How Do Performance Bonds Work?
Benefits of a Performance Bond
How do I get a Performance Bond?
Where do I get a Performance Bond?
How Much do Performance Bonds Cost?
How Do Claims Work For Performance Bond?
In the construction industry, a large project’s quality and performance are usually good and secure to protect the public. However, that does not mean the construction projects’ safety and quality are always guaranteed. Unforeseen issues can still arise, leaving the project owner with unwarranted financial losses. To protect project owners from such risks, mandatory construction bonds that provide financial guarantee to the building of large projects are introduced. The construction bonds include performance bond, payment bond, and bid bond.
The Federal Miller Act mandates the use of contract surety bonds for all public construction projects exceeding $100,000. Some local legislation mandate construction bond and contract bond for projects with lower value. As time progresses, many private project owners realize the advantages of contract bond, leading to more application of these financial insurance policy. Specifically, performance bond is the most relevant to the protection of project owners as well as public safety.
This article focuses on performance bonds, including what they are, why you need them, and how to get one. We’ll also guide you through the ins and outs of what to look out for when obtaining a performance bond.
A performance bond is a surety bond that guarantees that a contractor will complete a project as per the contract terms and conditions. In an event where the contractor defaults in fulfilling the contractual obligations, the surety companies responsible for issuing the bond will compensate the project owner up to the limits specified.
The parties in a performance bond include the surety, principal, and obligee. The surety is the third-party insurer responsible for issuing the bond, underwriting the bond, and making payment should the principal fail in their contractual obligations. The principal, in this case, is the contractor invested in executing the construction project; they need the bond to win the contract. Finally, the obligee is the project owner who requires the bond before allowing the contractor to start the project, ensuring that they have recourse in the event of a breach of contract.
Performance bonds become effective when a contractor obtains it and agrees to comply with the contract terms and conditions. The surety underwrites the bond, and once issued, the bond remains in effect until the contract completion date. The underwriting process involves evaluating the contractor's financial strength, experience, and capabilities to meet the project's requirements.
If the contractor defaults on their contractual obligations, the project owner can notify the surety of the breach illustrated on the contract. The surety will investigate the claim before deciding whether to intervene and remedy the situation. If the surety intervenes, it will select a qualified contractor to complete the project or compensate the project owner up to the bond limit specified. The contractor is then responsible for paying the surety for the amounts paid out to the project owner.
Construction projects that involve federal, state, municipal, or corporate clients usually come with performance bond requirements. These bonds provide financial assurance to project owners that contractors will honor their contractual obligations, particularly on large project. The bond serves as collateral in case the contractor is unable to complete the project or fulfill their obligations, including compensation to any project owner.
Notably, all the parties that may be involved in a construction project, including project owners, prime contractors, and subcontractors, should consider obtaining bonds. The bond ensures that each party involved in a construction project complies with their contractual obligations.
Performance bonds offer numerous benefits to project owners, as well as offering benefits to the contractor.
Performance bonds help mitigate the risk associated with a project by providing financial assurance that the contractor will complete the work according to the terms and conditions outlined in the contract.
Project owners can have confidence in the financial stability of the contractor, as obtaining a performance bond often involves a thorough financial review of the contractor by the bonding company.
Performance bonds may also include provisions for the quality of work. If the completed work does not meet the specified standards, the bond can be used to address the necessary corrections. This protects not just the general contractor and the project owner, but the public who have access to these large projects.
To obtain a performance bond, a contractor must follow a specific process involving multiple steps. Below are the general steps in obtaining a performance bond.
The first step should be to review the bond requirements with the project owner to ascertain that the contractor purchases the correct bond amount. You should verify the bond amount, indemnity language, and terms of the bond.
After the bond amount and the terms of the bond are established, identify a reputed and trustworthy surety bond company. Research should be done to find a company that specializes in bonding services for contractors and has a proven financial record in the industry. Some considerations for finding a suitable surety broker company are listed in the next section.
