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The Economic Value of
Surety Bonding in Canada
A networked agent-based economic assessment
August 2017
The Economic Value of Surety Bonding in Canada
Page | 2
About the Canadian Centre for Economic
Analysis
About the Report
The Canadian Centre for Economic Analysis
(CANCEA) is a socio-economic research and data
firm. CANCEA provides objective, independent
and strictly evidence-based analysis dedicated to
a comprehensive, collaborative, and quantitative
understanding of the short- and long-term risks
and returns behind market changes, policy
decisions and economic outcomes.
At the centre of CANCEA’s analysis is its
Prosperity at Risk® simulation platform which is a
networked agent-based, socio-economic
computer platform. Using a combination of “big
data” technology advancements with data sets
that are linked back to the objects that
generated them, Prosperity at Risk® simulates
the interactions of many millions of virtual
agents (individuals, corporations, governments,
and non-profit organizations) to provide a deep
and realistic understanding of the consequences
of market and policy developments for our
clients.
CANCEA does not accept any research funding or
client engagements that require a pre-
determined result or policy stance, or otherwise
inhibits its independence.
In keeping with CANCEA’s guidelines for funded
research, the design and method of research, as
well as the content of this study, were
determined solely by CANCEA.
This information is not intended as specific
investment, accounting, legal or tax advice.
©2017 Canadian Centre for Economic Analysis
Printed in Canada • All rights reserved
ISBN 978-0-9959981-4-8
Citation:
Smetanin, P. Stiff, D. The Economic Value of
Surety Bonding in Canada: A networked agent-
based economic assessment. The Canadian
Centre for Economic Analysis. August 2017.
The Economic Value of Surety Bonding in Canada
Page | 3
TABLE OF CONTENTS
Table of Contents .......................................................................................................................................... 3
List of Figures ................................................................................................................................................ 4
List of Tables .................................................................................................................................................. 4
Acknowledgements ....................................................................................................................................... 5
Executive Summary ....................................................................................................................................... 6
Findings at a glance ....................................................................................................................................... 7
Canada’s construction industry and surety bonds ........................................................................................ 8
Industry network structure ........................................................................................................................... 9
Results .................................................................................................................................................... 11
Conclusion ................................................................................................................................................... 15
Future research ........................................................................................................................................... 15
1. Introduction ........................................................................................................................................ 16
1.1 What is surety? ............................................................................................................................ 16
2. Canada’s construction industry ........................................................................................................... 19
2.1 Risk in the construction industry ................................................................................................. 19
2.2 Industry network structure ......................................................................................................... 21
3. Modeling the network ......................................................................................................................... 24
3.1 Methodology ............................................................................................................................... 25
4. Results ................................................................................................................................................. 31
5. Conclusion ........................................................................................................................................... 36
A. Data set characteristics ....................................................................................................................... 37
B. Defintions ............................................................................................................................................ 38
References ................................................................................................................................................... 40
Contact Information .................................................................................................................................... 42
The Economic Value of Surety Bonding in Canada
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LIST OF FIGURES
Basic surety diagram ............................................................................................................... 17
Contribution of the construction industry to Canada’s economy (%) ..................................... 19
Net worth of the construction industry in Canada .................................................................. 19
Operating profit margin in Canada (%) .................................................................................... 19
Return on capital employed in Canada (%) ............................................................................. 19
Distribution of construction employees across Canada .......................................................... 19
Canada’s construction industry breakdown by size of firm ..................................................... 19
Insolvency rates in the Canadian construction sector ............................................................. 20
Number and rate of insolvencies by industry .......................................................................... 21
Simple representation of surety in a networked economy ..................................................... 22
Network of 1,000 largest employers by industry .................................................................... 23
Suppliers or subcontractors of one construction company (left) have their own connections
(right) ....................................................................................................................................... 23
Distribution of companies by net worth and operating income (excluding extreme outliers) 26
Insolvency rates in the Canadian construction sector ............................................................. 27
Comparison of insolvency rates in Canada’s construction sector ........................................... 28
Relative insolvencies by firm size (by number of employees) ................................................. 28
Impact of financial stress on project overruns ........................................................................ 29
Baseline insolvency rates in the construction sector ............................................................... 31
Scenario insolvency rates in the construction sector .............................................................. 32
Change in delay distribution .................................................................................................... 32
GDP impact of all public infrastructure having performance and payment bonds.................. 34
GDP impacts as % of high risk-scenario, public infrastructure only ......................................... 35
GDP impacts as % of high risk-scenario, all infrastructure ...................................................... 35
LIST OF TABLES
Table 1 Summary economic impacts of surety (public infrastructure) .................................................... 34
Table 2 Characteristics of the surety data set .......................................................................................... 37
The Economic Value of Surety Bonding in Canada
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ACKNOWLEDGEMENTS
The report was prepared on behalf of the Surety Association of Canada. In keeping with CANCEA’s
guidelines for funded research, the design and method of research, as well as the content of this study,
were determined solely by CANCEA. The CANCEA researchers involved in the performance of this study are
Paul Smetanin and David Stiff.
This research has been prepared by the Canadian Centre for Economic Analysis (CANCEA) and would not
have been possible without data received under non-disclosure agreements from Aviva Canada Inc., The
Guarantee Company of North America, Intact Insurance, Travelers Insurance Company of Canada, Trisura
Guarantee Insurance Company, and Zurich Insurance Company Ltd (Canadian Branch). Collectively, these
companies underwrite the majority of surety bonds for the construction market in Canada.
CANCEA is grateful to those executives and experts who shared their expertise and insights via interviews
that were conducted as part of the research process for this project. The profile of those organizations
interviewed included several of the largest general contractors and subcontractors operating in Canada.
The Economic Value of Surety Bonding in Canada
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EXECUTIVE SUMMARY
Surety bonds protect against non-performance and non-payment risks associated with the operation and
financial standing of construction enterprises and their relationships. In a highly integrated economy,
understanding the economic value of surety bonds is no simple task and requires:
The ability to model the contractual and commercial connections (network structure) that
permeate through industries – particularly in the construction sector – to understand the “domino”
impacts of financial and operational distress on the broader economy;
A significant amount of data on the interaction of the surety industry with stakeholders in the
construction sector and the broader economy, how stakeholders purchase surety products,
construction projects on which surety bonds are used, and the performance of projects with and
without surety bonds; and
Analytical tools designed to quantify the economic impacts that extend beyond aggregate
economic activity and include impact on jobs and taxes, and quantify where risks and rewards
(intended or otherwise) arise for different stakeholders.
