What is a performance bond?

In the construction context, a construction performance bond protects against the risk of a contractor not completing the project as agreed. Performance bonds are typically required on larger construction projects, government contracts, and projects with high financial stakes. They provide performance guarantees and financial guarantees for property owners, contractors, and the public, helping mitigate the risks associated with non-performance or delays of private or public projects.

The Federal Miller Act mandates the use of contract surety bonds, which include payment bond and bid bond in addition to performance surety bond, for all public construction projects exceeding $100,000. Some local legislation mandate construction bonds and contract bonds for projects with lower value. As time progresses,  many private project owners realize the advantages of contract bond, leading to more application of these financial insurance policy. Specifically, performance bond is the most relevant to the protection of project owners as well as public safety.

Suppose the contractor fails to meet their contractual obligations, such as finishing the project on time, within budget, or meeting quality standards. In that case, the project owner can make a claim against the performance bond. If the claim is valid, the surety bond company that issued the bond will compensate the project owner up to the bond amount. This compensation can cover the costs of completing the project or rectifying any deficiencies caused by the contractor's failure to perform.

This article focuses on performance bonds, including what they are, why you need them, and how to get a contract surety bond and a performance bond claim.

Performance Bond vs Other Contractor Bond

Before we start, it's important to note that a performance bond is distinct from payment bonds and bid bonds. While a performance bond focuses on the performance guarantee of the project, a payment bond ensures that the contractor pays their subcontractors, suppliers, and laborers as required by the contract and a bid bond guarantees compensation to the bond owner if the bidder fails to begin a project. 

The terms and conditions of performance bonds can vary, and they are typically regulated by laws and regulations specific to each country or jurisdiction.

How much does a performance bond cost?

The construction performance bond cost can vary widely depending on several factors, including the size and type of project, the contractor's financial history, bonding capacity, and creditworthiness, the duration of the bond, and the specific b set by the obligee (the party requiring the bond). Generally, performance bond costs are calculated with bond rates, typically ranging from 1% to 5%. There is the general formula you can apply to determine the surety bond costs:

Price you pay = Contract Price * Premium Rate

For example, if the contract price is $1,000,000 and the performance bond rate of 5%, the cost of the performance bond would be $50,000. However, rates can be higher or lower based on the aforementioned factors. Additionally, some surety bond companies may charge additional fees or require collateral depending on the risk associated with the project and the contractor.

Factors that determine the performance bond premium

There are two factors that drive 80% of a performance bond premium.

1. Personal Credit Score

When a contractor or business applies for a performance bond, the surety company issuing the bond will assess the financial stability and personal credit score of the applicant. This assessment helps the surety company determine the level of risk involved in providing the bond. The cost of performance bonds can vary based on the applicant's creditworthiness. Contractors with higher credit scores might qualify for lower premium rates because they are perceived as lower-risk clients.

2. Financial History

A contractor's financial history can influence a performance bond's cost. When a surety company evaluates a contractor's financial history, they assess the contractor's ability to fulfill their contractual obligations and complete the project. Much like the personal credit score, the financial performance of a contractor allows the surety to assess your company's risk. Sureties usually look at your financial statements, working capital, track record, industry reputation, and other factors. If you are deemed high risk, your bond cost will be higher than if you are deemed low risk. 

Other Factors

Contract Price, duration and size of project, public or private sector, government requirement.

Do you need to pay to renew your performance bond?

