What Is a Contract Surety Bond?
Contract surety bonds, or construction bonds, provide governments, lenders, and businesses a guarantee that some specific type of work (performed by a contractor) will be completed per the contracted terms. The surety bond underwriter may even pay the hiring organization if the work isn’t completed as agreed.
When Are Construction Bonds Needed?
Construction bonds are most often required for large-scale construction projects, especially government construction contracts and commercial building projects. In many cases, construction companies can’t qualify for these projects without a bond.
Comparatively, these aren’t often needed for individual houses, but home builders should expect to get one if they’re working on a new development. In rare instances, a bond might be requested for an especially large new home build.
It’s also important to note that construction bonds/contract surety bonds differ from those that auto dealers, liquor stores, school bus contractors, and other businesses purchase.
Who’s Involved in a Construction Surety Bond?
All surety bonds typically involve three parties: the principal, the surety, and the obligee. In a construction surety bond, these are:
- Principal: The construction company that’s obligated to complete the work.
- Surety: The underwriting company that will make payment if the work isn’t completed.
- Obligee: The hiring entity or owner of the project that will be paid if the work isn’t completed.
Types of Contract Surety Bonds
Bid Bonds
The purpose of a bid bond is to ensure that a company that bids on a project will move forward with the work if they win the contract. The bond typically guarantees that the construction company will begin the project and that they won’t renegotiate the cost quoted.
A bid bond is the first type of surety bond that construction companies are required to have. Be prepared to acquire this bond before placing a bid so that you can include it in your bid’s paperwork. Many insurance agencies, including Allied Insurance Managers, do not require clients to purchase a bid bond—this bond type is generally free.
Performance Bonds
The purpose of a performance bond is to ensure that the hired construction company will complete the project according to the terms and conditions of the contract. The bond might pay if the project isn’t completed due to insolvency, inadequate quality, or some other contractual breach.
Performance bonds are usually needed when a contract is signed. They’re often set up after winning a project bid.
Payment Bonds
A payment bond ensures that subcontractors, laborers, and suppliers are properly paid for their work.
Although this bond doesn’t directly protect the entity that hires a construction company, it protects the subcontractors that the principal hires to perform work on the job. If workers aren’t paid their due wages, either because of a construction company’s insolvency or refusal, the workers might have legal recourse against the entity that hired the contractor, and, as a result, are able to put a lien on the bond. Thus, the bond helps protect the hiring entity by paying workers if they’re stiffed.
Payment bonds are often purchased alongside performance bonds. Both are typically needed for the duration of a construction project.
Warranty/Maintenance Bonds
A warranty bond (or maintenance bond) guarantees the work that a construction company does. The bond may make payment if defects in the work completed are found and the contractor fails to adequately address them. How long the warranty period lasts is specified in the bond’s terms.
This is the final bond purchased, but it might be set up before or during a project.
Do Contractors Need Both Bonds & Insurance?
Yes, contractors working on large construction projects usually need construction bonds and commercial insurance. The two provide different protections:
- Commercial Insurance: Primarily protects the contractor’s equipment against loss or damage and the construction company against liability risks.
- Surety Bond: Primarily protects the hiring entity against various risks associated with any large construction project.
Both are purchased by the contractor, even though surety bonds would pay the hiring entity if there’s a valid claim.
Contractors working on smaller projects, such as individual residential homes, are less likely to need surety bonds, but should still have insurance.
Factors That Influence the Cost
Contract bond premiums are based on two main factors: the bond amount and the perceived risk. The bond amount depends on the size, cost of a project, and the contractor’s financial standing.
The perceived risk is assessed during underwriting, and a corresponding premium is assigned. The specifics of a project, including its scope of work, type of project, and particular risks can impact cost. So, too, can a construction company’s financial state, credit report, and past history of work.
Applying for a Bond
The most cost-effective way to apply for a construction bond is through a specialized, independent agent. An independent agent who doesn’t work with just one bond underwriter/carrier can check rates from surety carriers and easily see which company offers the best terms at a competitive rate.
The application process typically requires providing financial statements, pulling a credit report, references, and information on any previously completed projects. Underwriters may ask for a range of other items that help them assess risk, but an agent can guide contractors through this entire process.
Once an underwriter approves a contractor’s bond, the bond is purchased. It can be purchased before the bond actually goes into effect, setting up the start date for when the bond is needed.
Can Contract Surety Bonds Be Extended?
Construction projects are sometimes delayed, and most insurance companies and surety carriers understand this. So, many contract surety bonds allow for a one-time extension. The best way to know if your specific bond can be extended is to speak with your agent.
Filing Bond Claims
If the principal (contractor) does not meet the obligations outlined in the bond, whether it’s failing to complete a project, not paying subcontractors, or refusing to address post-completion defects, the obligee (the entity that hires the construction company) can file a claim.
The surety (underwriting company) will investigate the claim to determine its validity. If the claim is valid per the bond’s terms, payment will be made to the obligee (or worker).
Even though the underwriting company pays the claim, the contractor still remains liable for the cost. The underwriting company will usually pursue the contractor through litigation.
Keep in mind, too, that the surety bond will also detail what reasons for failing to complete a project qualify for payment.
Learn More From Allied Insurance Managers
Allied Insurance Managers is one of the largest independent insurance agencies in Michigan. As an independent insurance agency, we can help you find better deals on commercial insurance, bonding solutions, and more, provide expert advice, and develop custom-tailored insurance programs for your business. Please contact us today with any questions you have regarding contract surety bonds or to learn more about our offerings.
