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If you’re a contractor looking to understand the basics of surety bonding, this article is for you!
While there are many industries that can require surety bonds, this surety bond overview is geared toward construction companies. Ready? Let’s begin.
So, what is a surety bond? The simplest definition is that surety bonds protect buyers from individuals or companies who don’t fulfill their contractual obligations.
Now, let’s look at the more technical definition of a surety bond. A surety bond is a three-part guarantee between the obligee (the entity paying for the work and who requires the bond), the principal (the person or company performing the work and who must obtain the bond), and the surety (the insurance company backing the surety bond).
For example, a developer (obligee) is building a new $15 million dollar mid-rise apartment building in Milwaukee, WI, and requires the general contractor (principal) to obtain a $15 million dollar surety bond before signing the contract. The surety bond guarantees that the contractor will faithfully perform the work in the contract. If they don’t, the obligee can file a claim with the surety and be compensated for up to the full $15 million of the bond amount.
Is a Surety Bond the same as Insurance?
Surety bonds are not the same thing as insurance. They’re actually a lot more similar to obtaining a line of credit from a bank.
For example, if the bonded principal (contractor) did work that was not up to code and put the entire project at risk, the obligee (the owner/entity paying for the project) can file a claim with the surety against the principal for not fulfilling their contractual obligations.
The surety would then pay the obligee the amount the surety bond stipulated, and the principal would have to pay the surety back the money they paid out to the obligee.
The principal is always 100% liable to repay the surety company for any claims the surety pays out to the obligee.
Why are Surety Bonds Required?
Surety bonds protect project owners from contractors who don’t do the work according to the contract they signed.
For example, let’s say a general contractor (the principal) was awarded a $4.5 million dollar elementary school addition project for the City of Phoenix (the obligee). Before signing the contract, the principal would be required to obtain a $4.5 Million dollar surety bond. That way, if the principal was failing to complete the project according to the contract, the obligee can file a claim with the surety who will step in and ensure that the principal completes the project satisfactorily. If the principal fails to complete the full project, they are liable to forfeit the entire $4.5 million dollar bond to the obligee as recompense.
The surety company is there to make sure that the project is finished. Their goal is to enforce that the project gets done and that the subs and suppliers get paid.
When it comes to government projects (roads, schools, military defense, etc.) surety bonds make sure that tax-funded dollars aren’t being wasted on bad contractors who don’t fulfill their contractual obligations. The surety company's role is to ensure that the work is performed and the project is completed on time. In the event that does not happen, the surety bond guarantees the contractor is liable to pay back the entire amount of the bond.
Do I need a Surety Bond?
Virtually all contractors who bid on government projects will need to be bonded.
All federal government projects valued over $150,000 require that contractors are bonded in order to be awarded the contract and most state and local governments have similar requirements.
Private owners can also require that contractors obtain a bond before they will award the contract.
What are the Different kinds of Surety Bonds?
In the construction world, the 4 most common types of surety bonds are:
Warranty (or Maintenance) Bonds
License and Permit Bonds
Let’s dig a little deeper into each of these, shall we?
Bid Bonds
Bid bonds show bid integrity in that the contractor (the principal) will do the job at the price they bid to the project owner (the obligee). They are a way for the principal to show the obligee they are pre qualified and capable of doing the project they are bidding on.
For example, if the City of Colorado (obligee) put out an RFP for a sidewalk improvement project, they would require all contractors (principal) to submit a bid bond along with their bid proposal. Any contractor who did not submit a bid bond with their bid proposal would automatically be rejected.
Bid bonds serve as a guarantee that the awarded contractor (the principal) will not back out of signing the contract at the bid price. If the principal does back out from signing the contract, the project owner (obligee) can file a claim against the principal with the surety company and be legally entitled to the full dollar amount of the bond (which is typically the full price of the contract).
Bid bonds ensure that any contractors who bid on a project are serious about performing the work and will not waste the owner's time.
Payment and Performance Bonds
Payment and performance bonds guarantee that the awarded contractor (principal) will faithfully perform all of the work specified in the contract.
For example, if a contractor (principal) is awarded a $10 million dollar road improvement project, the government entity (obligee) will require a $10 million dollar payment and performance bond. If the contractor does all the work on time and the work passes all inspections, they will be paid in full.
But, if the contractor fails to complete the project or doesn’t provide high-quality work that is up to code, the obligee can file a claim with the surety agency and be paid back up to the full amount of the $10 million dollar bond.
Obligees require payment and performance bonds after the work has been awarded but before the contract is signed and work commences.
Warranty (or Maintenance) Bonds
After final completion of a construction project, some obligees require a warranty or maintenance bond to be in place to ensure that the work performed won’t have any problems for a set period of time after completion.
For example, the City of Charlotte, NC requires a 2-year workmanship warranty on all roofing projects. Any contractor who does roofing work for the City of Charlotte must obtain a 2-year warranty bond guaranteeing their work for a period of 24 months after final completion. If there is a problem with the roof that the contractor doesn’t fix within the warranty period, the City of Charlotte can make a claim with the surety company and be paid as recompense.
License and Permit Bonds
License and permit bonds are typically required by federal, state, and local governments before a contractor can begin any work within that jurisdiction. Usually, they are in effect for a 12-month period with an option to renew if the contractor continues work in that county or jurisdiction.
For example, if a contractor was awarded a contract to build a new municipal building in the City of Columbus, OH, they would have to obtain a license and permit from the city in addition to obtaining a Performance and Payment bond.
Wrapping Up
Surety bonds are a three-part guarantee between the obligee, the principal, and the surety. They serve as a way to protect the obligee’s investment and ensure a project will be completed according to the contract. If not, the obligee can file a claim with the surety who will pay the bond amount. If the surety pays out a claim, the principal must pay back the surety.
The top 4 most common construction bonds are:
Bid Bonds
Payment and Performance Bonds
Warranty (or Maintenance) Bonds
License and Permit Bonds
And there you have it! You now know the basics of surety bonding for the construction industry.
Interested in getting a surety bond quote today? The team here at Shorewest Surety would love to help. For the last 20+ years, we’ve been exclusively focused on helping construction contractors get the best rates, expertise, and service possible. We truly care about our clients' success and are honored to partner with them and share our bonding expertise so they can bid on the projects that matter most. Give us a call today at (800) 264-1634 and talk with an agent who will give you a personalized quote.