Anyone who has dealt with surety has come across a reference to the three Cs of underwriting:
- Capital
- Character
- Capacity
These three criteria have been constants of the surety industry since its inception.
How To Understand The Three Cs Of Underwriting
- Capital is the most commonly discussed and the easiest C to understand. Contactors need to have sufficient capital to finance their construction activities. They need adequate liquidity to pay their suppliers and subs, the cushion to do so if there is a delay in compensation, and the ability to deal with unforeseen obstacles that can arise during a project.
- The second regularly discussed C is character. Contractors need to have high ethical and moral fortitude to fulfill their obligations. Gauging the contractor’s reputation in the industry or marketplace helps a surety understand how a contractor will conduct themselves on future jobs. Is the contractor honest in the way they conduct business with subcontractors and communicate with owners?
- The most overlooked and misunderstood C is capacity. It is the limit at which a contractor can perform jobs successfully. People often conflate capacity with capital, as yes, a contractor does need the financial capacity to fund the job, but in this instance analyzing contractor capacity refers to the other resources a contractor needs in order to properly perform a job. Capacity is best thought of as the bandwidth of the contractor. It is limited by physical ― whether inherent or situational ― bottlenecks in the contractor’s business.
When evaluating a contractor’s capacity, underwriters consider a number of factors:
Organization
This includes analysis of the contractor’s ownership, management, and key subcontractors with which it has relationships. Sureties evaluate these players to not only make sure they have the proper education and experience necessary to perform the work but that there are enough of them to support a potential backlog of the organization. A shortage of managers, laborers, and subcontractors can lead to overextension by an organization.
Plant, Equipment, and Production Resources
A contractor’s plant and equipment directly affect their capacity for work. Depending on the size and type of work a contractor performs, different amounts and types of equipment are necessary. HVAC contractors need sheet metal shops, while pavers and road builders need specialized heavy equipment to perform their jobs. Contractors need to be certain that they have enough equipment and production resources to complete their work obligations without spreading those resources too thin, as this again leads to overextension and causes delays and issues on jobs that can compound over time.
Danger of Overextension
The overextension of an organization’s capacity will negatively affect the specific job that led to the problem but also can have detrimental domino effects. If a contractor bites off more than they can chew, resources from other jobs must be borrowed, and those jobs become adversely impacted as well. The best metaphor I have heard for understanding this issue was from Darrel Lamb, Western Regional Vice President of Old Republic Surety Company. Consider his juggling analogy to explain the consequences of overextending capacity:
“While I may be able to juggle three balls with relative ease, the addition of a fourth ball introduces much more complexity to the task. I may be able to manage this complexity for a short time, but eventually, I will fail. The problem is that when I end up failing, I do not drop only the fourth ball; instead, all the balls end up on the floor.”
Understanding the third C, capacity, is key for a contractor to be able to assess risk and grow their business in a practical and judicious manner. Finding an equilibrium between growth and resource allocation requires a deliberate awareness of the physical constraints an organization faces.
To find out more about Old Republic Surety and contractors’ surety bonds, contact a local branch office.
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