Surety bonds assure project owners that a contractor can complete a project according to contract specifications. Requiring a surety bond on a project helps prequalify contracting firms based on their credit strength, experience and capability to successfully complete contracts and “weeds out” contractors that do not have the wherewithal to complete a job. Before a surety company issues a bond, it prequalifies a contractor and offers assurance to a project owner that the contractor can perform the contract according to its terms and conditions. Furthermore, the surety company guarantees that the contractor will pay certain laborers, subcontractors and suppliers associated with the project. The economic risk of contractor default stays with the bonded contractor, who must sign an indemnity agreement holding the surety harmless.
How a surety bond works
Contract surety bonds are three-party agreements whereby one party (the surety company) guarantees another party (the owner) that a third party (the contractor) will perform the contract. The owner specifies the bond requirement in the contract documents. It's the contractor's responsibility to secure the bonds.
Because of the intricacy of the bonding process, and the fact that each surety company has its own unique underwriting standards and practices, contractors turn to surety bond producers (often independent surety insurance agencies) to secure the surety bond on their behalf. Contractors include the cost of the bond premium in their bid prices. The surety company typically charges only for the final bond(s) when the contractor is awarded the contract.
Bonds are required on most public work projects. Contracts for these jobs are awarded under a competitive, sealed, open-competition bidding system where the work is awarded to the lowest responsive bidder. Surety bonds have been required on public construction jobs for more than 100 years. To protect taxpayer dollars from irresponsible bidders and incapable contractors, Congress passed the Heard Act in 1894, which required contractors to obtain surety bonds on public work. The Heard Act was later replaced by the Miller Act of 1935, which mandated performance and payment bonds on all federal public work contracts in excess of $100,000. Most state and local governments have adopted similar legislation (often referred to as “Little Miller Acts”). The requirements stipulated by “Little Miller Acts” vary.
Types of contract surety bonds
The bid bond provides financial assurance that the contractor is capable of performing the contract at the price bid, and will comply with the conditions of the bid, including entering into a final contract if the contractor is the successful bidder. It also assures the owner that the surety company will issue the requisite payment and performance bonds. If the contractor is awarded the contract but fails to enter into the agreement, the surety may be required to pay the difference between the awarded bid and the next lowest bid or pay the bond penalty.
The performance bond protects the owner from financial loss, should the contractor fail to meet the terms and conditions of the contract. If the contractor defaults, the surety will respond in accordance with the terms of the bond.
A payment bond guarantees that the contractor will pay certain laborers, materials suppliers and subcontractors. Payment bonds issued by themselves only guarantee that the project will remain lien free for the obligations assumed by the principal. If the contractor fails to pay, the surety will make the payments up to the penal amount of the bond (stipulated in the contract). Generally, payment bonds are supplied at no additional cost when purchased in conjunction with a performance bond.
Benefits of a bond
Surety bonds have several key benefits:
Greater pool of qualified contractors bidding for jobs, resulting in more timely project completion and less likelihood of contractor failure;
Payment protection for subcontractors, suppliers and laborers (Subcontractors and suppliers may submit more competitive prices if they are protected by a payment bond);
Technical, management and/or financial assistance for the contractor to keep the project on schedule;
No liens from unpaid subs and suppliers covered by the payment bond, which will smooth transition from construction to permanent financing;
Guarantees correction of defects as a result of faulty material or workmanship for at least one year.
Remember that contractors must qualify for surety bonds. The process of obtaining bonds is more like obtaining bank credit than purchasing other types of insurance. When obtaining bank credit, the financial institution only provides the loan if it determines the party is capable of repaying it in full with interest. With traditional insurance, premiums are paid based upon deductibles and expected losses. However, surety companies do not expect a loss, and they will not bond a contractor that does not meet their prequalification standards.
The prequalification process
The primary service of the surety is prequalification. Therefore, the surety bond that a contractor pays is primarily a fee for service and granting of surety credit. A surety offers financial backing for the contractor. It does not lend contractor money, but rather commits its financial resources to back the commitment of the contractor. This enables the contractor to acquire a contract with the owner.