Canada’s construction industry plays a significant role in the its economy, currently contributing
approximately 7.6% of its GDP and employment. Nationally, insolvency rates in the construction industry
are at a 35 year low, averaging around 3.4 insolvencies per 1,000 firms over the last 10 years. This is almost
6 times lower than in the early 1990s when insolvency rates were averaging 17.7 per 1,000 firms.
The objective of this research project was to conduct a network-based quantitative analysis of the economic
value of surety (e.g., performance bonds, payment bonds) for different construction activity (with varying
capital types), and industries (i.e., public and private capital projects). The aim is to illuminate surety’s value
proposition for policy-makers, the general public, and other key stakeholders.
A performance bond is a special class of contract signed by a contractor (the ‘principal’) and a surety in
which the contractor and surety guarantee to a third party (an ‘obligee’, often a project owner) that the
contractor will perform a specific construction contract. If the contractor fails to perform, then the project
owner may look to the surety under the bond for the costs of completing the contract and additional
related costs.
Labour and material payment bonds (or simply, payment bonds), a related class of bonds, are signed by a
contractor and its surety and guarantee that the contractor will pay its subcontractors, suppliers and
labourers on a specific contract. If the contractor fails to honour its payment obligations then
subcontractors, suppliers and labourers may look to the surety for payment under the bond.
The Economic Value of Surety Bonding in Canada
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Findings at a glance
A majority of public construction work in Canada is carried out under bonded contracts. Using surety
industry datasets of over 150,000 surety records and Prosperity at Risk® network modeling of the Canadian
economy, we found that:
Reduced risk of
insolvency
Non-bonded construction firms are ten-times more likely than bonded
companies to suffer insolvency at any given point in time. As a result, firms
whose projects are bonded see a general reduction in project delays through
a combination of reduced insolvencies and delays associated with insolvencies.
The process of underwriting bonds on construction projects appears to
contribute to capital and operational adequacy in bonded businesses.
Protection of
economic activity
(GDP)
In the current low interest rate economy, insolvencies in the construction
industry are at a 35 year low. At these current insolvency rates, surety bonds
protect 3.5 times more Canadian economic activity than their premium cost
(over $3.5M of GDP protected per $1M premiums paid), which amounts to the
equivalent of around 25 full time jobs (or about $6M in wages) protected per
$1M of premiums paid.
Economic risk
management
benefits
In the 1990s, insolvencies had reached 6 times current levels. At these
insolvency rates, surety bonds could protect 25 times more Canadian economic
activity than their premium cost (about $25M of GDP per $1M in premiums
paid), which amounts to the equivalent of 200 full-time jobs (or about $28M in
wages) protected per $1M of premiums paid.
Fiscally responsible
In the current economic environment, governments could recover $0.4M per
$1M of premiums paid on public infrastructure projects. In a higher insolvency
environment, such as the early 1990s, this could increase to $3.0M per $1M of
premiums paid indicating that governments (in total) become a net beneficiary
of surety bonding.
Extent of industry
coverage is
important
The size and significance of the surety bond benefits vary depending upon the
level of risk in the economy (e.g., increasing interest rates, debt levels,
recession, and global shocks). The highest economic and fiscal benefits versus
the premium costs required comes from a policy that requires a combination
of performance and payment bonds – with 100% of public infrastructure
projects bonded.
The Economic Value of Surety Bonding in Canada
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Canada’s construction industry and surety bonds
A majority of public sector construction work in Canada is carried out under bonded contracts. Based on
the surety bond data, it is estimated that companies involved in non-bonded projects have an insolvency
rate ten times greater than companies with bonded projects. While insolvency tends to occur more
frequently in smaller companies, the insolvency of larger companies appears to be much more disruptive
to the economy. Further, an examination of the surety bond data shows significant project delivery
overruns associated with companies in financial stress (negative net worth, operating losses).
As highlighted in previous work by CANCEA (2016)
1
, there are significant economic consequences to project
delays, as infrastructure delivery is about “right size, right place, and right time”. If something stands in the
way of delivering or enabling a vital public service at that time, then the economy suffers. As a result, any
delays could have a much greater impact than simply the direct financial cost of the delay, and there is
potentially significant economic value to preventing construction delays.
Many additional impacts of surety bonding may not be directly observable in the public records of
insolvencies or project delays. This includes changes to a firm’s financial planning or intervention of the
surety companies. In particular, these additional impacts could include:
Capital and operational adequacy: The process of underwriting bonds on construction projects
involves pre-qualification of bidders by surety companies, which is observed to accompany an
improvement in the capitalization and financial management within the construction industry. This
benefit reduces the potential and the severity of construction insolvencies;
Project completion and subcontractor payment: Costs of restructuring, financing and completing
failed projects can be significant and can be transferred to a surety under a bond. For example,
during the five-year period ending in 2016, the surety industry paid out more than $200 million
under bonds in Ontario to fund completion of projects and pay subcontractors, suppliers and
labourers
2
; and
Prevention of financial distress: While insolvencies are distinct legal and financial events,
operational and financial distress (such as cash flow issues, inability to access needed credit or
materials) often occurs prior to the recording of an insolvency. Given their role as guarantors to a
process, surety providers will at times support firms through a project or program of work when
needed, thereby reducing the incidence of solvency and enabling contractors to complete projects
and pay subcontractors, suppliers and labourers.
1
An analysis of 200 P3 infrastructure projects in Canada found that delays in construction could have significant long-
term economic impact particularly as the size of the portfolio of delayed projects increases
2
Source: MSA Research Inc.
The Economic Value of Surety Bonding in Canada
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Industry network structure
The construction sector is part of a complex economic system, with a vast array of networked interactions
between many diverse “agents”. How things are connected within such a system impacts how actions
reverberate through it. Without a good understanding of the key linkages between economic agents (e.g.,
firms), the measurement of the risks that could occur when an adverse event hits is significantly limited.
