Performance bonds are a type of contract surety bonds issued by surety bond companies, insurance companies or banks. Specifically, they are contract bonds that ensure contractors' satisfactory completion of a project. While the contract bonds can be used in private industries, they are more commonly adopted in construction projects or other public projects. In other words, performance bonds act as a financial and performance guarantee to protect project owners' losses in case the contractor defaults or fails to complete the project.
Payment bonds are a type of contract surety bond issued by surety bond companies to protect against non-payment in construction projects. Essentially, it acts as a financial guarantee that a contractor will pay subcontractors, laborers, and material suppliers for their work and materials provided during a construction project. Payment bonds and performance bonds are typically required together in project specifications, especially for public projects.
Contract surety bonds are typically established between three primary parties: the principal, the obligee, and the surety broker. The principal is usually the contractor or the entity that's required to perform the work. The obligee is usually the project owner or an entity that's requiring the surety bonds for any construction projects. The surety broker is the surety companies or insurance agents that help provide performance and financial guarantee for the given construction project.
In the bonding process, the project owner and contractor ender into a contract for the a specific project, in which the project owner requires the contractor to obtain performance and payment bonds as one of the project specifications. To obtain the contract surety bond, the contractor needs to submit a surety bond application to surety bond companies. Then, a surety broker conducts a risk assessment to understand the contractor's bonding capacity. This step involves evaluating the contractor's financial stability, work history, and capacity to complete and pay sub-contractors for the project before issuing the bond.
For performance bonds, if the contractor defaults or if the project delays, the project owner can make a claim against the performance bond and obtain necessary financial compensation based on the bonding requirements from the surety bond companies after investigation. For payment bonds, if the contractor fails to make payments to subcontractors or suppliers, these parties can file a claim against the payment bond. Ultimately, surety company can seek reimbursement from the contractor after compensating for contract performance or non-payment.
Both performance and payment bonds are deemed so essential to the project completion process that many obligees will not issue projects and contracts to prospective contractors without receiving these bonds beforehand. Specifically, there are federal and local legal legislations that demand performance and payment bonds.
The Little Miller Act refers to state-specific legislation in the United States that mirrors the federal Miller Act, requiring contractors on public construction projects to post performance and payment bonds. These laws ensure that public construction projects are completed as per the contract terms and that subcontractors, laborers, and suppliers are paid. The Little Miller Act applies to state and local projects, whereas the Miller Act applies to federal projects. Bonding history and bonding requirements act as risk management for public entities, legal resource for project owners and sub-contractors, and competitive advantages for contractor.
Surety bond underwriting is the process by which a surety company conducts risk assessment and evaluates the financial security of a contractor before issuing a surety bond. This process ensures that the contractor is capable of fulfilling their contract obligations. Surety underwriting not only provides financial and performance guarantees to the project owners, but also protect surety companies and the public so that the work space is secure.
Performance bond underwriting is the comprehensive process in which surety providers evaluate potential contractors when issuing performance bonds. This process entails a detailed review of a prospective contractor’s financial history, credit record, performance on previous projects, etc, in order to identify possible risk factors that may impact the contractor’s ability to follow through on the performance bond agreement.
Payment bond underwriting operates in much the same way, with surety providers conducting a similarly thorough search of a prospective contractor’s financial stability and project history to determine the amount of risk they pose and see how likely they are to fulfill their contractual obligations.
At their core, through both underwriting processes, surety underwriter is looking for the 3 C’s of surety:
Take performance bond for example, the contractor, in cooperation with their surety insurance agent, must have received the necessary approval and confirmation for the project from any relevant parties — especially the party that is funding and/or owning the project. Following this, in certain cases, a non-binding document called a letter of bondability may be requested by the project owner. This letter states how much money the surety is willing to bond the contractor for; in order to help formulate an accurate bond figure and the costs for the contractor, the prospective contractor will have to present different documents and sets of information to the surety provider based on the proposed project costs and the amount of money bonded.
For projects that have an expected cost of $750K or less, the underwriting requirements for the contractors are:
For projects that exceed a cost of $750K, the contractor will be expected to require the following, in addition to all of the above:
Based on a holistic review of all of these factors listed above, the surety provider will determine the amount they are willing to bond a contractor and how much the contractor will owe the surety provider in fees.
In general, factors that influence performance bond cost include:
Based on these factors, amongst others, performance bond rates are largely determined by the amount of risk that a surety provider deems a prospective contractor and their proposed project to present. Risk is defined as the contractor’s likelihood of non-payment to subcontractors or suppliers, in the case of payment bonds, or the likelihood of not completing a project within a set timeframe or not upholding the expected standard of workmanship. Thus, higher-risk projects and/or contractors will incur higher premium rates (2.5 - 5%) while lower-risk projects will incur lower ones (.75% - 1%), with premium rates being calculated as a percentage of the proposed bond amount.
It is also important to note that the rate of performance bond typically is at a slider scale. This means that for a project under 750K, it is straight percentage, e.g., 2-3%. However, for the portion of the bond above $750K but below $1.5M, it could be a different percentage rate like 1%. In general, the premium rate is $25.00 per thousand (2.5%) on the contract amount up to $500,000 and $15.00 per thousand (1.5%) on the remaining.
If you find yourself with a subpar credit score, the standard underwriting process may seem discouraging; however, it is still possible to obtain a performance bond, although it may be more complicated.
One alternative approach to credit is by offering collateral of some sort to offset the potential risk that a surety provider may determine from your credit score. Providing valuable assets like real estate properties, savings accounts, etc, can help increase your chances of being approved for a performance bond, as these valuable assets can be used to help address any liabilities that may arise in the case of the project’s failure.
Another potential alternative is to work with a co-signer with good credit. A surety provider is more inclined to grant a performance bond if they can recognize another associated contractor who is more likely to be able to pay back the bond and pose a lesser financial risk.
There are also many external companies and agencies that offer programs to aid individuals and companies with limited financial resources and credit. The U.S Small Business Administration (SBA) offers a variety of assistance and financial programs designed to help small businesses and individuals who may be disadvantaged in the traditional surety underwriting process. The SBA utilizes a similar process and application to a traditional surety provider but offers a more lenient and forgiving evaluation of a contractor’s credit.
Lastly, even if the previous two options are unavailable or unrealistic, surety providers may be able to offer you a special bad-credit performance bond that is better suited for individuals with worse credit but often comes with higher premium rates and stricter stipulations as a result. Nonetheless, these bonds are still a suitable option to cover your project-based needs.
In a similar vein to individuals with poor credit or bad financials, will be operating in what is known as an adverse market. Projects of this scale undergo a much more scrutinise underwriting process, with surety providers analyzing a greater deal of financial information about both the project and the contractors. For adverse markets, contractors may be expected to provide:
In addition to these, contractors operating in adverse markets should consult liscensed surety providers like SuretyNow to determine their best course of action when applying for performance and payment bonds.
While there is no set time for any given performance and payment bond, the process usually takes anywhere from 24 to 72 hours, depending on the scale and complexity of the proposed bond.
Performance and payment bonds are crucial financial tools that provide security and assurance in projects. Performance bonds guarantee that contractors will complete their projects according to the agreed-upon terms, protecting project owners from potential losses, while payment bonds ensure subcontractors and suppliers are paid for their services, preventing legal disputes and financial harm. These bonds involve a thorough underwriting process where surety providers assess contractors' financial history and project performance to mitigate risks. All in all, performance and payment bonds are essential components of any successful project, offering peace of mind and financial protection to all parties involved.
