Contract surety bonding is not a mystery. For those that are considering public work, public private partnerships or private work that requires surety bonding, you should understand what it is and why we underwriters request certain information. The SIO (Surety Information Office) published an excellent ten-point “things that you should know” list that will put you up to speed on contract surety. There are a few items that require revision. Most surety companies now are stand-alone rather than “departments”, we have never seen a 0.5% premium rate, and the Heard Act was passed in 1893, not 1984. Everything else in the list is super-on-target, as follows:
1.) A surety bond is a three-party agreement where the surety company assures the obligee (owner) that the principal (contractor) will perform a contract. Surety bonds used in construction are called contract surety bonds.
2.) There are three primary types of contract surety bonds. The bid bond assures that the bid has been submitted in good faith, that the contractor intends to enter the contract at the price bid and provide the required performance and payment bonds. The performance bond protects the owner from financial loss in the event that the contractor fails to perform the contract in accordance with its terms and conditions. The payment bond assures that the contractor will pay certain workers, subcontractors, and materials suppliers.
3.) Most surety companies are subsidiaries or divisions of insurance companies, and both surety bonds and insurance policies are risk transfer mechanisms regulated by state insurance departments. However, insurance is designed to compensate the insured against unforeseen adverse events. The policy premium is actuarially determined based on aggregate premiums earned versus expected losses. Surety companies operate on a different business model. Surety is designed to prevent loss. The surety prequalifies the contractor based on financial strength and construction expertise. The performance bond is underwritten with little expectation of loss.
4.) In 1893 Congress passed the Heard Act to protect federal projects from contractor default and protect subcontractors from nonpayment by contractors. The Heard Act was supplanted by the Miller Act in 1935, which basically requires performance and payment bonds in excess of $100,000 and payment protection for contracts between $30,000 and $100,000. A corporate surety company issuing these bonds must be listed as a qualified surety on the Treasury List. Also, almost all 50 states, DC, Puerto Rico, and most local jurisdictions have passed laws requiring surety bonds on public works called, “Little Miller Acts.” Owners of private construction may require surety bonds as part of their risk management strategy.
5.) Construction is a risky business. Of 1,424,124 contractors in business in 2007 only 969,937 were still in business in 2009 – a 31.9% failure rate. Surety bonds offer financial assurance that the contractor has the capacity to complete the job within the time-frame, within the budget and up to the specifications of the contract. Requiring performance bonding reduces the likelihood of default while simultaneously providong the owner has the peace of mind that a sound risk transfer mechanism is in place. The burden of construction risk is shifted from the owner to the surety company.
6.) Surety bond premiums vary from one surety to another, but can range from 1.5% to 3.5% of the contract value. There are MULTIPLE considerations when setting the rate but are largely based on who the contractor is and his or her capacity to complete the job. Most sureties do not charge for a bid bond when a contractor is awarded a job and subsequent performance and payment bonds are required. Payment bonds and an understanding that the contractor and surety guarantee work and material for one year is customary.
7.) A surety’s prequalification process of a contractor protects the project owner and offers 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 product. Surety companies and surety bond producers have over a century of modern underwriting practice. Their expertise, experience, and objectivity in prequalifying contractors is one of the contract surety bond’s most valuable qualities. Before approving contract surety bonding to a particular contractor the surety pays special attention to the following:
• proven character and history of fulfilling promises;
• the ability to meet current and future obligations;
• experience matching the contract requirements;
• the necessary equipment to do the work or the ability to obtain it;
• the financial strength to support the desired work program;
• an excellent credit history; and
• an established bank relationship and line of credit.
These observations build the bond underwriter’s understanding of the contractors CHARACTER, CAPACITY and CAPITAL, known as the “Three Cs” of surety.
8.) Contractor default is unfortunately, common. In the event of a default the project owner must formally declare the breach of contract. The surety conducts an impartial investigation prior to settling any claim. This protects the contractor’s legal recourse in the event that the owner improperly declares the contractor in default. Upon breach and finding that there is cause, a the surety generally has the right to re-bid the job for completion, tender a replacement contractor, provide financial and/or technical assistance to the existing contractor, or pay the bond penalty to the obligee (project owner). That owners have been shielded from risk is evidenced by the fact that surety companies have paid more than $10.1 billion due to contractor default since 1995. According to the SFAA in 2009, the surety industry paid more than $84.4 million in losses on private construction and more than $1.6 billion since 1995.
9.) When a performance bond is required by contract, it is the contractor’s responsibility to provide them. The prequalification process provides the contractor a “bond cost” so that he or she can include that premium expense in the bid. If the contract amount changes, the premium is adjusted for the change in contract value.
10.) After analyzing the risks involved with a construction project, consider how surety bonds protect against those risks. Owners, lenders, taxpayers, contractors, and subcontractors are protected because:
• The contractor has been subjected to a time-proven prequalification process and is judged capable of fulfilling the obligations of the contract;
• Contractors are more likely to complete bonded projects than non-bonded projects since the surety company may require personal or corporate indemnity from the contractor;
• Subcontractors are protected by payment bonds being in place;
• Bonding capacity can help a contractor or subcontractor grow by allowing him or her to bid on new project opportunities and by providing the advice and support of the surety bond producer and surety; and
• The surety company fulfills the contract in the event of contractor default.
National performance bond leader, Surety One, Inc. focuses on supporting the performance bonding needs of the commercial, highway, heavy industrial and general contracting sectors. We offer performance bonds to construction and commercial service contractor applicants small and large. Visit SuretyOne.com, call (787) 333-0222 or (800) 373-2804, or email Underwriting@SuretyOne.com for a performance bond submission package or information about any surety bonding need. Recuérde que le asesoramos en SU idioma, así que comuníquese con nosotros, SU compañía afianzadora preferida.