Construction is a risky business in more ways than one. In addition to the risk of physical loss or injuries, project owners depend on contractors to fulfill their obligations at agreed-upon bid prices, according to federal, state and local regulations and as specified in the underlying construction agreements. Similarly, subcontractors need to be able to trust that the contractors they are working for will pay them for their work.
Surety bonds offer financial protection in the event a contractor or project owner defaults on their obligations.
Understanding What a Surety Bond Is – And Is Not
While surety bonds for construction contracts are offered through insurance agencies, they are not actually insurance policies.
Instead, surety bonds are guaranteed contracts, offered by surety companies. Surety bonds for construction contracts guarantee the contractor will perform the work they agreed to or guarantee that the completed work will be paid for as agreed in the construction agreement.
There are three parties to a surety bond: The principal (the contractor), the obligee (owner) and the surety company.
Common Types of Surety Bonds
There are several common types of surety bonds for construction contracts, including but not limited to the following:
- Performance Bonds. Project owners buy performance bonds to ensure the contractor or subcontractor they hired for the job will actually complete the work as promised. In the event a contractor turns out to be unreliable and does not actually meet their contractual obligations, the surety company will pay an agreed-upon sum of money to help make the oblige whole.
- Bid Bonds. A bid bond protects project owners from contractors who may bid on and be awarded construction contracts, only to later fail to follow through with the project. Bid bonds can help ensure only qualified bidders are involved in the bidding process.
- Contractor License Bonds. In most state, county and local government levels in the U.S., contractors must purchase license bonds before obtaining their professional licenses. When purchasing a license bond, a contractor is essentially stating they will work according to the laws and regulations applicable to their line of work. If they fail to uphold the terms of their license bonds, contractors are expected to reimburse the surety for its claims settlement expenses.
- Payment Bonds. Payment bonds protect subcontractors and companies that supply construction materials by ensuring they will be paid. If a contractor does not pay suppliers or subcontractors, the surety bond kicks in, although the contractor is expected to reimburse the surety.
- Maintenance Bonds (also called Warranty Bonds.) A maintenance bond is often used for public projects and serves to warranty a contractor’s work for a set period of time after completion.
- Supply Bonds. Supply bonds may also be used for public construction projects, providing an assurance that supplies or materials will be delivered as agreed in the purchase order or other agreement.
- Subdivision Bonds. If a construction project involves improving roads, sidewalks, sewers or other public property within a subdivision, the local government may require a subdivision bond to guarantee the work will be done as promised.
Why Are Surety Bonds Necessary?
In some cases, surety bonds are required by law. The Miller Act of 1935 requires contractors on federal construction projects of $100,000 or more to have performance bonds and payment bonds of up to $2.5 million and more. In addition, most states and jurisdictions in the U.S. have similar jurisdictional-specific laws for public works projects. These are often referred to as “Little Miller Acts.”
For private sector projects, surety bonds are generally at the discretion of the project owner, lender and contractor. Self-insurance and letters of credit may not provide the protection needed, especially for large construction projects.
Requiring surety bonds in the construction contract ultimately serves to shift the risk of loss, giving assurances to everyone involved that their financial losses will be limited in the event the project does not go as planned.
Benefits of Surety Bonds
Ultimately, surety bonds protect everyone involved in the construction industry, including the project owner, contractors, subcontractors, lenders and even taxpayers.
First, if the contractor defaults, the surety bond provides financial protection for the project owner. They can help document that contractors (and subcontractors, as applicable) have met rigorous bonding standards and that the surety company believes the contractors will fulfill their obligations.
For their part, contractors have an incentive to complete projects with surety bonds because they could be on the hook to indemnify the surety company if they don’t follow through as agreed. The ability to prequalify for surety bonds may also result in the contractor or subcontractor obtaining more work.
If a contractor doesn’t pay subcontractors for their work, a surety bond can eliminate the need for the subcontractor to have to file a mechanic’s lien for a private property project.
Protect Your Interests with Surety Bonds for Construction Contracts
Purchasing surety bonds for construction projects can minimize the inherent risks of contractor or subcontractor default, ensure subcontractors, suppliers and laborers will be paid and protect your business from financial losses.