Metaphorically, a car accident on the highway may only do severe damage to the few cars directly involved,
but many more cars get affected due to traffic delays.
In order to capture the full effect of interruptions in the network, it must be modelled for over 3 million
companies in 20 industry sectors across Canada. The figure below shows the connections between the
largest 1000 companies in Canada. A typical construction company, could have a dozen linkages (e.g.,
suppliers, subcontractors or customers), each of which may have a dozen of its own, and so on. If such a
company were to become insolvent, its suppliers would have an increased chance of insolvency depending
upon how dependent it is on the insolvent company. In addition, if a supplier or subcontractor became
insolvent, it could introduce delays in other projects of its customers. Surety bonds can help protect against
such interruptions in the network.
The types of bonds considered in this analysis are performance bonds (which protect ‘upstream’ so the
project is completed) and payment bonds (which protect ‘downstream’ so that suppliers and
subcontractors are more likely to remain solvent). Section 2.2 presents more details on the industry
network structure.
The Economic Value of Surety Bonding in Canada
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Given the complexity of modeling the range of networked interactions and impacts required for this
research – a networked agent-based model was required. CANCEA’s Prosperity at Risk® (PaR) computer
simulation platform is used by several Ontario Ministries and municipalities to perform socio-economic
impact analysis, and was used for this project. This had allowed for the detailed simulation of dependencies
between:
1.2 million Canadian firms across 17 industries, 3 levels of government, 30 commodity types, 25
capital types;
More than 150,000 surety records (see Appendix A for details);
Other PaR (Prosperity at Risk®) datasets (e.g., many down to detailed geographic areas) on
demographics, income statements and balance sheets, consumption patterns, labour force
statistics, and commuting choices, among many others; and
Public data on insolvency from the Office of the Superintendent of Bankruptcy Canada (OSBC)
provide a good sense of the rates of insolvency by province and industry. These data allowed for a
detailed comparison between the experience of bonded firms and those in the construction sector
overall.
One benefit of using PaR is that multiple scenarios can be run and compared against a baseline. This shows,
across thousands of randomized trials, the likely outcomes (plus the not-so-likely ones), and their broad
impacts across the entire economy. It also allows for in-depth sensitivity analysis (employed here) to help
decision-makers determine “optimal” policies. To investigate this topic in detail, we define eight broad
scenarios (two risk scenarios times four bonding scenarios), and investigate over the next 20 years (2018-
2037).
The Economic Value of Surety Bonding in Canada
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Results
Surety bonds can significantly reduce the insolvency rates within the construction sector. In the following
figure the two risk scenarios are shown:
The blue line shows the historical national number of construction firm insolvencies since 1980;
The dashed green line shows a typical modelled rate of insolvency in the status-quo risk baseline
with no surety bonds; and
The dashed red line shows a typical modelled rate of insolvency in the high-rate risk baseline with
no surety bonds.
Companies that exhibit financial distress (negative net worth and operating losses) or become insolvent
can lead to project delays:
Directly if company is the general contractor; or
Indirectly if a supplier becomes insolvent (possibly through the previous insolvency of a different
customer).
By introducing the performance and payment bonds, we see a significant reduction in delays for bonded
projects through reduced insolvencies. As a result, many more projects are completed closer to the
scheduled time with a large decrease in projects with significant overruns, particularly in the high risk case.
Status Quo Risk: baseline
High Risk: baseline
The Economic Value of Surety Bonding in Canada
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Status Quo Scenario
With performance and payment bonds, insolvency rates are reduced considerably resulting in significant
economic benefits. The figure below shows that in the status quo scenario, if 100% of public infrastructure
projects have performance and payment bonds, over $3.5 of GDP is protected per dollar of surety bond
premium. Of this benefit, 32% is attributed to the reduction in insolvencies of companies, while the
remaining 68% are systemic benefits which arise from having the infrastructure built on time.
Attribution of GDP protected to insolvencies (green) and delays and compounding effects (blue) in the status-quo
scenario
High Risk Scenario
In the high risk scenario, as illustrated in the figure below, if 100% of public infrastructure projects have
performance and payment bonds, over $25 of GDP is protected per dollar of surety bond premium. Of this
benefit, 25% is attributed to the reduction in insolvencies of companies, while 75% are systemic benefits
which arise from having the infrastructure built on time, given a larger aggregate portfolio of projects
delayed at higher insolvency rates. Similar differences exist for the other outcome metrics such as tax
revenue and jobs.
Insolvencies 32%
Delays 68%
The Economic Value of Surety Bonding in Canada
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Attribution of GDP protected to insolvencies (green) and delays and compounding effects (blue) in the high-risk scenario
The following table highlights some of the key economic metrics from the analysis. A greater proportion of
the benefits in the status quo risk case are driven by direct insolvencies, while the high-risk case benefits
result more from the network effects.
Summary economic impacts of surety (public infrastructure)
Risk level
Economic activity, per $1 of
premium
% of benefits arising directly
from reduced insolvencies
Associated tax revenue, per
$1 of premium
Status Quo
$3.5
32%
$0.4
High Risk
$25
25%
$3.0
These results reflect status quo and high risk scenarios in which 100% of projects are bonded with both
performance and payment bonds, and reflect the best economic outcomes. When only a portion of projects
are bonded, or when performance bonds are used without payment bonds, the economic outcomes are
less than optimal.
Insolvencies 25%
Delays 75%
x
x
The Economic Value of Surety Bonding in Canada
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Surface plots of economic activity were generated for every combination of:
Minimum project size for bonding (x-axis); and
Percentage of public infrastructure projects bonded (y-axis).
The illustrations below show the expected GDP results of each combination (z-axis using percent of
maximum GDP seen in the analysis). As can be seen, the most optimal outcome for the economy as a whole
occurs when 100% of public infrastructure projects are bonded.
Bonding of Public Projects: Sensitivity of economic impacts, percentage of high risk scenario maximum
The “% of maximum GDP Impact” is the percent of the maximum GDP results we saw in any scenario. When
payment bonds are used together with performance bonds the GDP outcomes increase. In addition, the
combination of performance bonds with payment bonds shows significant economic outcomes at the 100%
project coverage level without negative marginal returns.