Whether or not you need to renew a performance bond yearly depends on the specific terms and duration of the bond, as well as the requirements set forth by the obligee (the party requiring the bond). Here are some common scenarios:

1. Single Project Bonds: Performance bonds are often issued for individual construction projects. Once the project is completed and all obligations are fulfilled, the bond may expire automatically. In this case, there's typically no need for renewal unless the project extends beyond the initial bond term.
2. Continuous Bonds: Some performance bonds are issued on a continuous basis, covering multiple projects or a specific period, such as a year. In these cases, the bond may need to be renewed annually or at specified intervals to maintain coverage.
3. Renewal Requirements: Even for single project bonds, there may be situations where renewal is necessary. For example, if the project timeline extends beyond the initial bond term, you may need to renew the bond to ensure coverage until project completion. Additionally, if there are changes to the project scope, terms of the contract, or bonding requirements, renewal may be required to reflect these changes.
4. Obligee Requirements: The obligee may specify renewal requirements in the contract documents or bonding agreement. It's essential to review these requirements carefully and ensure compliance to avoid any lapse in coverage.
5. Surety Company Policies: The policies of the surety company that issued the bond may also dictate renewal procedures and requirements. They may offer options for automatic renewal or require you to initiate the renewal process by submitting a renewal application and paying the premium.

Role of Surety Company

The surety company plays a crucial role in the process of the bonding process. They have several essential responsibilities as they issue the construction bond.

1. Bond Underwriting: The surety company assesses the risk associated with issuing the bond, i.e. does the contractor have the financial and performance capability to complete the project. Based on this assessment, the surety determines whether to issue the bond and, if so, under what bond terms and conditions.
2. Bond Limitations and Conditions: The surety company may impose certain limitations or bond terms, such as maximum payout amounts, duration of coverage, or specific requirements for claims handling. The contractor must adhere to these terms to maintain the validity of the bond.
3. Bond Issuance: The bonding company provides the necessary documentation to the contractor. This includes the construction performance bond cost and the bond itself, which serves as a guarantee to the project owner (obligee) that the contractor will fulfill their obligations according to the bond terms of the contract.
4. Bonding Services: Throughout the duration of the project, the surety company may provide support and guidance to the contractor. This could include assistance with bond-related paperwork, advice on risk management, or guidance on how to avoid potential claims and bond penalties.
5. Claims Handling: If a claim is filed against the bond due to the contractor's failure to perform according to the contract terms, the surety company investigates the claim and determines its validity. If the claim is found to be legitimate, the surety may fulfill its obligation by compensating the obligee for the losses incurred.

Overall, the surety company acts as a financial guarantor, providing assurance to project owners that the contractor will fulfill their contractual obligations. Their involvement helps facilitate trust and confidence in the construction industry and ensures that projects are completed successfully.

How does the surety company collect payment after settling a claim?

When surety companies settles a claim on a performance bond, the surety companies would pay for the contractor first. However, they would need to collect payment as the contractor violates the bond terms and conditions. To recover the paid out bond coverage, the surety companies usually pursue contractor through legal means to collect the fund. Specifically, before issuing a performance bond, the surety company often requires the principal to sign an indemnification agreement. This agreement is a contract that stipulates the principal to be responsible for reimbursing the bonding agency for any losses incurred due to a claim on the bond. With the indemnification agreement, the surety bond companies can then pursue the principal for repayment according to the terms of the agreement legally.

In some cases, the surety bond companies may require the principal to provide bond collateral upfront as security for the surety company against potential claims. If a claim is settled, the surety may retain or liquidate the collateral to cover the costs. If a claim is not, the surety would return the bond collateral to the contractor.

Subrogation is the legal process by which the surety assumes the rights of the obligee (the party who filed the claim) to pursue recovery from any third parties responsible for the losses. If another party, such as a subcontractor, contributed to the failure that led to the claim, the surety may pursue them for reimbursement. If the principal refuses or is unable to repay the surety for the settled claim, the surety may take legal action to enforce the indemnification agreement or recover the funds through other legal means.

Overall, the surety company employs various strategies to recover the amount paid out on a settled claim, aiming to minimize its losses and maintain its financial stability.

Conclusion

The cost of a surety bond is relatively simply in the process of bond application. However, upon issuance and bond approval, there are additional areas of payment possible for the performance guarantee of a construction project. Specifically, contractors may need to pay for bond renewal and for claim reimbursement. Overall, the bond coverage relates to contract value and applicants' financial status.