of Surety Bonds · 2015-11-11 · of Surety Bonds In Construction contract amount, depending on the...

The Importanceof Surety Bonds

In Construction

contract amount, depending on the size, type, andduration of the project and the contractor. Typically,there is no direct charge for a bid bond. In manycases, a performance bond incorporates thepayment bond and a maintenance period. The contractor includes the bond premium

amount in the bid and the premium generally ispayable upon execution of the bond. If the contractamount changes, the premium may be adjusted forthe change in contract price. Contract surety bondsare a wise investment—protecting public owners,private owners, lenders, and prime contractors fromthe potentially devastating expense of contractor andsubcontractor failure.

Benefits of BondsAfter analyzing the risks involved with a constructionproject, consider how surety bonds protect againstthose risks. Owners, lenders, taxpayers, contractors,and subcontractors are protected because:� The contractor has undergone a rigorousprequalification process and is judged capable offulfilling the obligations of the contract;

� Contractors are more likely to complete bondedprojects than non-bonded projects since thesurety company may require personal orcorporate indemnity from the contractor;

� Subcontractors have no need to file mechanic’sliens on a private project when a payment bond isin place, and because mechanics’ liens cannot beplaced against public property, the payment bondmay be the only protection these claimants have ifthey are not paid for the goods and services theyprovide;

� Bonding capacity can increase a contractor’s orsubcontractor’s project opportunities;

� The surety bond producer and underwriter may beable to offer technical, financial, or managementassistance to a contractor; and

� The surety company fulfills the contract in theevent of contractor default.

Any contractor—whether in business for one yearor 100, large or small, experienced or novice—canexperience serious problems. Through the yearssurety bonds have held fast as a comprehensive andreliable instrument for minimizing the risks inconstruction.

construction contractors, and special tradecontractors operating in 2009, only 702,618 were stillin business in 2011—a 21.72% failure rate. Despitethe surety’s rigorous prequalification process andbest judgment about the qualifications of thecontractor, sometimes contractor default isunavoidable. However, when a contractor fails on abonded project, it is the surety company thatremedies the default—not the project owner and notat taxpayers’ expense.In the unfortunate event that a bonded contractor

does default, the surety has legal obligations to theproject owner and the contractor. First, the ownermust formally declare the contractor in default. Thenthe surety company conducts an impartialinvestigation before settling any claim. This protectsthe contractor’s ability to pursue legal recourse in theevent that the owner improperly declares thecontractor in default. When there is a proper default,the surety’s options often are spelled out in the bond.These options may include the right to re-bid the jobfor completion, bring in a replacement contractor,provide financial and/or technical assistance to theexisting contractor, or pay the penal sum of thebond.

Bond RatesSurety bond premiums vary from one surety toanother, but can range from 0.5% to 2% of the

Surety Information Office (SIO)www.sio.orgsio@sio.orgThe Surety Information Office (SIO), formed in 1993, disseminatesinformation about the benefits of contract and other forms ofsurety bonding in private and public construction. SIO, a virtualoffice, is supported by the National Association of Surety BondProducers (NASBP), www.nasbp.org, and The Surety & FidelityAssociation of America (SFAA), www.surety.org. For informationon the benefits of surety bonds in construction and in othercontexts, contact the Surety Information Office at sio@sio.org.

National Association of Surety Bond Producers(NASBP)1140 19th St. NW, Suite 800Washington, DC 20036(202) 686-3700(202) 686-3656 Faxwww.nasbp.orginfo@nasbp.orgThe National Association of Surety Bond Producers (NASBP),founded in 1942, is the association of and resource for suretybond producers and allied professionals. NASBP producersspecialize in providing surety bonds for construction contracts and other purposes to companies and individuals needing theassurance offered by surety bonds. NASBP producers engage incontract and commercial surety production throughout the U.S.,Puerto Rico, Guam, and a number of countries. They have broadknowledge of the surety marketplace and the business strategiesand underwriting differences among surety companies. As trustedadvisors, professional surety bond producers act in many keyroles to position their clients to meet the underwritingrequirements for surety credit.

The Surety & Fidelity Association of America (SFAA)1101 Connecticut Ave., NWSuite 800Washington, DC 20036(202) 463-0600(202) 463-0606 Faxwww.surety.orginformation@surety.orgThe Surety & Fidelity Association of America (SFAA) is a District of Columbia non-profit corporation whose members are engagedin the business of suretyship worldwide. Member companiescollectively write the majority of surety and fidelity bonds in the United States. SFAA is licensed as a rating or advisoryorganization in all states, as well as in the District of Columbia and Puerto Rico, and it has been designated by state insurancedepartments as a statistical agent for the reporting of fidelity andsurety experience. SFAA represents its member companies inmatters of common interest before various federal, state, and local government agencies.

