10 Things You Should Know About Surety Bonding 

by Terry Starks, American Agency

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1. As surety bond is an instrument under which one party guarantees to another that a third will perform a contract. Surety bonds used in construction are called contract bonds.

2. There are three types of bonds used in construction: The bid bond protects the owner by guaranteeing that the contractor will enter into the contract at the determined price. The performance bond guarantees the performance of the work on schedule and according to the plans and specifications. The payment bond guarantees that the certain workers, sub-contractors and suppliers will be paid.

3. Construction is a very risky business. More that 10,800 contractors failed in 1997 - an increase of 11% from 1996. These failures caused more than $2 billion in liabilities. Even large, well-established contractors fail. In 1997, 37% of failures were contractors who had been in business ten years or more. (source: Dun & Bradstreet Business Failure Record). Since 1985, surety companies have paid $7.2 billion because of contractor failures on bonded construction failures on bonded construction projects. Without bonding, these costs would have been borne by the owners of the projects.

4. Federal law (the Miller Act) mandates surety bonds for all public works contracts in excess of $100,00.00. Federal procurement officials may, at their own discretion, require bonds on projects below that amount. All states have laws requiring bonds on public works, too (known as Little Miller Acts). Owners of private construction projects are recognizing the wisdom of requiring surety bonds to protect their company and shareholders from the enormous costs of contractor failure.

5. Although surety bonding is considered a line of insurance, it has many characteristics of bank credit. The surety does not lend the contractor money, but it does allow the surety's financial resources to be used to back the commitment of the contractor, thus enabling the contractor to acquire a contact with a private owner. The owner receives guarantees from a financially responsible surety company licensed to transact suretyship.

6. Surety bonds, through the surety company's rigorous prequalification of contractors, protect owner and offer assurance to the lender, architect and everyone else involved with the project that the contractor is able to translate the project's plans into a finished product. Before issuing a bond the surety needs to be fully satisfied, among other criteria, that the contractor is:

  • Of good character.
  • Has experience matching the requirements of the contact.
  • Has or can obtain the equipment necessary to do the work.
  • Has the financial strength to support the desired work program.
  • Has an excellent credit history .
  • Has established a bank relationship and a line of credit

7. Contract surety bonds:

  • Guaranty the project will be completed
  • Guarantee that the laborers, suppliers and subcontractors will be paid.
  • Relieve the owner from the risk of financial loss rising from liens filed by unpaid laborers, supplier and subcontractors.
  • Smooth the transition from construction to permanent financing by eliminating liens.
  • Reduce the possibility of a contractor diverting funds from the project.
  • Lower the cost of constriction in some cased by facilitating the use of competitive bonds.

8. With a surety bond, the owner can be satisfied that a risk transfer mechanism is in place. The risks of construction are shifted away from the owner to the surety. If the contractor defaults, the surety may pay for a replacement contractor, finance the existing contractor or provide technical and/ or financial assistance.

9. The costs for bonds vary, but generally are one to three percent of the contract amount. On very large projects, the cost may be less than one percent.

10. To bond a project, the owner merely includes the bonding requirements in the plans and specifications for the project. Obtaining bonds and delivering them to the owner is the responsibility of the contractor who will consult with and independent bonding agency.

Article furnished by Terry Starks of the American Agency, Inc., St. Louis Park, MN, 952-591-2755.

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