Surety bond definition
Surety bonds pertaining to a construction project or business are designated as contract surety bonds. With three parties involved, the surety (the entity guaranteeing the debt) guarantees the obligee (the project owner) that the principal (the contractor) can do the work as specified in the contract documents. In essence, Contract Surety Bonds guarantee a business owner that the contractor will fulfill the contract. For more information on contract surety bonds, explore Alpha Surety.
Types of Surety bonds.
Contract surety bonds can be grouped into three types:
First are the Bid Bonds, which give financial security that binds the contractor to provide required performance and payment bonds after the submission of the bid.
The second is the Performance Bond that assures the owner against the risks, especially the monetary ones, that arise when the contractor fails to perform under the terms of the contract.
It lastly is the Payment Bond, which assures that the contractor will pay his employees, suppliers, and others whom he has engaged in the project.
Differences between Surety Bonds and Standard Insurance Policies
Surety companies are classified under insurance companies, hence, a surety bond and a standard insurance policy shall be a risk transfer mechanism regulated by the state insurance departments. The main difference is that conventional insurance is designed for compensating the insured upon an unwanted event happening, while the companies underwriting surety bonds operate on a different basis. Surety bonds are employed to prevent loss and therefore bolster the contractor based on financial strength and their skills and expertise.
The Laws
The US Government requires all contractors to have Surety Bonds to guarantee that a contractor will complete the work stated in its contract and pay those hired for the project. This law, referred to as the Miller Act, requires contractors to prepare at least two bonds on contracts of more than $100,000.
Advantages of Contract Surety Bonds
Construction projects are risky, with many contractors struggling to complete them. In 2014, 53% of contractors reported underperforming projects, and by 2021, 64% had contractors unprepared for pandemic-related disruptions. Surety bonds help reduce the risks by guaranteeing project completion and maintaining the budget.
- Guarantees that the risk of construction is transferred to the surety company.
- Assesses contractors’ abilities to fulfill contracts.
- Promotes fast-tracking of projects.
- Removes the necessity for subcontractors to file mechanics’ liens.
- Creates more business opportunities with financial backing and guidance.
Cost: Surety bond premiums range from 0.5% to 3% of the contract price, depending on project size and timeline.
How Surety Bonds Operate
Surety companies help complete the project by assessing contractors’ ability to fulfill their duties. Following their assessment, they refer to years of industry experience with contractors and subcontractors.
Requirements for Surety Bond:
The surety company must be confident that the contractor has:
- A good reputation and good references.
- Ability to meet all contract obligations.
- Relevant experience for the subject project.
- Tools and equipment necessary (or access to).
- Financially capable of doing the job.
- Solid credit history.
- Good relations with banks and line of credit.