© 2012 Surety Information Office

Historical PerspectiveSurety bonds have been a valuable tool forcenturies. The first known record of contractsuretyship was an etched clay tablet from theMesopotamian region around 2750 BC. According tothe contract, a farmer drafted into the service of theking was unable to tend his fields. The farmercontracted with another farmer to tend them underthe condition they split the proceeds equally. A localmerchant served as the surety and guaranteed thesecond farmer’s compliance. Suretyship was addressed in the first known

written legal code, the Code of Hammurabi, around1792-1750 BC. A Babylonian contract of financialguarantee from 670 BC is the oldest surviving writtensurety contract. The Roman Empire developed lawsof surety around 150 AD that exist in the principles ofsuretyship today.While suretyship has a long history, it wasn’t until

the 19th century that corporate surety bonds wereused. Recognizing the need to protect taxpayersfrom contractor failure, Congress passed the HeardAct in 1894, which required surety bonds on allfederally funded projects. The Miller Act of 1935 (40U.S.C. Section 270a et. seq.) was the last majorchange in public sector surety, and is the currentfederal law mandating surety bonds on federalpublic works. It requires performance bonds forpublic work contracts in excess of $100,000 andpayment protection, with payment bonds thepreferred method, for contracts in excess of $25,000.Almost all 50 states, the District of Columbia, PuertoRico, and most local jurisdictions have enactedsimilar legislation requiring surety bonds on publicworks. These generally are referred to as “Little MillerActs.”

Risky BusinessHow one evaluates and manages risk onconstruction projects and makes fiscally responsibledecisions to ensure timely project completion is keyto success. To gamble on a contractor whose level of

commitment or qualification is uncertain orwho could become bankrupt halfwaythrough the job can be a costly decision.How can a public agency using the low-bidsystem in awarding public works contracts besure the lowest bidder is dependable? How canprivate sector construction project ownersmanage the risk of contractor failure?Surety bonds provide financial security and

construction assurance by assuring project ownersthat contractors will perform the work and payspecified subcontractors, laborers, and materialsuppliers. A surety bond is a risk transfermechanism where the surety company assures theproject owner (obligee) that the contractor (principal)will perform a contract in accordance with thecontract documents.

Types of BondsThere are three basic types of contract suretybonds:� The bid bond assures that the bid has beensubmitted in good faith and that thecontractor will enter into the contract at theprice bid and provide the requiredperformance and payment bonds.

� The performance bond protects the ownerfrom financial loss should the contractor fail toperform the contract in accordance with its termsand conditions.

� The payment bond assures that the contractor willpay specified subcontractors, laborers, andmaterial suppliers on the project.

Financial Security & Construction AssuranceAlthough surety bonds are mandated by law onpublic works projects, the use of surety bonds onprivately owned construction projects is at theowner’s discretion. Alternative forms of financialsecurity, such as letters of credit and self-insurance,

do not provide the 100%performance protection and 100%payment protection of suretybonds nor do they assure acompetent contractor. Withsurety bonds, the risks ofproject completion are shiftedfrom the owner to the suretycompany. For that reason,many private owners requiresurety bonds from their

contractors to protect theircompany and shareholders from theenormous cost of contractor failure.To bond a project, the ownerspecifies the bonding requirementsin the contract documents.Obtaining bonds and deliveringthem to the owner is theresponsibility of the contractor, whowill consult with a surety bondproducer. Subcontractors mayalso be required to obtainsurety bonds to help theprime contractor managerisk, particularly when thesubcontractor is a significantpart of the job or aspecialized contractor that isdifficult to replace.Most surety companies are

subsidiaries or divisions ofinsurance companies, and both

surety bonds and traditionalinsurance policies are risk transfer

mechanisms regulated by state insurancedepartments. However, traditional insurance isdesigned to compensate the insured againstunforeseen adverse events. The policy premium isactuarially determined based on aggregatepremiums earned versus expected losses. Suretycompanies operate on a different business model.Surety is designed to prevent loss. The suretyprequalifies the contractor based on financialstrength and construction expertise. The bond isunderwritten with little expectation of loss.

Prequalification of the ContractorSureties are able to accept the risk of contractorfailure based on the results of a thorough, rigorous,and professional process in which sureties prequalifythe contractor. This prequalification process is an in-depth look at the contractor's business operations.Before issuing a bond the surety company must befully satisfied that the contractor has, among othercriteria:� Good references and reputation;� The ability to meet current and future obligations;� The experience matching the contractrequirements;

� The necessary equipment to do the work or theability to obtain it;

� The financial strength to support the desired workprogram;

� An excellent credit history; and� An established bank relationship and line of credit.The surety company must be satisfied that the

contractor runs a well-managed, profitableenterprise, keeps promises, deals fairly, andperforms obligations in a timely manner. Suretybonds have played an important role in theconstruction industry’s success, allowing theindustry to sustain its position as one of the largestcontributors to the nation’s economic stability andgrowth.

Contractor FailureConstruction is a risk-filled enterprise, and evencapable and well-established contractors canultimately fail. According to BizMiner, of the 897,602general contractors and operative builders, heavy

The Importance of Surety Bonds in Construction

291,214

523,543

413,390

223,449

82,845 65,779

Construction Companies 2009-2011

Building Construction &Operative Builders

Heavy Construction (Except Bldg. Const.)

Special Trade Contractors

� 2009 � 2011

700,000

600,000

500,000

400,000

300,000

200,000

100,000

0

# of Estab

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ents

Source: BizMiner (2012)Failure rates track the actual experience of business establishments, firms, small businesses, branches andstartups doing business at the start of the time series, and still in operation today.