The Economic Value of Surety Bonding in Canada
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Conclusion
Credit and operational risk in the construction industry can vary significantly due to the movement of
interest rates, recession, supply shocks, debt levels, credit squeezes, and so on. Currently, Canada enjoys
historically low rates of construction insolvencies, which has been aided in part by the fact that many public
infrastructure projects are surety bonded.
By understanding, quantifying and simulating the way in which the construction industry is connected
between suppliers and subcontractors of materials and services and to the broader economy, the value of
providing surety guarantees for projects to the socio-economic network of Canada could be measured. We
found that the impact of surety – and the additional due diligence its use ensures – is generally positive,
regardless of scenario run (assuming some coverage). But a combination of performance and payment
bonds – with a focus on infrastructure investments – yields the highest benefits (measured in terms of GDP
growth) relative to the costs required.
Further, the process of underwriting bonds on construction projects appears to contribute to capital and
operational adequacy in bonded businesses and reduces financial stress and insolvencies.
The benefits in the high insolvency rate scenario (e.g., 1990s levels) were particularly significant and about
7 times greater than in the status quo scenario despite the insolvency rates being only 5 times higher, which
is a demonstration of how important network analysis is to such impact analysis. The analysis of the high
risk scenario indicated that the benefits include:
$25 of economic activity protected per $1 of premium paid;
$3.0 of tax revenue (across all levels of government) protected per $1 of premium paid by all levels
of government
3
; and
200 job-years protected per $1M of premiums.
Future research
Further, we have assumed zero administrative cost to construction companies in undertaking the due
diligence required by the surety. (This is somewhat similar to capital adequacy requirements in the banking
sector, where there are imposed costs to being a bank to ensure that the entire system isn’t “infected” by
poor performance.) Such research might suggest that there is a minimum project threshold that should be
imposed, to avoid an undue burden on smaller construction companies.
3
This analysis did not investigate any asymmetry in the government sector with respect to the level of governments
which may pay the premium and those that receive the benefits. However, see CANCEA’s report, “Ontario
Infrastructure Investment: Federal and Provincial Risks and Rewards (Canadian Centre for Economic Analysis, 2016).
The Economic Value of Surety Bonding in Canada
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1. INTRODUCTION
Understanding the true economic value of surety is no simple task. It requires the ability to model the full
network structure of industry – particularly in the construction sector – to understand the broad impacts
of an adverse event. It also requires a significant amount of data on surety, such as who purchases it, what
projects they work on, and what happens with those projects. Finally, it requires appreciating that
economic impacts go beyond GDP; that they also include the likes of jobs and taxes, to understand where
risks and rewards (intended or otherwise) may land. As such, as part of its industry advocacy work, the
Surety Association of Canada (SAC) approached CANCEA to undertake network modeling, with major
members confidentially providing significant amounts of data.
The objective of this independent report is therefore to provide the essential quantitative analysis of the
economic value of surety (e.g., performance bonds, labour & material bonds) for different:
Construction activity (with varying capital types); and
Industries (i.e., public and private capital projects).
Using the framework established in previous and related work, CANCEA’s unique modeling platform is
utilized to demonstrate the value proposition for policy-makers, the general public, and other key
stakeholders.
1.1 What is surety?
The enterprise of suretyship, where one person guarantees and answers for the performance of another
person’s obligations to a third party, is a form of performance security that has been effective and has
persisted through time. Religious and civic laws have regulated the use of surety instruments in commerce
and society since ancient times. By 1840, the first successful corporate Surety – Guaranty Society of London
– was founded, and in 1935, the US federal Miller Act was established to require use of performance bonds
for public works contracts in excess of $100,000 and payment bonds for contracts in excess of $25,000
(Surety Bonds Timeline, 2017). In 1992, The Surety Association of Canada (SAC) was formed by companies
seeking advocacy independent of the insurance industry. SAC currently has close to 80 members.
4
The diagram below illustrates the 3-party relationship that is at the heart of a surety bond. While the surety
engages in a process of due diligence in evaluating the credit and performance capacity of a construction
enterprise and often forms a business relationship with a contractor, the surety’s primary obligation under
a bond is to the obligee (often a project owner).
4
See http://www.surety-canada.com/en/members/index.html/Surety/advanced-directory/search for details
The Economic Value of Surety Bonding in Canada
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Basic surety diagram
Among the various types of surety bonds underwritten by the surety industry in Canada, this study focuses
on performance bonds and payment bonds used in the construction industry. In the Canadian market,
performance bonds typically have a value of 50% of the value of the bonded contract, and are normally
issued in tandem with a payment bond also having a value of 50% of the bonded contract.
The proceeds of a payment bond are restricted and can be used only to pay qualifying subcontractors,
suppliers and labourers on the bonded contract. Payment of these subcontractors and suppliers can
preserve warranty on products, equipment and work, and can ensure continuity of a project team to avoid
delay in completion of a defaulted project. A payment bond can also ensure payment of subcontractors
and others who would otherwise seek recovery of unpaid accounts by registering a lien on the project or
taking other legal action that could disrupt the completion of a project.
The proceeds of a performance bond are available to offset additional costs of completing a bonded
contract in the event of the default of the principal contractor and financial protection is provided to a
project owner against the risk of contractor default.
1.1 .1 ASSURANCE RATHER THAN INSURANCE
While surety has commonalities with insurance and banking, it should not be confused with either. An
insurance company typically gathers premiums from a large group of customers at risk of some adverse
event occurring (e.g., a car accident). This creates a substantial pool of money that can be used to pay out
the costs of adverse events to the small subset of customers to whom they occur, spreading the costs of
such risk across all customers. Details gathered on potential customers are generally only used to
Contractor
(e.g., principal)
Project Owner
(e.g., obligee)
Bond Issuer
(surety)
Contractor Agrees to
perform a contract;
owner agrees to pay
the contract price
Surety guarantees
performance of the
contract by the
principal
Surety underwrites
bonds; contractor
undertakes to
perform bonded
contracts
The Economic Value of Surety Bonding in Canada
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determine the premiums paid, without much regard for the individual characteristics that could determine
actual “riskiness” (e.g., while people of a certain subgroup, like teenagers, may be more at risk in general
of car accidents, individuals in that group may be excellent drivers).
