Ten Things You Should Know About Surety
1. A surety bond is an instrument under which one party guarantees to another that a third will perform a contract. Surety bonds used in construction are called Contract Bonds or Performance & Payment Bonds.
2. There are three types of bonds used in construction. The Bid Bond protects the owner by guaranteeing that the contactor will enter into the contract at the determined price. The Performance Bond guarantees the performance of the work on schedule and according to the plans and specifications. The Payment Bond guarantees that certain workers, subcontractors, and suppliers will be paid.
3. Construction is a very risky business. On average, each year more than ten thousand contactors fail which leads to more than $2 billion in liabilities. Since 1985, surety companies have paid billions of dollars because of contractor failures on bonded projects. Without bonding, these costs would have been borne by the owners of the projects.
4. Federal law (The Miller Act) mandates surety bonds for all public works contracts in excess of $10,000. Federal procurement officials may, at their discretion, require bonds on contracts below that amount. All states have laws requiring bonds on public works (known as Little Miller Acts). Owners of private construction projects are recognizing the wisdom of requiring surety bonds to protect their company and shareholders from the enormous costs of contractor failure.
5. Although surety bonding is considered a line of insurance, it has many characteristics of bank credit. The surety does not lend the contractor money, but it does allow the surety's financial resources be used to back the commitment of the contractor, thus enabling the contractor to acquire a contract with the owner. The owner receives guarantees from financially responsible surety company licensed to transact suretyship.
6. Surety bonds, through the surety companies' pre-qualification of contractors, protect the owner and offer assurance to the lender, architect, and everyone else involved with the project that the contractor is able to translate the project's plans into a finished projects. Before issuing a bond the surety needs to be fully satisfied, among other criteria, that the contactor is:
- of good character
- has the experience matching the requirements of the contract
- has or can obtain the equipment necessary to do the work
- has the financial strength to support the desired work program
- has an excellent credit history
- has established a banking relationship and a line of credit.
7. Contract surety bonds:
- guarantee the project will be completed
- guarantee that certain laborers, suppliers, and subcontractors will be paid
- relieve the owner from the risk of financial loss arising from liens filed by unpaid laborers, suppliers, and subcontractors
- smooth the transitions from construction to permanent financing by eliminating liens
- reduce the liability of a contractor diverting funds from the project
- lower the cost of construction in some cases by facilitating the use of competitive bids.
8. With a surety bond, the owner can be satisfied that a risk transfer mechanism is in place. The risks of construction are shifted away from the owner to the surety. If the contractor defaults, the surety may pay for a replacement contractor, finance the existing contractor, or provide technical and/or financial assistance.
9. The costs for bonds vary, but generally are one to three percent of the contract amount. On very large projects, the cost may be less that one percent.
10. To bond a project, the owner merely includes the bonding requirement in the plans and specifications of the project. Obtaining bonds and delivering them to the owner is the responsibility of the contractor who will consult with an independent bond agency.