What is the Purpose of a Surety Bond Pre-Qualification Letter?
A Surety Pre-Qualification Letter, or “Prequal” for short, is commonly asked of contractors and their surety bond companies or brokers. These are also commonly referred to as Surety Reference Letters. What are these letters really and do they serve a real purpose?
What is a Surety Pre-Qualification Letter?
A surety pre-qualification letter is a document written for a contractor that gives information about their surety bond program, including the surety bond company, single project limit and aggregate project limits.
The Prequal letter may or may not give additional information such as rates, capacity currently in use, length of time with the bond company and ratings of the surety bond company. You can see a sample of Surety Bond Reference Letter to the right or by clicking here.
Single Project Limit
A surety bond pre-qualification letter will almost always provide the contractor’s single contract limit. This is the largest contract amount that the surety bond company is willing to provide contract bonds on, for this particular contractor. Keep in mind that this is specific to the surety bond company providing the letter. A different bond company may be willing to provide more or less surety credit to this particular contractor.
A surety bond pre-qualification letter will also usually provide Aggregate Bond Limits for the contractor. The Aggregate Limit is the maximum dollar amount the surety bond company will provide contractor bonds on for this particular contractor. For example, if a contractor has a $20 million aggregate program, the surety may be willing to provide two separate $10 million projects, or they may provide bonds on five separate $4 million projects. However, the maximum amount of all projects that they want to bond is $20 million. Again, a different surety bond company may be willing to provide more or less surety credit to this particular contractor, but surety letters are specific to one surety for one contractor.
Surety Bond Company
The surety bond company will always be on a surety pre-qualification letter. This is the company willing to provide contract bonds for the contractor. Not having a surety bond company listed on a letter would be a major red flag and a sign that the contractor may not currently have a surety bond company.
It is very common for a surety prequal letter to be signed by a broker who is an attorney-in-fact for the surety bond company. Usually, the letter is written on the broker’s letterhead and not the surety bond company’s letterhead. However, some surety companies will provide surety pre-qualification letters for clients on their letterhead. When the surety is written on the broker’s letterhead and signed by the attorney-in-fact, it is usually stamped with the bond company’s seal. It is also very common to include the bond company’s A.M. Best rating on the letter. Additionally, whether the surety bond company is listed in the U.S. Treasury’s 570 Circular of approved surety bond companies may also be included on the letter.
A Reference or Recommendation
Most surety bond pre-qualification letters will include a recommendation for the contractor. These letters often say something like, “We find XYZ Construction to be very qualified and feel they are very capable of completing your project.” The reference may also include a statement about how long the broker or bond company has worked with the contractor. Keep in mind that these statements are written by the contractor’s surety bond broker or bond company.
The Bond Rate
Although not common, sometimes a surety bond letter contains the contractor’s bond rate. This is usually a general estimate such as 1% or 1.5% and not a full deviated rate. If the letter is project specific, the letter may include the exact premium that will be charged for the project. It is not a standard practice to include the bond rate on a surety letter, but some owners and contractors do require this.
A Non-Commitment Clause
Almost 100% of the time, a surety pre-qualification letter will include a clause specifically not committing the surety bond company to writing any bonds for the contractor. This language is usually in one of the last paragraphs and says something to the effect of:
“Should XYZ be awarded a contract, we see no issues with issuing a bond. However, each surety bond is written on its own merits and subject to a review of contract terms, financing and other conditions. Neither we nor the surety company assume any obligation to commit to writing a bond.”
This paragraph is extremely important for several reasons. It is very true that contract bonds guarantee the terms of a contract. Therefore, it is absolutely necessary to view contract terms before committing to write bonds on a project. Financing is also important. Projects without financing in place are more likely to cause problems for the contractor and surety company. Further, these letters have no expiration, so a contractor’s financial condition could change significantly between the time a letter is created and a contract bond is needed.
Why are Surety Bond Pre-Qualification Letters Used?
Surety Bond Pre-Qualification Letters are used by owners and contractors to try and mitigate risk. As the name suggests, they are the first step in many prequalification programs. Contractors using Subcontractor Default Insurance (SDI) are generally required to prequalify subcontractors before putting them in the program. Surety pre-qualification letters are one potential step in doing so.
Other owners and contractors may view these surety letters as a way to prequalify contractors and subcontractors. They sometimes use these letters as an alternative to using contract bonds and SDI. They may also provide these letters to their own surety bond company as a way to avoid subcontract bonds with their own subcontractors.
Are Surety Bond Pre-Qualification Letters Actually Useful?
There are different views in the industry on if surety bond pre-qualification letters are useful. The non-commitment language certainly makes them controversial. Most people believe that these letters are better than doing no prequalification at all. Some surety bond agents take them very seriously and will only provide them if the contractor can qualify for a bond and surety program of that size.
Unfortunately, I believe that to be the minority. Even in the best cases, the single and aggregate bond limits on these letters is usually extremely exaggerated. There is really no downside to doing so. Also, these letters do not provide information on a contractor’s workload or financial problems. In the worst cases, a broker may provide a letter for a client that cannot get a bond for a project of that size and scope.
For these reasons, surety pre-qualification letters are not a good substitute to protect contractors and owners from risk. A better form of prequalification should be used. This includes analyzing financial statements, insurance documents and job references. While not everyone has the resources for pre-qualification, Bid Bonds, Performance Bonds, Payment Bonds, and SDI insurance are much better for reducing risk in those circumstances.
Surety Bond Pre-Qualification Letters are common. We do many of them for clients daily. Unfortunately, they do not usually provide a good method of risk reduction. Owners and contractors should find additional ways to reduce their risk as these letters are more suited for marketing than prequalification.
If you need a Surety Bond Reference Letter or Pre-Qualification Letter, simply click here or on the image below.