Surety bonds were created to protect owners, taxpayers, subcontractors and suppliers from performance and payment risk during the construction phase of a project. Sureties use the underwriting process to determine which contractors are capable of completing a contract. Whether the contractor can afford the financial risks is merely one inquiry. Whether the contractor has quality staff and expertise to support the construction is a further inquiry.
The Difference between Insurance & Bonding
- Relationship of the parties—An insurance policy is a form of risk management. The insurance policy is a contract between the insured and the insurance company, with no third-party beneficiary. The insurance policy promises that the insurance company will compensate the insured in the case of a covered loss. In contrast, a surety bond is a contract between the bond principal (the primary obligor) and the surety (the secondary obligor), but includes a three-party relationship with the oblige—an express, third-party beneficiary.
- How risk is handled—Under an insurance policy, the insured transfers the risk, typically of personal injury or property damage, to the insurance company that insures a large pool of similar risks. When an insurance carrier pays on an insurance policy claim, it does not expect repayment. In contrast, the obligee transfers its risk to the surety for the failure of a principal to meet its contractual obligations. Because, a surety bond is a form of credit, the bond principal is responsible to reimburse the surety for any losses it suffers as a result of having issued the surety bond. Theoretically, the surety only suffers a loss if the bond principal/contractor and the individual indemnitors are unable to reimburse the surety for the loss.
- Premiums—The premium on insurance policies is designed to cover the potential losses, although pooled with other insurance policy premiums. Insurance premiums are typically charged and paid on an annual basis. The one-time premium on a surety bond is based on a percentage of the obligation guaranteed. Notwithstanding that sureties can charge a premium for bid bonds, sureties typically do not charge a premium until they issue what are called the “final bonds,” after the contractor has won the bid and been awarded the contract. Surety bond premiums can range from 0.5 to 3 percent of the contract amount, often with a sliding scale. Sureties charge a one-time premium based on the value of the bonded contract, notwithstanding that they have issued both a performance bond and a payment bond, each in the amount of the contract. Hence, the surety technically has double exposure. Because of the surety’s equitable subrogation rights, the surety does have the benefit of the remaining contract balance in a default scenario. If the contract amount increases by way of change order, the premium increases as well. However, unless the bond provides otherwise, the bond amount does not increase.
- Loss expectation—Under a surety bond, losses are not expected. Some surety professionals state that the only time a surety should suffer a loss—if its underwriting was solid—is when the bond principal files bankruptcy or dies. Surety bonds are underwritten more like bank lines of credit.
Construction Project Bonds
- Performance bond—The performance bond guarantees to the owner or, if a subcontract bond, to the general contractor that the contractor will perform the contract pursuant to the contract’s terms, covenants and conditions.
- Payment bond—The payment bond guarantees that the bond principal, either the general contractor or subcontractors, will pay its subcontractors, suppliers and laborers on the project.
Financial Security & Construction Assurance
Surety bonds are the only form of financial security related to construction project performance and payment that provides 100-percent coverage up to the maximum amount on the bond. Letters of credit are typically 10 percent of the total price of construction, and subcontractor default insurance typically carries a substantial deductible or self-insured retention. Surety bond requirements are almost always a part of the initial bidding process with the form of the required bonds included in the request for bids/proposal. That is, the procuring agency determines the bond form. The contractor, through a surety agent, obtains the bonds and provides them to the obligee.
Prequalification & Underwriting
One of the values that the surety industry offers to the construction industry is prequalification of the bond principal. Sureties can take on the risk of contract default because of their rigorous, in-depth investigation of the contractor. Before issuing a bond, the surety determines that the contractor has, among other attributes:
- Appropriate references from the construction community and an excellent reputation from its peers, customers and vendors
- The capacity to meet current and future obligations, including a cash reserve for unexpected expenditures
- The capability to perform the proposed bonded contract as to size, complexity, nature and location
- The required talent and equipment
- The financial wherewithal needed
- Adequacy of insurance coverage
- A relationship with a bank or financial institution and an available line of credit
The Three Cs
The 3Cs are a trademark of surety underwriting, listed below.
- Capital—Generally speaking, this criterion is the most important. Whether capital, cash, credit or a combination thereof, it is the financial evaluation of the bond principal.
- Capacity—A synonym for this is capability. It is the evaluation of the contractor’s ability to perform the contract.
- Character—Some underwriters advise that the way in which they evaluate character is by having a face-to-face meeting to determine the contractor’s honesty and integrity. Underwriters usually obtain references from others with whom the contractor has worked in the past.
Underwriting Contract Language
Surety underwriters review the proposed contract to determine whether there is problematic contract language, including:
- Liquidated or delay damages
- Warranties, particularly duration
- Insurance requirements
- Performance guarantees
- Change-order provisions
- Termination provisions, both in the contract and the bond
- Dispute provisions
- Attorney’s fees provisions
- Owner approval requirements
Based on the above information, it is clear that surety bonds provide a much-needed safety net for the construction industry as a whole, in addition to consumers, taxpayers and others. Use these guiding principles to assist your company in navigating the world of surety. This article is the first in a two-part series on the basics of surety bonding. To read Part 2, click here.