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What is a Surety Bond?
A surety bond is a legal contract that brings together three parties to ensure the completion of an agreed upon project. Surety bonds exist to guarantee that all contractually obligated tasks are fulfilled and to minimize the risk of project failure. As such, surety bonds are known as a risk transfer mechanism since you hope to minimize part or all of the risk of contracting with another party.
For example, you are hoping to complete a large scale renovation of your place of business. To do so, you must contract a general construction company to perform this large renovation. This project will be costly: it will include buying expensive materials up front, putting down a significant deposit, and closing your business for several weeks.
As an astute business owner, you are aware of the risks of placing such a huge investment in the hands of an external contractor, where so many variables are beyond your control. You want some sort of guarantee that the construction company will make good on their contractual obligations to you so that your business is not affected by their failure or lack of performance.
In order to guarantee the construction company’s performance, you require the company to post a bond with a surety in order to provide a third-party financial guarantee to you that the job will be completed. Therefore, in the event that things go under, and the construction company does not make good on their commitment, the surety will act on behalf of the construction company to fulfill their contractual obligations to you. In this case, this could mean that the surety compensates you with the money required to complete the construction project on behalf of the construction company.
In this situation, you are the obligee, since you are requiring the construction company to be bonded. The construction company is the principal since they are required to post the bond, in order to guarantee their contractual commitment to you. The third-party that provides financial guarantee to you on behalf of the construction company is the surety.
In summary, the three parties involved in a surety bond are:
- Obligee: the individual or entity requiring a contractor to purchase a bond to guarantee future work. In most cases, the obligee will usually be a government entity wishing to reduce the risk of financial loss. However, the obligee can be anyone who wishes to require a contractor to take out a bond to ensure their work.
- Principal: an individual or business that is required to purchase a bond with a surety in order to guarantee future work or performance.
- Surety: typically an insurance company that backs the bond and ensures the principal’s contractual obligation to the obligee. In most cases, the surety provides a line of credit that compensates the obligee in the case of the principal’s failure to fulfill the project.
You may be required at some point to take out a bond to guarantee your work if you are a:
How do Surety Bonds work?
With a surety bond, your company makes a payment to the insurance company and in return for this payment, the insurance company guarantees to the client that the work will be performed according to the contract. If your company is unable to complete the job as required by the contract, the client can file a claim to recover losses, which the insurance company is obligated to cover.
Are Surety Bonds required?
As a contractor, you only need to purchase a surety bond if it is required by your client or a governmental body.
You may be required to purchase a surety bond in the following situations:
- When bidding on government construction jobs, some federal, state, and local governments may require your company to purchase surety bonds.
- Some private owners, banks, and general contractors may require surety bonds.
- Some states require a surety bond in order to receive a business license as a contractor.
What types of Surety Bonds are there for contractors?
There are several types of surety bonds. It is important to know what type of bond you are required to obtain for a project.
- Bid Bond: A bid bond is a guarantee issued by either an insurance company or a bank that ensures that a contractor is financially stable and possesses the resources required to complete a project. A bid bond is a good faith assurance that the contractor is able to fulfill its responsibilities. A bid bond is typically the first kind of bond you must obtain as a contractor in order to put in a bid for the project; it is usually followed by a performance or payment bond.
- Performance Bond: A performance bond, also known as a contract bond, is usually issued by an insurance company or a bank to protect the project owner from financial loss if the contractor fails to complete a project. This bond guarantees satisfactory completion of an agreed upon project by the contractor.
- Payment Bond: A payment bond guarantees that the contractor will pay his subcontractors, employees, laborers, and material vendors for expenses in relation to the project in a reasonable and timely fashion.
- Maintenance Bond: A maintenance bond protects the project owner for a specified time period from losses arising from faulty or defective workmanship, design, and materials.
How much does a Surety Bond cost?
The cost of a surety bond depends on a number of factors, including:
- Type of bond
- Bond amount
- State you’re located in
- Personal credit score
- Financial health of your business
- Experience in the industry
Surety bond premiums generally fall between one and ten percent of the total bond amount. Much of the pricing of a surety bond depends on your personal credit score, where lower credit scores correlate with higher premium percentages.
Typically, for a bid bond, there will be no charge or a nominal flat fee. A performance bond, however, will charge a percentage of your project contract price. This percentage ranges based on the insurance agency or bank issuing the bond and is typically between 0.5% and 5%. The cost of payment bonds are typically accounted for in the cost of the performance bond.
What do I need in order to obtain a Surety Bond?
In order to obtain a Surety Bond, you may be required to show proof of the following:
- Good credit history
- Any applicable licenses and proof of expertise
- Your company’s history
- You and your company’s financial stability
- Experience in matching similar contract obligations
- Past customers and references
- Organization structure
- Line of credit
- Good character
- Current works and projects in progress
- Proof of equipment needed to fulfill the contract
Why do I need a Surety Bond?
Although you may not think you will ever default on a project, there may be a number of situations that force you or your company to fail to complete a project you have committed to. Your company may not be able to finish a project for a number of reasons, both in and out of your control.
Some of these factors may include:
- Inadequate project management systems
- Business strategy changes
- Shortage of labor materials
- Inaccurate estimate of costs and time of project
- Severe weather that affects the project
- Death, illness, or departure of crucial employees
- Unexpected economic failures
There are a number of things to consider when looking to obtain a Surety Bond. Here are some tips that will set you and your business up for success:
- Look for a surety underwriter that is familiar with your line of work and has experience dealing with projects that are similar to the one you will be handling.
- Make sure to read through all the bond forms and look for any unmanageable or unreasonable terms and conditions — it is important to know exactly what you are signing up for!
- Before you choose to go with a company or bank, be sure to verify the surety’s licensing abilities. You can do this by checking with your state’s insurance regulating department.
If you own a business, especially in construction, you may be required to obtain a Surety Bond in order to proceed with a project. Knowing what types of bonds are available and their purposes can help you make an informed decision in obtaining a Surety Bond.