But the fundamental idea of surety bonds is to avoid adverse events, because a surety company is putting
up its own resources to ensure projects get completed. This makes surety bonds more like an extension of
credit with the assumption that there will be no losses, such as co-signing a loan. This means that surety is
more about assurance than insurance. A surety company assesses a contractor’s experience and track
record (e.g., in financial and project management), capacity (both financial and performance), character,
and other factors before deciding whether or not to issue a bond. If a particular contractor is deemed too
risky, the surety will simply decline to issue bond. Premiums are collected to cover the costs of underwriting
expenses, not to pay losses. Taking on an overly risky contractor can be a costly decision.
The Economic Value of Surety Bonding in Canada
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2. CANADA’S CONSTRUCTION INDUSTRY
Canada’s construction industry
5
plays a significant role in its economy, contributing approximately 7.7% of
provincial GDP and employment – a share that has risen over the last 15 years. Over that period, the
construction sector in Canada has built up a significant net worth, having grown their aggregate assets (net
of liabilities) by nearly 500%.
Contribution of the construction
industry to Canada’s economy (%)
Net worth of the construction
industry in Canada
Sources: Statistics Canada, tables 379-0028, 282-0008, and 187-0001
That said, this growth has come more from a return on capital investment than on operating profit margins.
Operating profit margin in Canada (%)
5
For the purposes of this analysis construction includes building construction (non-residential – industrial,
commercial, and institutional, plus residential); and engineering construction (e.g., transportation, water &
wastewater, communications, and other engineering construction). Each has a public and private component.
Return on capital employed in Canada
(%)
4.0%
4.5%
5.0%
5.5%
6.0%
6.5%
7.0%
7.5%
8.0%
8.5%
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
GDP Employment
-
20
40
60
80
100
120
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
Total assets - liabilities ($B)
-
2
4
6
8
10
12
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
Total all industries
Total non-financial industries
Construction
-
2
4
6
8
10
12
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
Total all industries
Total non-financial industries
Construction
The Economic Value of Surety Bonding in Canada
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Sources: Statistics Canada, table 180-0003
Further, construction employs a significant fraction of the population geographically distributed across the
country.
Distribution of construction employees across Canada
This distribution stems from the fact that the construction sector is dominated by a large number of small
companies, both in terms of the number of companies (over 2/3) and number of employees (over 1/4) and
the construction is location dependent.
Canada’s construction industry breakdown by size of firm
2.1 Risk in the construction industry
As discussed in previous CANCEA work, it has become fairly common to read a news headline about a major
infrastructure project having blown through its budget or construction timelines. Research suggests that
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such cost overruns and construction delays “are a global epidemic. They affect projects conducted by
national, provincial, and local government, and by private sector organizations; they are a feature of a wide
diversity of infrastructure project types; and they have been stubbornly persistent throughout history”
(Siemiatycki, 2015). Cost overruns and timing delays are often borne of multiple issues, including poor
schedule management, trade strikes, unknown site conditions, harsh environmental conditions, design
errors, delivery delays of core elements, scope changes, or inspections by other authorities having
jurisdiction (Hanscomb, 2015).
Another driver is contractor insolvency. Currently, as shown in Figure 8 , the insolvency rate in the
construction industry is at a 35 year low, having fallen consistently over the last twenty years.
Insolvency rates in the Canadian construction sector
Part of that is likely due to the significantly low interest rate environment and the significantly increased
amount of liquidity held by Canadian construction companies, who have seen the share of their (aggregate)
assets held in cash nearly double from 7% in 2002 to 13% in 2016. However, underlying these trends are
risks, for instance, in Ontario, the average collection period in construction has increased by nearly a
quarter from 2002 to 2013, from 57.3 to 71.1 days (Reynolds & Vogel, 2016), and thus a larger “pot” of
receivables has developed on corporate balance sheets (accounts receivable have grown as a share of total
assets over that period by 36% to 19%. There are no readily available data to know whether these financial
trends are simply dominated by the larger players
6
in the industry, though a review of the financial
statements for a few of the bigger companies would suggest this to be the case.
6
In the Canadian construction industry, the top 3 companies represent roughly 5% of the revenue generation and the
next 10 companies another 5% (Sources: On-site Magazine and Statistics Canada table 187-0001)
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Nonetheless, as shown in Figure 9 , over the last 5 years the construction sector in Canada has had:
The highest absolute number of industry insolvencies;
The 5th largest industry rate per 1,000 companies; and
An insolvency rate significantly higher for smaller companies.
Number and rate of insolvencies by industry
The construction industry has been making efforts to reduce their exposure to risk. Part of this has come
from the introduction of modern risk management practices that understand the role of the external
environment (Baloi & Price, 2003; Fan, Lin, & Sheu, 2008), and that appreciate that different stages of a
project face different risks and so should be managed differently (Nielsen, 2006).
2.2 Industry network structure
The construction sector is part of an incredibly complex economic system with a vast array of networked
interactions between many diverse “agents”. If analysis only relies on averages to estimate causes and
effects, then it only looks at the economy from the top down. But we are not averages. We behave
differently. We offer different things to different people. And we all face different constraints.
In other words, how things are connected within a system impacts how actions reverberate through it.
Without properly understanding the linkages between economic agents (e.g., firms), a full understanding
of what happens when an adverse event hits is impossible. Metaphorically, a car accident on the highway
may only do severe damage to the few cars directly involved, but many more cars get affected.
As an example, Figure 10 illustrates the ease with which networked companies can indirectly impact other
organizations within a network. Trying to model such a network top down would entirely lose these
linkages, and hide knock-on effects from an interruption (e.g., from a financial hardship).
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Simple representation of surety in a networked economy
Taking this to the fullest, in order to capture the effect of interruptions in the network, it must be modelled
for over the 3 million companies in 20 industry sectors across Canada
7
. While difficult to represent
graphically, Figure 11 presents a subsection of such a set of networked companies, by showing the linkages
(inputs and outputs) between the largest 1,000 companies by industry (the size of marker here represents
the number of employees). Figure 12 then shows an individual construction company (brown square),
which has (say) a dozen linkages (e.g., suppliers or subcontractors), each of which has (say) a dozen of its
own, and so on.
