A surety bond is a three-party agreement where the Surety (an insurance company), assures the Obligee (the Owner or Prime Contractor) that the Principal (bonded Contractor) will perform a contract. Contrary to popular belief, a bond is not insurance, but an extension of credit. It just happens to be issued by an insurance company. Although everyone hopes for the best, a surety bond helps to ease the mind of the Obligee/Owner that the contractor they hired will perform the work according to the contract and pay any subs and suppliers. If not, they can call on the bond.
When pre-qualifying a contractor for bonding, we focus on three things……the “three C’s of bonding”. They are Character, Capital, and Capacity. In the Surety’s experience, a successful contractor has all three qualities.
- Character: Does the Principal (bond applicant) have a credit record and other history suggesting good character? Will they be faithful to their obligations?
- Capacity: Does the Principal have the skill, experience, knowledge, staff and equipment necessary to perform their contracts?
- Capital: Does the Principal have the financial wherewithal to finance the new project as well as other current obligations, and address any problems that may arise?
Once we can confirm that the contractor meets the requirements of the 3 C’s, we will look into the type of bond required. Although we issue many types of bonds, the three most common construction contract bonds are Bid Bonds, Performance & Payment Bonds, and Maintenance Bonds.
1. Bid Bonds or Letter of Intent: A bid bond provides financial assurance that the contractor is submitting a bid in good faith and, if successful, the bidder will enter the contract at the price bid and provide required Performance & Payment bonds. This form of bid security gives the Obligee assurance that if the contractor backs out of the contract, the Surety will pay the penalty prescribed. The Surety’s liability is limited to the bond penalty.
A letter of intent is another form of bid security. Sometimes, instead of a bid bond, the Obligee will ask for a letter from the Surety indicating they agree to execute the bidder’s obligation in an amount equal to the amount upon which the project award was based.
2. Performance & Payment Bonds: These bonds are typically issued together.
- Performance Bond – Protects Owner from financial loss if contractor fails to perform.
- Payment Bond – Assures contractor will pay certain workers, subs and suppliers.
4. Maintenance Bonds: Often a contractor must agree to fix any defects in the workmanship for a period of time after the project is complete. A maintenance bond guarantees to the project Owner that the contractor will meet this maintenance obligation.
The bond is in place to protect the Owner/Obligee as well as certain subcontractors/suppliers. Sureties underwrite the potential risk of the bond, as well as the contractor, to make sure that the job is a good fit with the goal of ensuring that all parties are happy with the outcome.
If you have any questions regarding what a bond is or the obligation that you, the contractor, would be responsible for, please give us a call! We are more than happy to walk you through the process and explain how it works.