A surety bond is a three-party agreement between a surety, a contractor, and an owner. The surety, (typically an insurance company) promises to satisfy the contractor’s obligations if the contractor fails to perform in accordance with the construction contract. The surety’s obligations, however, are generally limited to the amount of the bond. If the surety incurs any liabilities in correcting the work or paying subcontractors and suppliers, that liability is usually recovered from the contractor pursuant to a general indemnity agreement between the contractor and the surety, which includes personal indemnities from key parties with the contractor.
Here are some of the benefits of a surety bond to owners:
The best way for a surety company to protect itself is to make sure that the contractor is going to perform its obligations in the first place. Before agreeing to provide surety credit and bonding capacity to a contractor, the surety company will require the contractor to undergo an extensive pre-qualification process. The surety company will collect information during the process, such as the past three fiscal year financial statements, current copies of any loan agreements, lines of credit, and the contractor’s current work in progress. In addition, the surety company will also request the contracting company’s and key employees’ resumes, a letter of recommendation from past projects, and other statements regarding the qualifications of the company, as well as the certificates of insurance. All of these criteria are considered in the surety’s evaluation of the contractor’s ability and quality to perform contracts within the bonding capacity. Additionally, this qualification process will occur on an on-going basis as the surety regularly evaluate the viability of the contractors they underwrite. Accordingly, when a contractor is able to provide bonds sufficient to cover a project, the owner can take some comfort that the surety has actively evaluated the contractor’s ability to adequately perform the construction contract.
If an owner requires a contractor to have payment and performance bonds, the surety agrees to back up the contractor if it fails to fulfill the contractual obligations, at least up to the amount of the bond.
These are the benefits to the owners that often times owners don’t even know exist on a contract and on a construction project. Often times, especially in the performance bond arena, the surety will intervene and provide assistance to the project. For example, the surety could assist the owner and the contractor to reach a conclusion that doesn’t require the owner to declare the contractor in default. In other instances and without the owner’s involvement, to avoid a problem on a project, the surety may offer the contractor additional assistance to ensure that the project is completed. In some instances, the surety may even take control of the funds that are coming into the contractor to ensure proper payment of subcontractors and even provide additional capital to a struggling contractor so they can avoid default.
Generally speaking, surety bonds cost around one percent of the contract amount and can be renewed for an additional fee. For a performance bond, it’s a one-time premium that is usually incorporated into the contract, which could be between a half percent to three percent of a contract amount, and the cost will typically be in the first pay request. The contractor will be the party obtaining the bonds, but the owner is the party who pays and ultimately gets the benefits of the bond. For a bid bond, there is usually no fee associated with it. If a contractor has bonding capacity, a surety will typically issue a bid bond as a matter of course for the contractor. For payment bonds, because they are almost always issued in conjunction with a performance bond, there is no additional charge. Material maintenance and warranty bonds typically require an additional fee, but it is AIA’s understanding that the amount is not that high.
In the construction industry, the four most common types of bonds are as follows:
The owner receives a bid bond from the contractor when they bid on the project. Bid bonds protect the owner. If for some reason the owner and the contractor are not able to ultimately agree to and sign a construction contract f, and the owner has to move on to the next best bid, the surety bond will cover the difference in cost. That means if the owner incurs a higher contract sum because they could not reach an agreement with the original contract, the bid bond will cover that difference. Depending on how the bid bond is written, it may also cover any cost the owner has incurred of having to rebid on the project, but that somewhat depends on the language of the bond.
Performance bonds protect the owner in the event that the contractor does not perform the agreed-upon work. In this scenario, the surety is obligated to step in and take action. The surety may make arrangements with the contractor to complete the work, solicit bids and find a new contractor that can perform the work, perform the work itself, or simply pay the amount of the bond to the owner.
Payment bonds are important for owners because payment bonds ensure the contractor pays their subcontractors and precludes the possibility of a subcontractor filing a lien on the owner’s property.
Warranty bonds, also called maintenance bonds, a cover warranty obligations that a contractor would have after completion of the project. Warranty bonds guarantee that the workmanship of the contractor will be of adequate quality. Typically, warranty bonds last a short period of time after substantial completion, with a length of usually one to two years.
AIA Contract Documents offers three industry-standard bond forms and these forms are an important precaution that guard against broken contracts and also strengthen the trust between an owner and contractors.
A310™-2010, Bid Bond: AIA’s simple, one-page bid bond form is used most commonly on public projects. The bid bond establishes the amount due to the owner from the surety should a selected bidder fail to execute a contract per specifications. A310-2010 may also be used by subcontractors when required by the contractor.
A312™-2010, Performance and Payment Bond: AIA Document A312™- 2010 incorporates two bonds—one covering the contractor’s performance, and the other covering the contractor’s obligation to pay subcontractors and others for materials and labor.
A313™-2020, Warranty Bond: AIA Document A313-2020 is an assurance by the Contractor and the Contractor’s Surety that the Contractor’s warranty obligations will be performed and completed in accordance with the terms of the Construction Contract. Watch On Our Terms short video to learn more about the warranty bond.
Learn about how surety bonds can help you manage risk and protect your business. Watch this on-demand webinar “The ABCs of Construction Surety Bonds”. Watch Now >