.
However, over the recent past procurement of performance bonds has become an issue for building contractors, the Government building capital programme and the construction industry generally. Indeed, members have contacted the Quantity Surveyors Professional Group seeking direction in this matter. In this context the Society of Chartered Surveyors Ireland, together with other construction industry representatives, held information-gathering meetings to seek clarity and a better understanding of what was happening across the market.
Invitations were issued to sureties, some of whom attended and communicated useful information on their analysis of the industry.
The state of play
As might have been expected, the international insurance providers noted the present dysfunctional state of the construction market and the exceptionally high cost of completing out projects. Sureties also noted that the impaired state of many of their customers’ (contractors’) balance sheets had deteriorated substantially and accordingly many bond applications were marginal at best. This uncertain outlook, combined with poor credit facilities, the prolonged duration of the recession and in particular the frequency and scale of losses incurred by the sureties, appears to have made most of them re-assess their business model.
They advised that the negative international image of Ireland Inc. had the effect of reducing the ability of these insurers to lay off a portion of their risk on the international reinsurance markets. Increased capital ratio requirements necessitated that multi-line insurers (like Aviva or Allianz) reconsider how best to deploy reduced capital across their competing divisions. In light of the above, construction performance bonds were not as attractive a return as they were in the boom years.
The net result of all of the above is that the capacity of the surety market is much reduced. This problem is further compounded by the lack of capacity of many contractors to obtain bonds due to the impaired nature of their balance sheets.
Another critical issue is the apparent disproportionate cost of completing out projects in Ireland. Sureties noted that their international experience of calls-on-bonds was that losses incurred were on average less than 5% of the contract sum. Hence the fact that most bonds in international markets are set at a maximum of 10%, rather than 25% of the contract sum as in Ireland.
Reasons for this disparity in the context of the Irish market are below cost tendering, coupled with the excessively prolonged public reprocurement process lasting many months and longer, and ancillary costs – retendering fees, maintenance, security, further deterioration, temporary works requirements and insurances.
The effect on contractors
The reality in the market is that building contractors are finding it increasingly difficult to secure bonds for projects. Furthermore, an increasing number of sureties are not willing to provide bonds in excess of 10% of the contract value, and those that are theoretically available have a list of stringent conditions attached whereby the cover is often unobtainable.
It is also apparent that contracting authorities, by insisting on provision of a bond, are by default allowing sureties to dictate the award of a competitive tender process. In many instances the fifth or sixth placed tenderer has been selected solely on the basis that the lower tenderers could not procure a compliant bond.
Equally, there is anecdotal evidence that contracting authorities are amending the terms of the pre-qualification process post tender in an effort to progress particular projects.
The net effect of the above is that the taxpayer is not getting value for money, as the tendering system is only as effective as the availability of performance bonds at that time.
Solving the problems
In this context a further meeting was held in the Office of Public Expenditure and Reform on January 16, 2013. The meeting was attended by Government officials, the Government Construction Contract Committee (GCCC), the Construction Industry Federation (CIF), the Association of Consulting Engineers of Ireland (ACEI), the Royal Institute of Architects in Ireland (RIAI), Engineers Ireland, the Society of Chartered Surveyors in Ireland (SCSI) – represented by Niall Newman, Andrew Nugent and Ed McAuley – and three bond providers: HCC International, Construction Guarantee and Allianz (all sureties had been invited to attend).
At the meeting two of the sureties (Allianz and HCC) summarised their market concerns as we have outlined above. The sureties also stated that where a contractor runs into difficulty and ceases trading, very often the total cover (25%) of the bond is fully expended, whereas in the UK the overall level of claims cost is much lower (less than 5%).
They also noted that they have more control over organising a replacement contractor, which negated any lengthy public procurement bottlenecks.
Interestingly, Construction Guarantee advised that it was “business as usual” for them and that they saw opportunities in the market. They also noted that they would continue to provide 25% bonds to suitable applicants in accordance with the GCCC recommended thresholds.
The Department received a number of suggestions and recommendations from the Society and other industry representatives, which included reviewing the public procurement directives to allow for the second or third lowest tenderer to be approached as a completion contractor, to review the current bonding threshold levels and to evaluate a method of eliminating abnormally low tenders. It was also recommended that contracting authorities be advised to comply with GCCC thresholds.
The Department of Public Expenditure and Reform agreed to review all the issues raised and consider the suggestions put forward by the industry representatives. The Society will continue to engage constructively with the Government and it is envisaged that another meeting will take place in the near future, which, it is hoped, will result in some positive steps towards avoiding future paralysis of the construction industry.
So, in conclusion there are mixed messages but overall the bond market is tighter and the availability of bonds will continue to be an issue. While the general consensus is that the construction market is bottoming out and that the worst is behind us, the withdrawal of the larger sureties will undoubtedly constrict bonding capacity until such time as replacement sureties can be attracted back into the market. Members should also be aware that reduced cover levels of bonds may prove insufficient to balance work-out costs and accordingly should advise their clients of potential shortfalls.