Construction projects can carry significant price tags. If a contractor fails to honor their bid after winning a project or winds up defaulting on obligations, project owners can experience out-of-pocket expenses and lost revenue if businesses aren’t able to open as scheduled.
Construction bonds are financial guarantees allowing project owners to proceed with confidence knowing they’ll be compensated in the event the contractor doesn’t complete the work. While they are not insurance products per se, construction bonds are issued by surety companies and offered through commercial insurance providers as part of a suite of risk mitigation tools.
Benefits and Risks of Construction Bonds
Requiring construction bonds provide assurances to project owners that the contractor they’ve chosen to work with is serious about the project and intends to honor their agreement. To obtain a construction bond, a contractor must meet rigorous standards and is expected to reimburse the surety company if it must make a payment on the bond, in most cases. This obligation provides a built-in incentive for contractors to work hard and to ensure the project meets expected standards. Obtaining a construction bond may also help them get more work thanks to prequalification requirements.
Frequently Asked Questions About Construction Bonds Explained
Understanding construction bonds and how they work in practice can be confusing, especially given unfamiliar insurance and surety jargon. Here are answers to several of the most frequently asked questions about construction bonds, explained in layman’s terms:
Q: Are construction bonds the same as surety bonds?
A: Construction bonds, also called contract bonds or contractor bonds, are a type of surety bond.
Q: Who are the parties to a construction bond?
A: Like other surety bonds, there are three parties to construction bonds: the principal (the contractor); the obligee (the project owner – generally a government department or business owner); and the surety (the guarantor agreeing to pay the obligee if the principal defaults).
Q: Does every construction project require a construction bond?
A: According to federal law, contractors on federal construction projects worth $100,000 or more must have construction bonds; they may also be subject to additional state laws requiring bonding.
Contractors on private projects may or may not be required to become bonded; the decision to do so is at the discretion of the project owner or lender.
When in doubt, consult the construction agreement to determine if bonding is required and, if so, whether there is a minimum bond amount or other terms in that agreement.
Q: What is the role of the surety company?
A: The surety company is the organization guaranteeing the contractor’s performance. If the contractor performs their obligations as agreed, the surety company does not need to get involved.
If the contractor defaults or otherwise does not honor all obligations, the surety company steps in and pays the project owner the agreed-upon bond amount. In most cases, the surety will hold the contractor liable and will expect reimbursement of the amount paid.
Q: What is the difference between a bid bond and a performance bond?
A: A bid bond is used to ensure that a contractor bidding on a construction project will actually follow through and agree to perform the work at the proffered price. This can limit the bidding process to only serious contractors who want the work. The bond serves as compensation for the project owner in the event the contractor backs away from their bid.
A performance bond activates after the two parties sign the construction contract, to ensure the contractor follows through. If the contractor fails to follow through, the surety will pay the amount of the bond to the project owner.
Q: Is a payment bond the same thing as a performance bond?
A: As discussed above, a performance bond protects the project owner. A payment bond is a type of construction bond that protects subcontractors and suppliers, helping ensure they receive payment from the contractor for the work they performed or the materials they supplied.
Q: Are there other types of construction bonds?
A: Other common types of construction bonds include license bonds, which guarantee that contractors will agree to follow applicable laws to obtain and maintain licensing; maintenance/warranty bonds guaranteeing work quality for a period of time after completion; supply bonds to guarantee materials will be provided as agreed; and subdivision bonds that may be required for work completed in city subdivisions.
Q: In a bonded construction project, what happens when the contractor defaults on obligations?
A: If the contractor doesn’t honor their obligations, the surety company pays the project money. This payment is intended to help the project owner cover expenses associated with the contractor’s default, including any penalties or other damages incurred. The contractor is then liable to the surety company to repay the amount expended.
Q: How can a contractor obtain a construction bond?
A: Construction bonds are available through approved surety agencies in each state. Working with an insurance agency that handles commercial insurance products can help contractors and business owners protect their risks and risk management needs.
Construction Bonds Explained: Protect Everyone’s Interests
There is a lot that could go wrong with any construction project. Using construction bonds can help mitigate some of that risk by providing financial protection for project owners and subcontractors.