The surety company's process for prequalification (also referred to as underwriting) carefully analyzes the contractor's entire business operation, because the surety is backing the promise of that contractor to perform the contract. The company evaluates the contractor's capacity to perform this particular contract as well as other contracts already written, determines his/her financial strength, reviews his/her character and may ask for personal or corporate indemnity. The surety bond producer assists the contractor with prequalification and evaluates the company in several key areas: capacity to perform; financial strength; character; and often the strength of the indemnity agreement that they may require.
When analyzing a contractor's capacity to perform, the surety company will look at the resumes of the contractor and key personnel, the contractor's track record of successfully completed work and the adequacy of the contractor's equipment and tools required to perform the contract. The surety company will also want to know the rationale for why the contractor is undertaking the project; the continuity plan that illustrates how the company will continue performing its obligations in the event of the demise or departure of key personnel; and the contractor's future plans, short and long-term goals, objectives and growth strategies.
Surety companies will also perform an analysis of a contractor's financial strength. This will usually require that the contractor provide detailed financial statements for the past three to five years, and accounting methods that comply with Generally Accepted Accounting Principles (GAAP). These financial statements should include a balance sheet; statement of earnings; statement of changes in owner's equity; statement of cash flow; notes to financial statements; and contract schedules. The surety may ask for interim financial statements. Requirements for interim statements vary, but a six-month statement usually is the minimum.
Sureties also will require a schedule of work in progress (usually quarterly). This schedule should list each job by name and indicate the total contract price including: change orders, amount billed to date, cost incurred to date, revised estimate of the cost to complete, estimated gross profit; anticipated completion date; cost records that account for the financial status of the contractor's jobs; credit reports demonstrating how the contractor handles payment of debts; and a bank line of credit showing unsecured credit that can be used as short-term working capital.
To evaluate a contractor's character, surety companies may review trade references from owners, architects, subcontractors, general contractors and material suppliers with whom the firm has worked to get a sense of the contractor's reputation for fair, businesslike dealings.
In addition, surety companies may require the “personal indemnity” of the owners, their spouses, or major stockholder(s) of the contracting firm to assure that they are going to put forth their best efforts to meet contract obligations. In some cases, the contractor may have to declare personal assets to increase the amount of surety credit available. For a proper evaluation of how much loss the personal indemnity can cover, the surety may request the contractor to provide personal financial statements.
Although the prequalification process greatly reduces the likelihood of contractor default, things do happen on a construction project that can cause a contractor to fail. These problems include but are not limited to poor cost and project management systems; estimating, bidding or procurement problems; cost overruns; lack of adequate insurance; a change in leadership or personnel at the company; catastrophic weather, fire or other problems on the job site; lack of or late payments by the project owner; or a host of other problems.
When a contractor gets into trouble, the surety may look at several options to avoid further deterioration of the situation and an ultimate default. Default may be averted because of the surety company's expertise in seeing projects to completion. To avoid default, the surety company may provide trained personnel, direct payment to subcontractors, laborers and suppliers and/or offer financial assistance to the contractor.
While everyone would prefer to avoid default, it's not always possible — especially if the contractor or owner fail to talk about problems as they arise. In the event of default the surety company may, according to the particular language of the bond and construction contract, retain the original contractor and provide trained personnel offer financial assistance, provide payment for subs and suppliers, rebid the job to another contractor for completion or pay some or all of the penalties included in the bond.
Cost of surety bonds
The cost of the surety bond is referred to as the premium. The premium is a fee for the surety's prequalification, underwriting and other services. Bonds typically cost between 0.5% to 1% of the contract price, although rates vary from company to company. A payment bond generally is provided at no additional cost when issued in conjunction with a performance bond.
In charging this small fee for prequalification, the surety underwrites the contractor with the assumption that it will not incur a loss under the bond.
