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Introduction surety bond definition

Surety Bonds have been around in one form or another for millennia. Some may view bonds as an unnecessary business expense that materially cuts into profits. Other firms view bonds as a passport of sorts that allows only qualified firms access to bid on projects they can complete. Construction firms seeking significant public or private projects understand the fundamental necessity of bonds. This article, provides insights to the some of the basics of suretyship, a deeper look into how surety companies evaluate bonding candidates, bond costs, warning signs, defaults, federal regulations, and state statutes affecting bond requirements for small projects, and the critical relationship dynamics between a principal and the surety underwriter.

What is Suretyship?

The short answer is Suretyship is a form of credit wrapped in a financial guarantee. It is not insurance in the traditional sense, hence the name Surety Bond. The purpose of the Surety Bond is to ensure that the Principal will perform its obligations to theObligee, and in the event the Principal fails to perform its obligations the Surety steps into the shoes of the Principal and provides the financial indemnification to allow the performance of the obligation to be completed.

There are three parties to a Surety Bond,

Principal - The party that undertakes the obligation under the bond (Eg. General Contractor)

Obligee - The party receiving the benefit of the Surety Bond (Eg. The Project Owner)

Surety - The party that issues the Surety Bond guaranteeing the obligation covered under the bond will be performed. (Eg. The underwriting insurance company)

How Do Surety Bonds Differ from Insurance?

Perhaps the most distinguishing characteristic between traditional insurance and suretyship is the Principal's guarantee to the Surety. Under a traditional insurance policy, the policyholder pays a premium and receives the benefit of indemnification for any claims covered by the insurance policy, subject to its terms and policy limits. Except for circumstances that may involve advancement of policy funds for claims that were later deemed to not be covered, there is no recourse from the insurer to recoup its paid loss from the policyholder. That exemplifies a true risk transfer mechanism.

Loss estimation is another major distinction. Under traditional forms of insurance, complex mathematical calculations are performed by actuaries to determine projected losses on a given type of insurance being underwritten by an insurer. Insurance companies calculate the probability of risk and loss payments across each class of business. They utilize their loss estimates to determine appropriate premium rates to charge for each class of business they underwrite in order to ensure there will be sufficient premium to cover the losses, pay for the insurer's expenses and also yield a reasonable profit.

As strange as this will sound to non-insurance professionals, Surety companies underwrite risk expecting zero losses. The obvious question then is: Why am I paying a premium to the Surety? The answer is: The premiums are in actuality fees charged for the ability to obtain the Surety's financial guarantee, as required by the Obligee, to ensure the project will be completed if the Principal fails to meet its obligations. The Surety assumes the risk of recouping any payments it makes to theObligee from the Principal's obligation to indemnify the Surety.

Under a Surety Bond, the Principal, such as a General Contractor, provides an indemnification agreement to the Surety (insurer) that guarantees repayment to the Surety in the event the Surety must pay under the Surety Bond. Because the Principal is always primarily liable under a Surety Bond, this arrangement does not provide true financial risk transfer protection for the Principal even though they are the party paying the bond premium to the Surety. Because the Principalindemnifies the Surety, the payments made by the Surety are in actually only an extension of credit that is required to be repaid by the Principal. Therefore, the Principal has a vested economic interest in how a claim is resolved.

Another distinction is the actual form of the Surety Bond. Traditional insurance contracts are created by the insurance company, and with some exceptions for modifying policy endorsements, insurance policies are generally non-negotiable. Insurance policies are considered "contracts of adhesion" and because their terms are essentially non-negotiable, any reasonable ambiguity is typically construed against the insurer. Surety Bonds, on the other hand, contain terms required by the Obligee, and can be subject to some negotiation between the three parties.

Personal Indemnification & Collateral

As discussed earlier, a fundamental component of surety is the indemnification running from the Principal for the benefit of the Surety. This requirement is also known as personal guarantee. It is required from privately held company principals and their spouses because of the typical joint ownership of their personal assets. The Principal's personal assets are often required by the Surety to be pledged as collateral in the event a Surety is unable to obtain voluntary repayment of loss caused by the Principal's failure to meet their contractual obligations. This personal guarantee and collateralization, albeit potentially stressful, creates a compelling incentive for the Principal to complete their obligations under the bond.

Types of Surety Bonds

Surety bonds come in several variations. For the purposes of this discussion we will concentrate upon the three types of bonds most commonly associated with the construction industry: Bid Bonds, Performance Bonds and Payment Bonds.

The "penal sum" is the maximum limit of the Surety's economic exposure to the bond, and in the case of a Performance Bond, it typically equals the contract amount. The penal sum may increase as the face amount of the construction contract increases. The penal sum of the Bid Bond is a percentage of the contract bid amount. The penal sum of the Payment Bond is reflective of the costs associated with supplies and amounts expected to be paid to sub-contractors.

