How Does a Construction Surety Bond Work
In the construction industry, surety bonds are often required in order for the contractor to be considered for a project. For example, a surety bond is required for all federal projects, as well as publicly funded projects in most states (including Maryland). A lot of private entities also require a contractor to be bonded, and this is a strong consideration among many consumers when they are choosing a someone to build a home, do a home renovation, or perform other types of construction work.
A surety bond is a contract between three parties; the principal, the obligee, and the surety. In construction, the principle would be the contractor who is overseeing the project. The obligee would be the party who is being protected from loss; this could be either the project owner/consumer, a subcontractor or worker who will be working on the job, or a supplier who will be providing materials for the job. The surety would be the institution that is providing financial backing for the bond.
The principle purchases the surety bond from the surety for a premium. The surety, in turn, provides assurance to the obligee that a certain result will occur. For example, the surety guarantees the project owner that the work will be completed in accordance with the terms and conditions of the contract, even if the principal fails to meet these obligations.
There are three general types of contract surety bonds in the construction industry:
- Performance Bonds: These are bonds that protect the project owner from the failure to perform the desired work. If the principal defaults on their performance obligation, the owner can call on the surety to satisfy the principal’s obligation.
- Payment Bonds: These are bonds that provide assurance to subcontractors and other workers that they will be paid for the work they perform, and to suppliers that they will be paid for the materials they provide. Again, if the principle defaults on their obligation (in this case, to pay subcontractors, workers, and suppliers as agreed), the obligees can call on the surety for payment.
- Bid Bonds: This type of bond provides assurance to project owners that a contractor who is bidding on a project will follow through, sign the contract, and perform the required work if they are awarded the bid.
Many contractors understand that they need to be bonded, but there is a lot of confusion about how surety bonds work. Perhaps the most common misconception is that a surety bond protects the principal (contractor), similarly to how an insurance policy would. However, it is important to understand that, although surety bonds and insurance policies are similar, there are some significant differences.
Insurance involves the transfer of risk from one party to another. For example, if you have auto insurance and your car is totaled in an accident, your insurance company would cover the loss of your vehicle (in accordance with the terms and conditions of the policy). There is no obligation on the part of you the policyholder to pay back the insurance company, because they have already assumed the risk for the covered event (the accident).
Surety bonds, on the other hand, involve three parties instead of two. And it is this third party, the obligee, who is protected from loss, rather than the person who purchases the bond (the principal). Although the surety will make sure the principal’s obligations to the obligee are satisfied (if there is some type of default), this does not mean that the principal is off the hook. Ultimately, the principal is obligated to pay the surety back for the loss. As such, it is always in the principal’s best interests to follow through on all of their obligations.
Not All Surety Bond Providers are the Same
One final point that is very important to emphasize is that not all sureties are created equal. For example, there are some that will only issue a bond for a contractor with good credit, while others specialize in the high-risk market. And as with insurance products, premiums can vary widely from one company to another, and different companies have different ratings and certifications you need to be aware of before you do business with them.
To find the right surety bond provider for your project, it is best to work with a local independent agent. Independent agents have access to several of the top providers in your state, and they can work closely with you to thoroughly analyze your specific circumstances and shop freely to find you the surety bond provider and product that best fits your needs and budget.