Posts|January 28, 2022
Surety 101 for Contractors – Part I: Types of Bonds & Their Purpose
By Oliver Craig
Surety Risk Advisor
You’ve started your new construction company, and you’re off to the races. Depending on the type of work and owners you have chosen to work with, your contracts will have different requirements. One common requirement, most often seen in the public-works space, is the need for surety bonds. The goal of this article is to provide a basic understanding of what bonds are and why they are needed by contractors. Future parts of this series will detail the process used to establish a Surety Bond Program and other factors to assess as you work to obtain surety bonds. The series will focus primarily on the bonds needed by contractors, but will also touch briefly on other types of bonds available in the market.
There are three primary pieces of the surety bond process for contractors – Prequalification/Bondability Letters, Bid Bonds and Final Bonds (i.e. Performance, Payment or Labor & Materials, Maintenance/Warranty and/or Supply). Each has unique characteristics and uses, which are explained below. A contractor must first understand the parties involved in a surety bond, so the most complex instrument – Final Bonds – is explained first.
The most common types of Final Bonds are Performance and Payment (P&P) bonds for construction projects. In general, a bond ensures contractual terms will be met as specified in the contract. There can be large payments made in the event of a claim – therefore, bonds are truly a financial instrument, meaning underwriting and an evaluation of a company’s creditworthiness is required. Many companies believe obtaining a bond is more akin to buying an insurance policy, as most insurance brokerages nowadays typically have a surety (bonding) department. This is not the case, and companies should understand obtaining a bond is more along the lines of getting a new bank loan.
The primary driver for requiring bonds is the Miller Act. This Act was enacted in 1935 in an effort to protect the interest of taxpayers, the federal government and subcontractors in constructing federal projects. It requires prime contractors provide bid, performance and payment bonds for any contract exceeding $150,000 to construct, alter or repair any public building or public work. Most states also have what are commonly referred to as a Little Miller Acts (LMAs), applying the same concept as the federal Miller Act for construction projects at the state and local level. These LMAs can have a lower threshold for requiring the bonds (i.e California does not require payment bonds for projects under $25,000). Other entities that may require bonds for construction projects include universities, colleges, and school districts among others.
There are three parties to a bond – the Principal (contractor), the Obligee (project owner) and the Surety (typically an insurance company). Each party has different responsibilities as it relates to performance, notices and remedies in the event of a claim. In the most basic terms, the Principal is liable to the Obligee to complete the scope of work in the amount of time allotted in the contract, and to pay their subcontractors and suppliers under the contractual terms. The Obligee is required to fulfill its requirements under the contract. In the event either party does not fulfill its obligations, the likelihood of a termination or default from either party increases substantially.
The third party to the bond – the Surety – is obligated to “step into the shoes” of the Principal (contractor) in the event the Obligee calls upon either a Performance or Payment bond. Depending on the contract terms and bond form used, the Surety has various options when this occurs, which include (in the most basic sense):
- Financing the Principal through the completion of work
- Hiring an alternative contractor to complete the remaining work
- Making payment to the Obligee for the balance of remaining work and associated costs
These options are evaluated by the Surety as they complete an in-depth review of the issue that caused the Obligee to make a claim on the bond. It is the Surety’s responsibility to make this assessment and work to resolve the issue with the Obligee as expeditiously as possible. In the event of a claim, it is to the Principal’s benefit to have open communication and transparency with the Surety to ensure the most favorable resolution to the claim.
Another type of bond typically required by project owners is a Bid bond. For the most part, the requirement to post a Bid bond is driven by the same statutes that require P&P bonds. Bid bonds are typically written as a percentage of the bid amount (usually 10% to 20%), and are meant to ensure the contractor will enter into the contract with the project owner if awarded the work. In the event the contractor refuses the contract, the owner would incur additional costs to award and administer the contract to the second-place bidder. The Bid bond allows the owner to recoup the difference in dollars between the low bidder and the contractor who actually accepts the contract via payment by the Surety, up to the amount of the bond.
While not an actual bond, Sureties also provide their clients with Prequalification or Bondability Letters. These letters provide the owner of a project with the assurance that a Surety has underwritten the contractor and generally believes they can complete the work. It also indicates the strength of the Surety by illustrating their A.M. Best Rating and their financial rating with the U.S. Department of the Treasury. It is important to note these letters are not a commitment by the Surety to provide bonds for the contracts. There is generally language indicating the Surety reserves its right to make an assessment of the contractor’s financial capacity at the time the bond request is made.
In the next part of this series, we will discuss the types of bonding relationships most commonly seen in the industry. It will evaluate which might be the right type of relationship for your company, and what factors you will need to consider when pursuing bonds. Obtaining a Surety Bonding Program can be an intimidating process for some, and our goal is to create a foundation of understanding to help contractors achieve their long-term vision for their company.
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