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The Value of Surety Bonds - April 2017
The way project owners
evaluate and manage risks on construction projects and make fiscally
responsible decisions to ensure timely project completion are crucial to their
success. Since private owners cannot afford to gamble on a contractor whose
reliability is uncertain or who could end up bankrupt halfway through the job,
a surety bond is a great safety net for the investment.
Suretyship is a
very specialized line of insurance that is created whenever one party
guarantees performance of an obligation by another party.
A surety bond is
a written agreement where one party, the surety, obligates itself to a second
party, the obligee, to answer for the default of a third party, the principal.
Types of Surety Bonds
- Contract (or Corporate) Surety Bond
The contract (or
corporate) surety bond provides financial security and construction assurance
for building and construction projects by assuring the project owner (obligee)
that the contractor (principal) will perform the work and compensate certain
subcontractors, laborers and material suppliers, as outlined via their
contract. Contract surety bonds include the following:
- Bid bonds provide financial assurance that the bid has
been submitted in good faith and that the contractor intends to enter into the
contract at the price bid and provide the required performance and payment bonds.
- Performance bonds protect
the owner from financial loss should the contractor fail to perform the contract in
accordance with its terms and conditions.
- Payment bonds guarantee
that the contractor will pay certain subcontractors, laborers and material
suppliers associated with the project.
- Maintenance bonds
guarantee against defective workmanship or materials for a specified period.
- Subdivision bonds
make guarantees to cities, counties or states that the principal will finance
and construct certain improvements such as streets, sidewalks, curbs, gutters,
sewers and drainage systems.
2. Commercial Surety Bond
surety bonds guarantee performance by the principal of the obligation or
undertaking described in the bond. Commercial surety bonds include:
- License and permit bonds are required by state law or
local regulations in order to obtain a license or permit to engage in
a particular business (contractors, motor vehicle dealers, securities dealers,
employment agencies, health spas, grain warehouses, liquor and sales tax).
- Judicial and probate
bonds, also referred to as fiduciary bonds, secure the performance on a
fiduciaries' duties and compliance with court orders (administrators,
executors, guardians, trustees of a will, liquidators, receivers and masters).
Judicial proceedings court bonds include injunction, appeal, indemnity to
sheriff, mechanic's lien, attachment, replevin and admiralty.
- Public official
bonds guarantee the performance of duty by a public official, (treasurers, tax
collectors, sheriffs, judges, court clerks and notaries).
(non-contract) bonds are required by the federal government (Medicare and
Medicaid providers, customs, immigrants, excise and alcoholic beverage).
- Miscellaneous bonds
include lost securities, lease, guarantee payment of utility bills, guarantee
employer contributions for union fringe benefits and workers’ compensation for
- The principal is the
party that undertakes the obligation.
- The surety company
guarantees the obligation will be performed.
- The obligee is the
party who receives the benefit of the bond.
It’s important to recognize the similarities between suretyship and other
forms of insurance:
- State insurance
commissioners regulate both suretyship and other insurance.
- They both provide a
safety net for financial loss.
- In traditional
insurance, the risk is transferred to the insurance company. However, in a
suretyship, the risk remains with the principal and the protection of the bond
is designated for the obligee.
- In traditional
insurance, the insurance company assumes that part of the premium for the
policy will be paid out in losses. Yet, in true suretyship, the premiums paid
are "service fees" charged for the use of the surety company’s
financial backing and guarantee.
- In underwriting
traditional insurance products, the goal is to "spread the risk,” while in
a suretyship, surety professionals view their underwriting as a form of credit.
Therefore, the emphasis is on the pre-qualification and selection process.
Since 1893, the U. S. Government has required
contractors on federal public works contracts to obtain surety bonds to
guarantee that they will perform such contracts and pay certain labor and
material bills. The current federal law on federal public works is known as the
Miller Act. It requires performance and payment bonds for all public work
contracts in excess of $100,000 and payment protection, with payment bonds the
preferred method, for contracts in excess of $25,000. Almost all 50 states, the
District of Columbia, Puerto Rico and most local jurisdictions have enacted
similar legislation requiring surety bonds on public works as well. These are
generally referred to as "Little Miller Acts."
bonds are mandated by law on public works projects to protect taxpayer dollars,
the use of surety bonds on privately-owned construction projects is at the owner's
discretion. Alternative forms of financial security, such as letters of credit
and self-insurance, don't guarantee performance or payment protection of a
surety bond or ensure that a contractor is competent. With a surety bond, the
risks of project completion are shifted from the owner to the surety company.
For that reason, many private owners require surety bonds from their
contractors to protect their company and shareholders from the enormous cost of
contractor failure. Subcontractors may be required to obtain bonds to help the
prime contractor manage risk, particularly if the subcontractor is completing a
significant part of the job or is a specialized contractor who is difficult to
Surety bonds are
issued through agents and brokers who are knowledgeable about the surety and
construction industries. Surety bond agents and brokers usually work for
companies that specialize in surety bonds or in insurance agencies that have a
sub-specialty in surety bonds.
surety bond agent or broker usually maintains a business relationship with
several surety companies, which enables them to match a contractor with an
appropriate surety company. Also, a solid surety company and producer will help
a contractor maintain and increase its capacity.