Contract Surety is the category of surety bonds used to protect the project Owner from financial loss in the event the Contractor (“Principal”) fails to fulfill their contractual obligation.
Contract Surety is typically used in the construction industry, but it’s also applicable to many other non-construction contractual relationships such as service contracts and various equipment and material supply contracts. The bond company provides its guarantee by co-signing the bonds with the Contractor, to allow the bond company’s financial resources to back the commitment of the Contractor. Subcontracts can also be bonded, whereby a specific Subcontractor would be the “Principal” and the General Contractor would be the Owner or Beneficiary of the contract surety bonds.
Different types of Contract Surety Bonds
There are different contract surety bonds that are required at different stages of the construction cycle.
- Prequalification Letters are provided at the Pre-Tender stage;
- Bid Bonds and Agreements to Bond are provided during the Tendering Stage;
- Performance, Labour & Material and Lien Bonds are provided during the Construction Stage;
- Maintenance and Early Release of Holdback Bonds are typically issued during the Post Construction stage.
What is a “Bond Facility”?
A Bond Facility is a commitment from a surety company to provide contract surety bonds for a qualified contractor to an agreed limit subject to the stated terms and conditions being met. The surety company will set a limit to the allowable amount of the bonding facility. This limit will outline a single job size limit as well as an aggregate job size limit. The single job size limit states the maximum bonded job size allowable and the aggregate limit states the maximum amount of total bonded contracts you can carry at any given point in time. The Bond Facility will also address to the scope of work.
For example, if your company is engaged in road construction and you request a bond for a mechanical system, it may not be supported by the bond company without a discussion. The parameters of a Bond Facility will always be outlined in a Terms & Conditions Letter.
How do I obtain a Bond Facility?
Contract Surety Bonds are underwritten by Insurance companies commonly known as a “Bond Company”. There is an application process that the contractor must go through in order to qualify for a bond facility. This involves providing financial information about the company and its owners as well as information about the history of the company and its relevant experience in the construction field for which they are applying. Once approval to issue the bond has been granted, there are some documents that need to be signed. The next step is the issuance of the bond.
What information is required to qualify for bonding?
In order to qualify for a contract surety bond facility, you must provide the bond company with information about your financial situation as well as your experience in your field. You will be required to submit:
- Year-end financial statements prepared by a chartered accountant
- Listing of the companies payables and receivables
- A bank reference letter
- Personal financial statements of the main shareholders
- Contractor Questionnaire often supported with shareholder resumes or other information that helps explain what kind of work you or your company have completed in the past.
The amount of information and detail required generally depends on the size and frequency of your bonding needs. A larger, more demanding bond facility would require more underwriting information than a small facility requiring one or two small bonded jobs per year.
Is it difficult to get bonding?
In todays’ market place, it has never been easier to obtain bonding. With automation and access to information, bond companies are better able to assess the credit worthiness of a contractor. Small and simple one-off bond requirements can usually be done relatively easy through bond company’s online portals. This is a big shift as bonding used to be an onerous process regardless of the size of the bond required. Larger and more active bond facilities will require more in depth financial reporting as there is potential for greater bond exposure to the bond company. In some cases a meeting may be required between you and the bond company to establish a greater comfort level with you and your business.
Why do I need a Contract Surety Bond?
Project owners often require some form of guarantee from contractors with whom they enter into a contract. From an owner’s perspective, they want an assurance that the project will be completed on time and on budget, according to the terms and conditions of the contract. Imagine the issues that would arise if a contractor went into receivership halfway through construction of a public bridge. The bond ensures continuity of the project in the event of a default under the contract. The reality is that without the ability to provide bonds, some owners will not allow you to work for them.
What are the advantages to using surety bonds over other types of security?
The alternative acceptable security to a surety bond is typically a letter of credit. When a letter of credit is issued by a bank, they will require you to freeze that amount of money in your bank account and will charges a fee for issuing the letter of credit. Keeping large sums of money tied up by a letter of credit restricts your access to cash and ultimately hurts operations.
For most it’s not an option. By using a surety bond instead of a letter of credit the contractor gains access to additional bank financing that may be crucial to your company’s operations. To make matters worse, in the event of a default, the Owner can cash your letter of credit with no questions asked. In the case of a default with a surety bond, the bond company will investigate the situation before they pay out on a claim.
How much does a Contract Surety Bond Cost?
This is a very important part of the initial Bond Facility negotiation your broker enters into with the bond company. The cost of a Contract Surety bond varies depending on the type and size of the surety bond required, the duration of the contract and the rate factor that is applied. There is normally an annual administration fee that covers all of your bonds at the tender stage including Prequalification Letters, Bid Bonds and Agreements to Bond. Whether you bid once or 50 times a year, the same fee will apply.
If you are awarded a contract and require Performance bonds, Labour & Material bonds, Maintenance bonds or Lien Bonds, the fee associated for these bonds is typically between 0.5% and 1.5% of the contract amount including tax. This rate varies depending on the percentage of bond required and the financial strength of the construction company requiring the bond. If the contract surpasses one year, additional fees may apply.
Can I use any insurance broker?
Bonding is a specialised part of the insurance industry. It is very different to typical insurance because it is more of a credit application rather than risk management. Your broker needs to be well versed in Financial Statement analysis, understand different types of construction and know what the bond companies look for when establishing a bond facility.
A true Surety Broker will know what bond facility limits are possible, will understand market rates and will have access to multiple bond markets which will allow you to access the competitive market place. With improper representation you risk being denied bonding ultimately not allowing you to take on the work you need to operate.