Therefore, if such a company were to become insolvent, suppliers would have an increased chance of
insolvency, based on both their own underlying industry rates and a fraction of revenue from the insolvent
customer. (Payment bonds remove the impact of fraction of revenue from insolvent customers but do not
affect underlying industry rates.) On the flip side, if a supplier or subcontractor became insolvent, it could
introduce delays in other projects depending on the fraction of inputs it supplies.
7
For Canada, the full network includes 1.2 million companies across: 17 industries and 3 levels of government, 30
commodity types, 25 capital types. Most companies have dozens of suppliers and customers
AO1
Asset Owners
(Obligees)
General
Contractors
Sub-contractors
and suppliers
AO2 AO3 AO4 AO5
GC2 GC3GC1
Contract to
deliver
construction
project
Contract to
deliver
portion of
project/
supplies
sc1 sc2 sc3 sc4 sc5 sc6 sc7 sc8
Payment bond from GC2 to sc3 ensures sc3 doesn’t
face hardship, risking delivery to GC1 and GC3
Performance bond from GC2 to AO3 ensures GC2
delivers asset as specified
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As such, surety bonds can help protect against interruptions in the network. The types of bonds considered
here are performance bonds (which protect ‘upstream’) and payment bonds (which protect ‘downstream’).
Network of 1,000 largest employers by industry
Suppliers or subcontractors of one construction company (left) have their own connections (right)
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3. MODELING THE NETWORK
Given the complexity of modeling the range of networked interactions and impacts required for this
project, a different approach is required. Improvements in computing power and data have given rise to a
new method of socio-economic inquiry.
Agent-based modeling provides a framework for investigating dynamic, networked systems, such as an
economy (with specific land-uses), by means of individual agents (e.g., households, businesses,
governments), their mutual interaction with each other and their environment. Prosperity at Risk® (PaR) is
CANCEA’s “big data” computer simulation platform that incorporates social, health, economic, financial,
and infrastructure factors in a networked system. This platform models agents as:
Individuals, with individual budget constraints (e.g., income, expenses, assets, and liabilities) and
production/consumption activities (dependent upon economic input/output tables), thereby
recognizing the independence of their motivations and decisions; and as
Part of a spatial and economic network, thereby recognizing the dependence of their economic
decisions upon other agents (via, for example, policy, investment decisions, and land use).
As such, PaR simulates the interactions of more than 40 million agents (people, households, dwellings,
companies, government) across Canada that are each encoded with financial, behavioural/motivational
rules to guide their decisions, act based on those rules, and be influenced by the actions of others. This is
enabled by an enormous “linked-path” database that links hundreds of disparate (and typically cross-
sectional) data sources back to the very objects that created them (e.g., individual companies)
8
. This allows
for the introduction of varied constraints and behaviours over time. The goal of such analysis is to identify
the risks and rewards (intended or not) across various stakeholders.
Because PaR features the entirety of the Canadian economy and adopts a micro-simulation approach, all
scenarios can be evaluated with precision regarding their impacts on various types of agents or sectors of
the economy. This also allows for unforeseen spillover effects (or ‘externalities’) to be accounted for,
tracked, and assigned to the correct cause, as agents dynamically adapt to their environments. Small
changes in behaviour, spending, or infrastructure lead to local adaptations by agents, which then spread to
others, such that all the relevant aspects of the economy reflect all the ‘ripples in the pond’.
In this way, the breadth of effects can be tracked as they unfold geographically and temporally, and an
intervention or scenario can be assessed holistically, such that all impacts are taken into consideration. The
model is therefore realistically sensitive to the particular type of investment, intervention, or behavioural
change with as few a priori assumptions as possible.
8
For example, PaR imbues in agents hundreds of data sources (e.g., Statistics Canada tables, many down to detailed
geographic areas) on demographics, income statements and balance sheets, consumption patterns, labour force
statistics, and commuting choices, among many others.
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3.1 Methodology
In addition to the hundreds of data sources that have already been triangulated into agents in PaR, the
larger members of the Surety Association of Canada (SAC) provided detailed (proprietary) claims data
(collectively called the SAC data for simplicity) that included:
Surety industry datasets of over 10,000 construction firms
Over 150,000 bonded construction projects
Over 3,000 surety claims
Additional details on the SAC data are provided in Appendix A.
Further, public data on insolvency from the Office of the Superintendent of Bankruptcy Canada (OSBC)
provide a good sense of the rates of insolvency by province and industry.
These data allowed for a detailed comparison between the experience of bonded firms and those in the
general construction sector. Given that the number of companies involved with surety bonds is small
relative to the number of construction-related companies overall, these average rates of insolvency provide
a good estimate for the rate of insolvency for companies with non-bonded projects.
Given the number and distribution of firms in the construction industry, its dependence on other sectors,
and the inherent (and often unforeseen) risks associated with construction, the industry writ large is
affected by insolvency at a relatively high rate. Recall from Figure 9 that the industry has the highest
absolute number of insolvencies across Canada on an annual basis, and has the 5th highest rate (per 1,000
companies), behind the likes of accommodation and food services, and retail trade.
However, identified by companies with large losses or expenses (greater than 50% of project value), and
operating losses, and negative tangible net worth, Figure 13 shows that insolvencies are quite rare within
the SAC data.
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Distribution of companies by net worth and operating income (excluding extreme outliers)
This suggests that the due diligence that surety enforces, along with the surety itself (in cases requiring it),
help to reduce strain in the economic network, although this does not apply to all companies evenly.
Individually, smaller companies are not eligible for larger projects since they do not have the resources
available. As the project values requiring surety bonds decreased, a greater number of smaller companies
would require their projects to be bonded. It is assumed for this project that any policy which may require
surety bonds for small projects will not impose an undue burden on either the smaller companies or the
surety. (This assumes no attrition of small companies due to the surety requirement.) As a result, they
experience a reduction in insolvency (though stay at a higher rate than larger companies).
