Whether you are a project owner, contractor, supplier, or subcontractor, evaluating and managing risk on construction projects are crucial so that you can make fiscally responsible decisions and ensure that the project is timely completed according to the terms of the contract. Since large construction projects can sometimes span several years, situations can sometimes arise making timely project completion difficult. Inflation can greatly increase the cost of supplies, and supply chain problems can interfere with various deadlines. A contractor without good financial stability could potentially go bankrupt in the middle of a project and abandon it or fail to pay the subcontractors and suppliers for their work.

Surety bonds help to address these and other potential problems and provide owners with a guarantee that the contractors will perform their contractual duties and pay their suppliers and subcontractors. Construction bonds work as a risk-transfer mechanism by transferring the risks involved with construction projects away from the project owner and to the surety company and contractor. If the contractor fails to perform or pay its subcontractors or suppliers, the surety company will pay valid claims. The contractor will then be legally obligated to repay the surety for all amounts it paid out on claims. Here is some information about the role of surety bonds in the construction industry and why they are important.

What Is a Surety Bond?

In the construction industry, surety bonds are also known as contract or construction bonds. A construction bond is an agreement involving three parties, including the following:

  • Principal- Contractor who must purchase a required bond
  • Obligee – Governmental agency or private project owner that requires the bond
  • Surety – Bonding company that prequalifies the principal and issues the bond

If the contractor fails to comply with the law, perform under the contract, or pay its suppliers and subcontractors, the project owner or the government can file a bond claim with the surety company. The bonding company will pay valid claims, but it will then go after the contractor through the court if the contractor does not fully reimburse it for what it had to pay.

Types of Bonds

While there are many different bonds you might encounter in the construction industry, the most common types include the following:

  • Bid bonds – These bonds guarantee that bidding contractors have submitted their bids on projects in good faith and that they will enter into the contracts at the price they have bid even after they have learned what the bids of other companies were for the projects.
  • Performance bonds – A performance bond guarantees the contractor will perform under the contract and protects the owner or government from financial loss if the contractor fails to perform or abandons the project.
  • Payment bonds – These bonds provide an assurance that the contractor will pay its suppliers and subcontractors for their work and remove the risk from project owners of mechanic’s liens placed against their property titles.

Why Surety Bonds Are Needed in Construction

Surety bonds are legally mandated for work performed on many public works projects since taxpayer money is involved. Federal and state governments require surety bonds to prevent the loss of taxpayer money when contractors fail to follow through with their bids, fail to perform under their contracts or fail to pay their suppliers and subcontractors. For example, under the federal Miller Act, contractors who wish to perform work on federal building projects valued at $100,000 or more must purchase performance and payment bonds. Federal agencies also require bid bonds before a prospective contractor will be allowed to submit bids for federal projects.

Many states have laws modeled after the federal Miller Act. However, these state laws might have different and lower minimum thresholds for the value of public projects that trigger the bonding requirements.

While construction bonds are legally mandated for work on public projects, they are required at the discretion of private project owners. However, many private project owners also require surety bonds as a contract requirement to mitigate the risks of a project and transfer them to the surety company. Other types of financial security, including self-insurance and letters of credit, do not provide similar types of protection to project owners that the contractors will perform or pay their subcontractors and suppliers. Since surety bonds transfer the risks from the project owner to the surety company, many private project owners also require surety bonds to protect themselves against the costs of contractor failures.

Surety Bonds as Contractor Prequalifications

Because of the risks involved, surety companies complete a rigorous underwriting process when contractors apply for bonds. Through this process, the surety company prequalifies the contractor by thoroughly evaluating the contractor’s business stability, experience, credit, reputation, performance on past projects, character, and ability to complete the intended project.

Surety companies evaluate multiple criteria when determining whether to approve a bond application. They want to see that the contractors have good credit, sufficient working capital, strong references, experience handling projects of a similar size, and the necessary equipment needed to complete the project or the ability to obtain what is needed. Before a surety company will approve a bond application, it will need to be satisfied that the contractor’s business is financially stable, profitable, well-managed, and ethical in its business operations and dealings.

Since a bonded contractor has already been prequalified by the rigorous underwriting process, project owners are typically more comfortable contracting with them. Bonded contractors have already been evaluated and determined by the surety company to be stable, of good character, and have the financial capacity to complete the proposed projects. Suppliers and subcontractors might also be likelier to agree to perform work on projects when the contractors have purchased payment bonds since they have a guarantee that they will be paid for their work without having to file mechanic’s liens.

No matter the role you play in the construction industry, construction bonds are important. If you are a contractor, purchasing surety bonds might be a cost of doing business. Project owners might also feel more confident that their projects will be completed on time when they require the contractors to purchase bonds as a contractual obligation.