It's important to inquire about the rates when you are charged a premium. Rates may very depending on the type of work the contractor normally performs. Also, some surety companies offer preferred rates for contractors with proven track records. Don't just look for the absolute lowest rate in the industry. When evaluating the premium, contractors should take into account the opportunities and services that the surety company offers, such as customer service, support, confidence and capacity to grow.
Most surety companies file their individual rate plans with the various insurance departments of the states in which they operate. Almost all surety companies file multiple rate plans along with prequalification requirements for each category. Most rate plans are financial requirements based on net worth, sales volume and quality/frequency of financial reports.
Choosing a surety producer
The surety bond producer plays an essential role in helping a contractor obtain bonds, and can be an integral part of the contractor's external advisory group, which includes attorneys, bank officers and auditors. Surety bond producers, however, receive a commission on the bond premium only when the contractor is awarded the job and the bonds are issued.
By using his/her specialized knowledge of the construction industry, the surety bond producer prepares the contractor for the surety company's rigorous prequalification process. Contractors should look for a producer that specializes in bonding for the construction industry. A surety bond producer should have a reputation for integrity and respect in the industry; personal interest in the contractor's success; ability to build solid relationships with surety underwriters; and thorough knowledge of financial practices in the construction industry.
Choosing a surety company
The surety underwriter is an employee of the surety company. The underwriter reviews the contractor's case by thoroughly analyzing the financial records and the contract to determine the contractor's ability to complete the project. The underwriter ensures that bond forms, application forms, forms for indemnity, collateral and other agreements are completed and filed appropriately.
As a contractor develops a strong business relationship with a surety bond producer, a relationship will also ensue between the contractor and the surety company, who will help the contractor keep and increase its surety capacity. When choosing a surety company, look at its reputation, experience with your type of work, access to representatives, good relationships with producers and claims handling.
Work hard to develop a personal connection and credibility with the surety bond providers and underwriters. Don't underestimate the importance of developing a good working relationship with the local surety agents and the underwriters at the surety bonding companies. If they get to know you and believe in your company, they will be your best allies in securing bonds.
This article was edited from material provided by the Surety Information Office, Washington, D.C.
FOR MORE INFORMATION
To learn more about surety bonding, the four best sources of information are the Surety Information Office (SIO), the Surety Association of America (SAA), the National Association of Surety Bond Producers (NASBP) and the Small Business Association (SBA). Contact information for these associations is listed here. You can get more information on surety bonding from the Associated General Contractors of America (AGC) Alexandria, Va., at www.agc.org.
Surety Information Office (SIO)
5225 Wisconsin Ave. NW, Suite 600
Washington, D.C. 20015-2014
Phone: (202) 686-7463
Fax: (202) 686-3656
Web site: www.sio.org
The Surety Information Office offers information to contractors, owners, design professionals, legislators, public officials, bankers and others about the benefits of contract surety bonds in public and private construction.
Surety Association of America (SAA)
1101 Connecticut Ave., NW, Suite 800
Washington, D.C. 20036
Phone: (202) 463-0600
Fax: (202) 463-0606
Web site: www.surety.org
The SAA is a voluntary, non-profit incorporated association of companies involved in suretyship. It has about 600 member companies that collectively underwrite the majority of security and fidelity bonds in the United States.
National Association of Surety Bond Producers (NASBP)
5225 Wisconsin Ave., NW, Suite 600
Washington, D.C. 20015
Phone: (202) 686-3700
Fax: (202) 686-3656
Web site: www.nasbp.org
NASBP is the international organization of professional security bond producers and brokers. It represents more than 5,000 members who specialize in surety bonding and provide performance and payment bonds for the construction industry.
Small Business Association (SBA)
Office of Surety Guarantees
U.S. Small Business Administration
409 Third St., SW, Suite 8600
Washington, D.C. 20416
Phone: (202) 205-6546
Web site: www.sba.gov/OSG/
The U.S. Small Business Administration (SBA) can guarantee bonds for contracts up to $2 million, covering bid, performance and payment bonds for small and emerging contractors who cannot obtain surety bonds through regular commercial channels. This program is open to small contractors whose annual revenues for the past three years have not totaled $6 million.