3.1 .1 SCENARIOS
One benefit of using PaR is that multiple scenarios can be run and compared against a baseline. This shows,
across thousands of randomized trials, the likely outcomes (plus the not-so-likely ones), and their broad
impacts across the entire economy. It also allows for in-depth sensitivity analysis (employed here) to help
decision-makers determine “optimal” policies. For this project, there are some key steps:
Define a ‘baseline’ capital investment profile: construction (public and private) under the status quo
Assign companies to build projects: Under the status quo, companies are randomly assigned to
build the projects (accounting for insolvencies)
Quantify impacts of Surety bonds: Vary the number of bonded projects to study the impact through
changes in insolvency and project delays
Insolvency
Risk
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To investigate this topic in detail, we define four sets of projects and the related bonds issued. For varying
project sizes, we consider – over the next 20 years (2018-2037) – the fraction of:
1. Public sector infrastructure (e.g., transportation and transit, health, education, water &
wastewater) projects with only performance bonds;
2. Public sector infrastructure projects with only performance and payment bonds;
3. All construction (i.e., public plus residential/commercial/industrial construction and private
engineering construction) projects with performance bonds; and
4. All construction projects with performance and payment bonds.
For each set, the analysis is performed:
1. Maintaining the current status quo insolvency rates – that is, maintain the average insolvency rate
over the last 10 years (see Figure 14 ); and
2. Using ‘high-risk’ insolvency rates from the late-1980s to mid-1990s.
Insolvency rates in the Canadian construction sector
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This leads to a total of eight broad scenarios, and a few key hypotheses:
Insolvency rates for companies with non-bonded projects differ from those with bonded projects
(could be tied to different capital levels as a correlating factor for insolvencies); and
Projects that experience profit losses or have claims tend to have greater time overruns than those
that don’t after accounting for project size (difficult to attribute cause of overruns).
3.1 .2 IMPACTS OF BONDS
To summarize some of the data used to help undertake the network modeling done in PaR, there is a
noticeable variety in what happens to companies with bonded vs. non-bonded projects across Canada
9
.
First, as shown in Figure 15 , the estimated difference in insolvency rates between bonded and non-bonded
companies is almost a factor of ten. That is, non-bonded companies are ten-times more likely to go
insolvent at any given point in time. Further, insolvency tends to hit smaller companies far more frequently
than their larger counterparts (by orders of magnitude).
Comparison of insolvency rates in
Canada’s construction sector
Relative insolvencies by firm size (by
number of employees)
Further, as highlighted in previous work by CANCEA (2016)
10
, there are significant economic consequences
to project delays, as infrastructure delivery is about “right size, right place, and right time”. If something
9
Limited data due to the relative infrequency of surety claims require that the impact of surety bond be evaluated on
a national scale but the results can be applied regionally.
10
An analysis of 200 P3 infrastructure projects in Canada found that delays in construction could have significant long-
term economic impact particularly as the size of the portfolio of delayed projects increases
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stands in the way of delivering or enabling a vital public service at that time, then the economy suffers.
Specifically:
Since infrastructure plays a critical role in the efficient operation of the economy, the effect of delays
today compound over decades. As a result, the effective present-day value of an infrastructure
project is reduced significantly for larger projects and greater delay in implementation…. That is, for
smaller projects, the impact of delays even up to a few years has a relatively small effect, but as the
projects grow in size, the cost of delays to the Canadian economy quickly become more significant.
The Economic Impact of Canadian P3 Projects (Canadian Centre for Economic Analysis, 2016)
Examining the data, as shown in Figure 17 , we see there is a distribution of delays given financial stress
(where claims were used as a proxy for financial stress) with different bond types. Non-bonded companies
experiencing financial stress would conservatively have projects facing the largest delay distribution.
Similarly, the percentage of projects with claims have more delays than those without. This provides:
A lower estimate of the delays that might be experienced without bonds; and
The delays that might be avoided for projects that become bonded.
Impact of financial stress on project overruns
What this shows is that:
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Most projects are completed around the expected timeframe, though less so for those being
undertaken by companies with under financial stress (i.e., with claims); and
While roughly 90% of projects not under financial stress (i.e., without claims) are completed within
a 40% delay, a similar proportion of those under financial stress (i.e., with claims) are only
completed within a 200% delay.
Note that we are not assigning any specific reason for the change in total time from expectation. Projects
may extend beyond their initial target date for a variety of reasons – such as scope changes or unforeseen
issues – in additional to financial issues, hence overruns for projects without claims as well.
3.1 .3 DISTRIBU T ION OF PROJ ECTS AND BOND PROPERTIES
Project values range from tens of thousands to multi-million dollars with the majority in the $100,000 to
$1,000,000 range. Note that project values are “annualized” by dividing total value by expected duration
of construction (in years), as this is more reflective of the rate that money enters the economy. The model
picks bond properties based on the distributions from the SAC dataset, and premiums may vary depending
on bond type (performance vs performance and payment). This gives us a way of randomly selecting
realistic bond characteristics in the simulations.
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4. RESULTS
Beginning with the baseline, or reference scenario, against which the impacts of surety bonds will be
measured.
Baseline insolvency rates in the construction sector
In Figure 18 :
The dashed green line shows a typical modelled rate of insolvency in the status-quo scenario with
no surety bonds; and
The dashed red line shows a typical modelled rate of insolvency in the high-rate scenario with no
surety bonds.
Now, consider a specific example in which all public infrastructure capital projects are eligible for bonds
and are bonded, no minimum project threshold is applied, and all bonds can have characteristics randomly
drawn from the characteristics seen in the SAC data. For example:
The percentage of project value covered is randomly drawn from the “Bond Coverage” distribution
(usually 50% or 100%); and
The premium paid relative to the original bond is randomly drawn from the “Premiums”
distribution.
Status quo risk: baseline
High Risk: baseline
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Scenario insolvency rates in the construction sector
As shown in Figure 19 , with performance and payment bonds, insolvency rates are reduced considerably
(shown is the case when 100% of infrastructure projects have bonds). In the high-insolvency scenario, there
is significantly more room for improvement, and as such, we see a significant decline in insolvencies. This
results in much larger economic benefits overall.
