The choice to reduce and skillfully handle the risk attached with construction projects and choosing the right financial decisions to ensure the completion of projects is crucial to the success of the projects.
Gambling on a contractor or subcontractor with a questionable level of commitment or who could go bankrupt in the middle of the job can be a wasteful decision. Surety bonds provide a desirable solution, which is to offer assurance of the project and provide financial security by making sure the contractors are capable of carrying out a construction contract and paying subcontractors, workers, and materials.
Let us dive into some things you should know about surety bonds.
A surety bond is an agreement between three parties: The obligee, the principal, and the surety company. The surety company offers the obligee (owner) a guarantee that the principal (contractor) will execute the contract. In construction, a surety bond is referred to as contract surety bonds.
Contract surety bonds have three types. One is the bid bond, it guarantees that a bid has been tabled, and the contractor has intentions to work on the contract at an agreed price and provide performance and payment bonds.
A performance bond is a cover that protects the owner against financial loss when the contractor does not execute the contract in compliance with the agreed terms and conditions. Payment bonds guarantee that the contractor shall pay the materials suppliers, subcontractors, and workers.
A lot of surety companies act as subsidiaries of insurance companies. Surety bonds and insurance policies are mechanisms of risk transfer that have been regulated by the state insurance departments. Since 2007, out of 1,424,124 contractors in the business, only 969,937 were still active in business, in 2009; a failure rate of 31.9% was reported.
Surety rates are based on statistical calculations and the potential for loss is usually considered, they are also a levy for the surety’s underwriting and prequalification service.
The Heard Act to protect federal projects was passed in 1894 by Congress, the Act was to protect federal projects from contractor default and replaced by the Miller Act in 1935. The latest version of the act that calls for a performance bond and payment bond for contract surety bonds above $100,000 and $150,000 by regulation, and payment protection for contracts between $30,000 and $100,000.
A corporate surety company that issues these bonds must be a certified surety on the U.S. Department of Treasury List, Circular 570. Aside from the 50 states, Puerto Rico, the District of Columbia, and some local jurisdictions have effected similar laws that call for surety bonds in public projects. These are also regarded as “Little Miller Acts.” Private construction owners also manage risk with surety bonds.
Construction has always been a risky business, and surety bonds offer the guarantee that a contractor can complete the contract in the right time frame, according to specifications, and within budget. This bond does not only reduce the happening of a default, it also gives the owner peace of mind because there’s a risk transfer mechanism in place. The risk of construction is transferred from the owner to the surety company.
The difference in surety bond premium from one surety to another is within the range of 0.5% to 3% of the contract price; however, it is close to 3% with Small Business Administration Bond Guarantee. The difference also varies, depending on the type, size, project duration, and contractor.
A bid bond does not attract charges if the performance and payment bonds are called for on the project. The payment bond cost and a 12-month maintenance bond are included in the purchase of a performance bond.
The contractor’s assessment by the surety company covers the project owner and assures the lender, contributors, architect, and everyone involved in the project that the contractor is capable of handling and converting the plans into a complete project. Surety companies and the producers of surety bonds have always assessed the contractor and subcontractor’s achievements for over a century. Their skill set and experience in placing a contractor’s qualification reflect key attributes of a bond.
Before a bond is issued, the surety company must have checked that the contractor has the following:
- Matching experience with the contract ;
- Ability to meet all obligations;
- Worthy reputation and reference;
- Adequate equipment to complete the project;
- Financial strength for the required work;
- A good credit line and a proper bank relationship.
Contractor default is not a pleasant and fortunate circumstance, if the contractor has failed in their duties, the project will declare the contractor in default. The surety carries out a detailed investigation before the settling of a claim. This also secures the contractor’s legal recourse if the owner falsely declares the contractor in default.
In an event that the default stands, the surety options will be spelled out in the bond. Part of the options may include the grace to
- Rebid for the job completion
- Assist another contractor that’s being employed or pay the penal due of the bond
- Provide another contractor
Project owners have truly been protected from the construction risk, an obvious evidence is that from 1995 to 2014, surety companies have paid over $13.8 billion as a result of contractor default. The surety industry dispensed over $84 million in 2014 to private constructions, and over $2 billion have been paid since 1995.
When a bond is specified in the contract documents, the contractor is obligated to have the documents. On most occasions, the contractor pays the bond premium amount. The premium becomes payable upon successful execution of the bond. If the amount stated in the contract changes, the premium also changes because of a change in the contract price.
Contract surety has always been regarded as a wise investment as it provides competent contractors and shields project owners and prime contractors from default.
After evaluating the risk attached with a construction project, consider how a surety bond protects the owners, contractors, and subcontractors from the risk, here’s why:
- Contractors will likely complete bonded projects more than non-bonded projects because surety companies will obligate compensation from the contractor;
- The contractor has been thoroughly assessed during the employment process and is capable of executing the contract;
- Surety bonds can help grow a contractor and increase their project opportunities;
- Subcontractors don’t have to file mechanics’ liens when a payment bond is included in private projects;
- Surety company offers assistance to the contractor to prevent default;
- Surety companies complete the contract when there’s a contractor default.