After selecting a surety bond company, one needs to provide information of one's company, financial statement, work history, personal credit score, and proposed project size to complete a performance bond application. Then, the surety company would evaluate the application and provide a quote that outlines the contractor’s qualifications and the performance bond cost before the contractor commits to purchasing the bond.
Upon submission of a performance bond application, the surety company will still evaluate the contractor's personal credit scores to assess one's ability to fulfill their obligation. If one passes the assessment, the surety will issue the performance bond for construction.
If the contractor meets the surety company's requirements, the surety will issue the performance bond, typically for a percentage of the total contract amount. The contractor will pay this percentage in exchange for the surety’s guarantee that they will cover up to the bond amount in the event that the contractor fails to satisfy the terms of the project contract.
Performance bonds are typically obtained through either banks or surety bond companies. Surety companies assume the risk of the bond and provide financial guarantees to owners that the contractor will complete the project according to the terms of the contract.
It's important to choose a reputable and experienced surety broker when obtaining a performance bond. A surety broker should have a thorough understanding of the construction industry and have established relationships with multiple surety companies. They should also be able to provide personalized service, be responsive to inquiries, and provide guidance on the bond application process.
When choosing a surety broker, consider the following factors:
Like other surety bonds, the price one pays depends on the bond amount—which is the size of the contract—and the premium rate—determined by the contractor's credit and financial history. As always, the price will be the bond amount multiplied by the premium rate.
Price you pay = Bond Amount * Premium Rate
The cost of a performance bond will depend on several factors, including the project size, complexity, and total contract price. The premium for a performance bond is typically a percentage of the total contract price, usually ranging from 1% to 5%. For example, if the contract price is $1,000,000, the price for a performance bond with a premium rate of 2% would be $20,000.
Financial history and credit are also important factors that can affect the cost of a performance bond. Surety companies use a contractor's financial history, credit score, and other financial metrics to determine the risk of underwriting the bond, which factors into the premium rate. Contractors with a strong financial history and credit will typically be able to obtain a performance bond at a lower cost than those with poor financial history. With smaller construction projects, underwriting only requires good credit and a clean license history, but larger projects may need financial statements, balance sheets, and tax returns.
If the contractor fails to deliver on the terms of their contract, then the project owner or developer can file a claim with the surety for an amount equivalent to their losses on the project, with the maximum payout being the bond amount. It is then the surety’s job to investigate the extent of the losses, determine whether or not the claim is valid, and if so, value the payout accordingly.
In a valid claim, three conditions must be met:
In the event that the claim is deemed legitimate, the surety company has four options for managing the dispute.
There are two other common types of bonds in the construction industry: bid bond and payment bond.
Bid bonds are used to ensure that contractors submit legitimate bids for a project. Bid bonds protect the project owner by guaranteeing that the contractor will enter into a contract to perform the work at the bid price if their bid is selected. If the contractor fails to meet their obligations, the surety company will pay the owner the difference between the contractor's bid and the next lowest bid.
Payment bonds, also known as labor and material payment bonds, guarantee that the contractor will pay all subcontractors, suppliers, and laborers associated with the project. Payment bonds protect owners and subcontractors from financial loss if the contractor fails to pay their debts. If a contractor fails to pay their debts, the surety company will pay the debts owed up to the bond limit.
Bid bonds and payment bonds are often required along with a performance bond. Owners require bid bonds to ensure that contractors submit legitimate bids and payment bonds to ensure that subcontractors and suppliers are paid. Performance bonds are required to ensure that the contractor completes the project on time and according to contractual obligations. All three bonds work together to provide financial protection to the owner and subcontractors.
Performance surety bonds are an important financial tool for contractors working on large-scale construction projects. Contractors should work with an experienced and reputable surety broker to obtain a performance bond and consider their financial history and credit when determining the cost. Bid bonds and payment bonds are also common in the construction industry and work together with performance bonds to ensure that projects are completed on time and according to contractual obligations.