Further, companies that become insolvent lead
to project delays – directly if the company is the
general contractor or indirectly if a supplier
becomes insolvent, such as through the
insolvency of a different customer. (These are
modeled based on the distribution of project
delays with claims.) By introducing the
performance and payment bonds, however, we
see a significant reduction in delays – as shown in
Figure 20 . As a result, many more projects are
completed closer to the scheduled time with a
large decrease in the number of projects with
large overruns, particularly in the high risk case.
Change in delay distribution
Status quo risk: bonded scenario
High Risk: bonded scenario
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The economic contribution due to project delays and compounding effects are significantly greater in the
high-insolvency scenario. This is largely driven by the bigger aggregate portfolio of projects delayed at
higher insolvency rates. Similar differences exist for the other outcome metrics such as tax revenue and
jobs.
GDP impact of all public infrastructure having performance and payment bonds
Table 1 highlights that the high insolvency risk case is disproportionately large. That is, the status quo risk
case is driven more by direct insolvencies while the high-risk case more by the network effects.
Table 1 Summary economic impacts of surety (public infrastructure)
Risk level
Economic activity, per $1 of
premium
% of benefits arising directly
from reduced insolvencies
Associated tax revenue, per
$1 of premium
Status Quo
$3.5
32%
$0.4
High risk
$25
25%
$3.0
As a demonstration of the importance of both bond types, Figure 22 and Figure 23 highlight the economic
impacts as a percentage of the scenario maximum for public infrastructure only (Figure 22 ) and for all
capital projects (Figure 23 ) in the high-risk scenario. That is, inclusion of both bond types (performance
and payment) for projects leads to better economic outcomes than performance bonds only.
Insolvencies 32%
Delays 68%
Insolvencies 25%
Delays 75%
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GDP impacts as % of high risk-scenario, public infrastructure only
GDP impacts as % of high risk-scenario, all infrastructure
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5. CONCLUSION
Credit and operational risk in the construction industry can vary significantly due to the movement of
interest rates, recession, supply shocks, debt levels, credit squeezes, and so on. Currently, Canada enjoys
historically low rates of construction insolvencies, which has been aided in part by the fact that a majority
of public infrastructure projects are surety bonded.
By understanding, quantifying and simulating the way in which the construction industry is connected
between suppliers and subcontractors of materials and services and to the broader economy, the value of
providing surety guarantees for projects to the socio-economic network of Canada could be measured. We
found that the impact of surety – and the additional due diligence its use ensures – is generally positive,
regardless of scenario run (assuming some coverage). But a combination of performance and payment
bonds – with a focus on infrastructure investments – yields the highest benefits (measured in terms of GDP
growth) relative to the costs required.
The benefits in the high insolvency rate scenario (e.g. 1990’s levels) were particularly significant and about
7 times greater than in the status-quo scenario despite the insolvency rates being only 5 times higher. The
analysis indicated that the benefits in the high risk scenario include
$25 of economic activity recovered per $1 of premium paid;
$3.0 of tax revenue (for all levels of governments) recovered per $1 of premium paid (by all levels
of governments); and
200 job-years recovered per $1M of premiums.
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A. DATA SET CHARACTERISTICS
The following table outlines the characteristics of the surety dataset used in the analysis.
Table 2 Characteristics of the surety data set
Characteristics
Value
Number of Surety Firms
6
Year of Earliest Record
1997 (not all firms provided data back to this date)
Total Number of Project
150,000+
Total Number of Construction Firm Records
10,000+
Total Number of Surety Claims
3,000+
Various firms provided different levels of details for construction firms, projects, and claims.
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B. DEFINTIONS
Agent: An autonomous individual, firm or organization that responds to cues from other agents and their
environment using a set of evidence-based behavioural rules in response to those cues.
Agent-based modeling: A framework for modeling a dynamic system, such as an economy, by means of
individual agents, their mutual interaction with each other, and their mutual interaction with their
environment(s)
Beneficiary: A person who is entitled, by law or bond language, to claim against a bond even though they
may not be specifically named as an obligee.
Bid bond: An instrument which guarantees that a bidder, if awarded the project, will execute a contract for
the amount bid and will provide the appropriate performance and payment bonds.
Collateral: Assets (e.g., cash) which is placed with the surety company and reduces the risk that the surety
assumes when issuing a bond for high risk principals or unusual obligations.
Commercial surety bonds: Bonds that guarantee the performance of all obligations that do not arise from
contracts.
Contract surety bonds: A classification of bond that guarantees the principal’s obligations under a
construction contract.
Obligee: The party to whom a service will be provided, and to whom a surety bond guarantees the service
provider will perform as expected.
Payment bonds: Also known as “labour and materials bonds”, a classification of bond that guarantees
payment by a contractor to subcontractors, labourers, and suppliers involved in contracted project.
Performance bonds: A classification of bond that guarantees performance of the contract. The obligee will
be protected from financial loss resulting from the principal’s failure to perform the work according to the
contract, plan, and specifications at the agreed price. Most of these contracts are for construction, and the
contractor must meet pre-qualification standards before being approved for the bond.
Principal: The bonded party (e.g., contractor) who bears primary responsibility on a surety bond and who
has the duty to perform for the obligee’s benefit.
Prosperity at Risk®: An event-driven, agent-based, microsimulation platform that tracks over 50 million
agents for all of Canada. It simulates the economy’s processes, including consumption, production, labour
force dynamics, as well as evolving financial statements of agents. It conserves the flows of people, money
and goods.
Surety (company): The party to a surety bond who answers to the obligee for the principal’s failure to
perform as required by the underlying contract, permit, or law.
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Surety bond: A written contract in which one party guarantees another party’s performance to a third party.
Protects the obligee against losses, up to the limit of the bond, that result from the principal’s failure to
perform its obligations or undertaking. Unlike insurance, a loss paid under a surety bond is fully recoverable
from the principal.
System effects: Impacts that transcend direct, indirect and induced effects, which are not traditionally
measured by economics. These impacts arise from the relationship between every economic agent and the
environment in which they operate, as they influence one another’s states and behaviours.
Systemic risk: In the context of this report, “systemic risk” refers to risks that are inherent to an entire
market segment as well as the wider macroeconomic framework.
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