If you are in the contractor construction industry, you’ll know that the success of a building project is not guaranteed., Unforeseen issues can still arise, and disputes may emerge, leaving the project owner with unwarranted financial losses. To protect project owners from such risks, there's an insurance policy known as a performance bond that contractors can get to certify that they will deliver their work according to the signed contract. A performance bond is often mandatory for public projects.
In this article, we’ll answer your questions about 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. But first, the basics.
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 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, while often applied to contractor-specific contexts, can also be used for any contract where one party is completing a job requiring payment from another party. As such, they are a widely applicable surety bond and not only restricted to the contractor business. Funnily enough, performance bonds have been around for millenia; in fact, a form of insurance similar to a performance bond has existed since around 2,750 BC, and the Romans created laws surrounding surety around 150 AD—this testifies to how essential and important performance bonds are to guaranteeing financially fair and safe transactions in the construction industry.
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 require a performance bond from contractors or their subcontractors. These bonds provide financial assurance to project owners that contractors will honor their contractual obligations, particularly on larger contracts. The bond serves as collateral in case the contractor is unable to complete the project or fulfill their obligations, including compensation to any subcontractors.
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.
|Benefits for project owner||Benefits for contractor|
|Serves as financial protection in case of any breach of contract by the contractor: The bond acts as an assurance for project owners that the contractor can fulfill its end of the bargain under the contract terms and conditions, giving them peace of mind and financial protection.||Enhances the contractor's credibility in the industry: If the surety company has approved the bond, it means that the contractor has undergone a rigorous financial evaluation process and passed the financial stability test, thus lending them credibility. This may assist in winning future contracts.|
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.
Step 1: Determine the Bond Amount
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.
Step 2: Identify a Suitable Surety Bond Broker
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.
Step 3: Completion of Application
Once the surety bond company is identified, the contractor fills out a bond application form, seeking a letter of bondability. This non-binding letter states the extent to which the surety would be willing to financially bond the contractor, based on factors like the contractor's creditworthiness and the size of the proposed project. This is in essence a quote that outlines the contractor’s qualifications and the pricing of the bond before the contractor commits to purchasing the bond.
Step 4: Underwriting
After the application is submitted, the surety company will evaluate the contractor's creditworthiness and likelihood of fulfilling the terms of the contract, after which they will issue a letter of bondability.
Step 5: Bond issuance
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.
Going back to Step 2 of getting a performance bond, finding a surety broker is an essential step to get right when seeking a performance bond.
Performance bonds are typically obtained through either a bank or an insurance company. If you opt for the insurance company route, it’ll be important to find a surety broker, also known as a bonding agent or surety bond producer. Surety brokers act as intermediaries between contractors and surety companies, which is the entity that underwrites the bond. 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:
SuretyNow has experts licensed in all 50 states on hand to answer personalized questions 24/7. Contact us if you need help with looking for a performance bond!
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.
For the claim to be valid, 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 bonds and payment bonds.
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.