Let’s face it — if you’re a contractor, you may be obligated as part of the contract bid process to obtain performance bonds. Of course, we all know they’re critical to guaranteeing you’ll complete the project based on the terms and conditions written in the contract and at the agreed upon price.
However, just thinking about the process to obtain a bond makes you break out in the cold sweats. Where do I go? Who do I call? Is my credit OK? What will the premiums be? Those are just a few of the questions some contractors ask themselves prior to obtaining a performance bond. However, it’s really not as scary as you think.
How much do you understand about your construction bond requirements?
In order to make the process a little easier to understand, let’s step back and take a closer look at the bond basics. A bond is a three-party agreement between the:
- Obligee – the owner or party paying to have the project completed and who the bond will benefit in the event of a contractual default.
- Principal – the contractor being hired to perform under the contractual agreement.
- Guarantor – a surety company that guarantees the performance of the contractor to the owner.
Bid bonds, performance bonds, and payment bonds, in most cases, are required by law (the Miller Act, discussed in more detail later in this article). A bid bond is intended to provide financial assurance that the big the contractor submitted is in good faith, and the bid the required performance and payment bonds can be obtained. Performance bonds and payment bonds may be written as one, but are actually two bonds.
A performance bond, also known as a contract bond, is issued by an insurance company, which secures the contractors’ promise to “perform” the contract or guarantee the satisfactory completion of the project. If the contractor fails to complete the project according to the terms and conditions in the contract (i.e., bankruptcy of the contractor), the owner or client is guaranteed compensation for the loss up to the amount of the performance bond. If a loss occurs, the surety has the following options:
- Replace the current contractor with another to complete the job;
- Pay the bond penalty; or
- Help fund the existing contractor to finish the job.
A payment bond assures the contractor will pay its subcontractors and suppliers, preventing the project owner from having to make double payments or risking liens placed on the property by unpaid subs or suppliers.
Why do bonds exist? A history lesson.
While performance bonds go back thousands of years, it wasn’t until the late 1800s that the federal government took notice of a significant failure rate among the private firms performing work on public construction projects.
Many private contractors either became bankrupt before the work started or sometime during the project. Unfortunately, the taxpayers were left with the bill to cover the costs of the default. Congress passed the Heard Act in 1894, which authorized the use of corporate surety bonds to secure federal construction projects performed by private firms. In 1935, it was replaced by the Miller Act, which requires the combination of performance and payment bonds for federal construction projects. Almost all states follow similar requirements on public construction projects, and these are called Little Miller Acts. The legislation of both Miller Acts protects the government, private contracting firms, and also the taxpayers.
What do bond companies look at when underwriting?
There are three primary factors that surety bond companies take into account when determining the risk of underwriting a bond: a bond type, bond amount, and the applicant’s financial strength and credit quality. The higher the risk, the higher the surety bond premium.
Bond Type — Surety companies have access to the claims history for all bond types and have been able to determine which bonds carry more risk than others.
Bond Amount — The larger the bond amount, the greater the risk, and bond companies evaluate the financial strength of the contractor and their past experience relative to the bond amount.
The Applicant’s Financial Strength/Credit Quality — The surety bond companies use financial history and credit rating to predict the risk of the applicant.
The construction project owner is requiring me to get a performance bond. Where do I go?
Bonds are issued by most surety companies through responsive, knowledgeable surety bond producers, also known as agents or brokers (for example, Brunswick Companies), who are qualified to assist contractors with all their bonding needs.
Even if you feel you are too small of a company, have bad credit, or less-than-perfect history, there is a solution for you — and it’s easier than you think. Working with an experienced broker can provide you the edge in obtaining the best pricing. The broker will guide you through each step of the process of obtaining your bond with the best rates possible and answer any questions you may have. Remember, there are no dumb questions!
Finding a broker with strong relationships with leading surety bond underwriters and performance bond companies helps to provide you with access to more favorable terms and conditions. The Small Business Association (SBA) also has programs that can help.
One of the more confusing parts of the bid process is the bond premium. Do you include it in the bid? Do you leave it off? The surety company prequalifies the contractor based on financial strength and construction expertise. The premium is primarily a fee for prequalification services as the bond is underwritten with no expectation of loss. It is common practice as part of the bid process that the bond premium should be included in the contractor’s bid price and serve as a pass-through cost to the project owner.
Performance Bonds – they’re a good thing!
If you are a contractor, owners or parties paying for the contract want to make sure that you are capable of completing a project, which is why they require you to obtain a performance bond. If the surety company is able to obtain a bond for you, it shows that you and your business are financially stable and are a good risk. Taking a proactive approach to addressing any underwriting concerns streamlines the approval process, and is the key to expanding your access to surety credit — putting you on the path for successful growth.
This article originally appeared in July-August 2015 issue of Construction Savvy (currently DCD Magazine).