The Importance of Surety Bonds for the Construction Industry

Starting a construction company is no easy task. You need plenty of different things to get the ball rolling. One of the less obvious requirements to consider is surety bonds. But what exactly are surety bonds, and how do they work? In this article, we go over the answers to these questions, and more. By the end of it, you will learn about why they’re such an integral part of the construction industry.

Introduction to Surety Bonds

Before we discuss construction bonds in particular, we need to cover the basics of the concept. So, what is a surety bond? Well, to put it in the simplest terms possible, it’s a type of agreement between three different parties regarding financial coverage.

The three parties are called the surety, the principal, and the obligee. The obligee is the party that requires the bond. Usually, this is a government agency or project owner. The party that is required to purchase the bond is the principal. Principals are contractors or businesses, and their role is to follow through with an agreed set of conditions in order for the project to go off without a hitch. Finally, there’s the surety itself. This party is the financial guarantor of the surety bond and a mediator of claims.

Types of Surety Bonds

Generally speaking, there are as many different variants of a surety bond as there are types of agreement between three parties. In other words, there can literally be hundreds of thousands of bond variations. Of course, we can still classify them into several different groups based on the nature of the agreement. Most often, surety bonds are classified into three groups:

• Contract bonds
• Commercial bonds
• Court bonds

For the purposes of construction, you will need contract bonds. As their name suggests, they relate to contracts, and their purpose is to see those contracts through. For instance, if a principal doesn’t see the project through, the obligee will receive either compensation or some other means of finishing the project. These types of bonds also vary depending on when they need to be utilized during the construction process. The most common subtypes of contract bonds include bid bonds, performance bonds, and payment bonds.

Bid Bonds

The project owner usually requests a bid bond during the tendering process of the contract. Its purpose is to give the owner reassurance that the contractors who are bidding will enter the contract. Furthermore, it makes sure that a contractor will provide all the performance and payment bonds necessary once they enter the contract post-bidding.

The surety backs the initial proposal by the contractor at this early stage, allowing the bid bond to take effect.

Performance Bonds

If the contractor fails to fulfill their end of the agreement, the project owner needs some type of protection. One such type is the performance bond. Acquiring one will give you one of these benefits:

• The surety will find a way to arrange performance to complete the work; alternatively, they will provide the necessary payment to fulfill the contractual obligation
• These bonds take effect the second you experience your first dollar of loss

Payment Bonds

A contractor is not the only entity that participates in the project. More often than not, they will have subcontractors, trade workers, and other project claimants involved. As such, all of those parties need proper compensation. So, it’s up to the contractor to see that they all receive their fair pay, which is where payment bonds come in.

Generally, payment and performance bonds work in tandem. A payment bond, in and of itself, can help you in the following ways:

• It makes sure that all subcontractors, trade workers, suppliers, and claimants receive their allotted pay
• It garners more competitive prices for the owner (a subcontractor, for example, will want to work on a project if they know that their credit is secured)
• Project continuity will stay intact (subcontractors and trade workers will have more incentive to work on a project with proper financial security in place)

Subdivision Bonds

A construction project often can impact the surrounding area, necessitating additional work to restore or improve public property such as sidewalks, curbs, utility lines, and sewers among other things. A subdivision bond serves as a guarantee that public improvements will be completed in accordance with all applicable regulations, and within the required timeframe. While this work is a benefit to the public, it is usually paid for by the builder or developer.

Benefits of Surety Bonds in Construction

Surety bonds benefit everyone involved in a construction project in different ways:

• Contractors undergo a rigorous process of prequalification and are deemed capable of fulfilling the obligations stipulated in the contract
• Subcontractors have a good legal claim for compensation if they feel they’re not paid enough for their goods and services (and they don’t need to file a mechanic’s lien)
• Contractors are more likely to complete a client’s project if there are surety bonds in place
• Surety bond producers and underwriters can offer all necessary assistance to the contractors in the event of a claim

Final Thoughts

Surety bonds are essential for both contractors and project owners. They make sure that all parties honor the agreement completely and that neither the government agency nor project owner suffers any financial or material damage.

One thing you need to understand is that, while in some instances insurance companies issue surety bonds, the bonds themselves are not insurance. Insurance will protect the buyer themselves, while a surety bond will cover the party with which the buyer is working. Furthermore, the party that provides compensation is the bond buyer and not the insurance company.