Bid Bonds - Provide assurance to the project owner that the contractor has submitted the bid in good faith, with the intent to perform the contract at the bid price bid, and has the ability to obtain required Performance Bonds. It provides economic downside assurance to the project owner (Obligee) in the event a contractor is awarded a project and refuses to proceed, the project owner would be forced to accept the next highest bid. The defaulting contractor would forfeit up to their maximum bid bond amount (a percentage of the bid amount) to cover the cost difference to the project owner.

Performance Bonds - Provide economic protection from the Surety to the Obligee (project owner)in the event the Principal (contractor) is unable or otherwise fails to perform their obligations under the contract.

Payment Bonds - Avoids the potential for project delays and mechanics' liens by providing the Obligee with assurance that material suppliers and sub-contractors will be paid by the Surety in the event the Principal defaults on his payment obligations to those third parties.

How Are Surety Bonds Underwritten?

Surety underwriters have a complex and continuing responsibility of assessing Principals seeking a bond. Companies that rely upon bonding to win projects fully understand the importance of establishing a maintaining a strong relationship with their Surety companies. Surety underwriters are required to place the Principal through a rigorous underwriting process prior to issuing a bond, and will continue to monitor the progress of the Principal's projects in order to identify any warning signs of potential default. The information required from firms seeking a surety bond is perhaps the most detailed of any "insurance" application process. Companies that will require bonds are well advised to maintain a current portfolio of the required documents in order to facilitate and expedite the underwriting process.

The underwriting Questionnaire or application form the Principal completes is supplemented by the following information required by underwriters:

Financial Capacity:

   Most recent annual audited financial statement,
   Year-to date unaudited financial statement, including cash flow,
   Last three years' audited financial statements,
   List of bank credit lines and other forms of credit relationships,
   Bank or lender's letter of reference,
   An inventory of all work-in progress,
   Accounting and cost controls,
   Personal (unaudited) current financial statements of the individual Principals

Performance Capabilities:

   Proposed Project information, plans, etc..
   Summary of all prior experience with similar projects,
   Labor required for the project, quality of sub-contractors,
   Equipment required for the project,
   Project Management Plan,
   Summary of all past and pending bonded and non-bonded projects,
   Summary of potential future projects,
   Continuity Plan,
   Resume of individual Principals

Reputation & Relationships:

   Lending institutions,
   Project Owners,
   Suppliers,
   Sub-contractors

Cost of Surety Bonds

Every Surety company's rates differ, however there are general rules of thumb:

Bid Bonds are typically provided at either a nominal cost or on a complementary basis as the Surety is seeking to underwrite the Performance Bond should the contractor be awarded the project.

Performance Bond premium or fees can range anywhere from 0.5% of the contract's final amount to 2.0% or greater. The two main factors affecting pricing are the amount of the bond as higher amounts usually have lower rates, and the quality of the risk. For example, a performance bond in the amount of $250,000 might carry a 2.5% rate translating to a fee of $ 6,250 versus a $30 million bond at a rate of 0.75% which would cost $225,000.

Even experienced contractors sometimes operate under the misconception that bond costs are fixed at the time of their issuance. In fact, a bond premium or fee will often adjust with the final value of the contract. The final value is typically, but not exclusively, greater than the initial contract amount as a result of work change orders during the construction process. It is important for contractors to realize the potential for a negative surprise represented as an increased cost of their bonds. This realization should initially occur during the bid preparation process, and whenever possible, during the contract negotiation process contractors should explore the feasibility of addressing any incremental increase in bond cost that will result from increased contract values due to change orders effectuated by the project owner.

Warning Signs

A Surety's main purpose is to screen out those contractors that may be well-intentioned, but simply not completely qualified in all aspects of their business to take on certain projects. Surety underwriters are always on the lookout for warning signs both prior to issuing the bond and after its issuance.

Factors That Concern Bond Underwriters include:

   Poor project management and accounting systems
   Excessively rapid expansion
   Key Management changes
   Material change in historical business focus
   Quality issues with sub-contractors
   Shortage of labor and/or supplies
   Cost overruns
   Failure to require sub-contractors to secure their own surety bonds
   Unreasonable project contract terms
   Catastrophic weather related delays
   Adverse macro-economic conditions  

What Happens in the Event of a Contractor's Default?

Upon notification, and if after conducting a thorough investigation, and the Surety determines the Principal has defaulted, it may:

   Provide the defaulting contractor with additional resources or economic assistance to complete the project, or,
   Select a replacement contractor to complete the project, or,
   Arrange for a re-bidding process to complete the project,
   Pay the Obligee (project owner) the "penal sum" of the Performance Bond

The Surety is required by law to conduct a diligent investigation of a potential default so as not to prematurely or improperly declare a contractor in default. