Construction is a risky business, especially with large multi-year projects. Economic downturns and material shortages can bring down a contractor, but while some risks can be covered with insurance policies, that isn’t the only tool available to mitigate risk.

Surety bonds transfer risk to your contractor and subcontractors, giving you financial security and construction assurance in a business where large projects inevitably run over budget and take longer than expected to finish.

The bond serves as a contract to ensure the contractor will do the work and pay all their people and suppliers. It’s a good way to protect against non-payment, lack of performance, and even company default.

Let’s look at surety bonds, what they cover, and who can make a claim against them.

What Is a Surety Bond?

A surety bond is a type of contract where a surety company promises to pay a project owner if the contractor taking out the bond fails to meet its obligations. The bond premium is paid for by the contractor who is covered by the bond.

There are always three parties involved:

• Principal—the contractor, person, or company that must make good on an obligation
• Obligee—the project owner who needs the guarantee
• Surety—the issuer of the bond

Because no one wants to take a chance on a contractor that might go bankrupt halfway through a project, surety bonds are a good way to help smaller contractors prove they can be counted on to do their part of a project.

These are occasionally called construction bonds, and while they are like an insurance policy, they are different from such.

The contractor purchases the bond to protect the contractor and the project owner from financial issues during the project. If a problem occurs, the owner can file a claim against the bond. Once the bond claim is paid out, the contractor is obligated to pay the surety company back that money.

Surety bonds are commonly required on federal projects over a certain amount. State and local governments might also have requirements for such. Any private company or project owner can ask its contractors or suppliers to provide surety bonds as well.

One great benefit of surety bonds is that they serve as prequalification of the contractor since the surety company will be looking at the company finances and work history. Roughly two-thirds of construction companies fail within five years, largely because of a poorly managed business. A surety bond confirms the stability and quality of the contractor.

Types of Surety Bonds

There are a few different types of surety bonds to address different situations and risks. Most have these things in common:

• Bonded amount—usually capped at 10 to 15 times the principal’s business equity
• Working capital—equals at least 10 percent of the bonded amount’s total
• Bonding capacity—the maximum bonded amount you can get
• Bond premium—1 percent to 15 percent of the bonded amount
• Bond term—usually one to four years

Within construction, a contract surety bond serves as the most common type. It guarantees the performance of a contractor by protecting the project owner against harmful business practices and failure to finish or properly complete the work.

Other types of surety bonds might be required by government entities or serve to protect against employee dishonesty and theft. You can even get a bond to protect against losses during a court case.

How to Get a Surety Bond

If you’re in a position where you need to secure a surety bond, you can start by asking your insurance agent to recommend a surety company. That company provides the bond and pays out any claims.

Working with an agency helps cut down the amount of time needed to get the bond as you can fill out one application. The agency then shops your business around to find you the best option.

Unlike with insurance, you have to qualify for the bond. The surety company will gather a lot of information about you and the company during the process. They’re looking to ensure your company is well-managed, profitable, deals fairly, etc.

The documents the surety will want to see include financial statements, work history, and project references. Make sure you have them, that they’re accurate, and that they’re up to date.

Specific information a surety company might ask for as part of your application includes:

• Company organizational chart
• Resumes for top-level management
• Business plan
• List of largest completed jobs and gross profit earned
• Line of credit from your bank
• Subcontractor and supplier references
• Recommendation letters from owners, architects, and others
• Year-end financial statements

The surety will be evaluating your financial situation, your capacity to do the work, and the status of your previous projects.

How Does a Surety Bond Work?

Once a contractor has qualified, the surety issues the bond. It assures that the contractor will do the work for the project owner as laid out in the contract. The bond can be called at any time if the project owner believes there has been a contract violation.

The project owner makes a claim to the bond, then the surety company investigates. If the claim is justified, the surety pays the costs specified on the bond to the project owner. The contractor then pays back the monies to the surety company.

The premium is paid for either as a down payment that is a percentage value of the project or as an annual premium.

Need Surety Bonds?

Managing risk is a big part of any extensive project, especially high-dollar ones like in construction. Surety bonds are a way to protect yourself from certain types of risk in these projects. Protect yourself from financial damages and ensure your project finishes on time.

Interested in getting a contractor surety bond? Contact us to ask questions or request a quote so you can budget the bond for your next construction project.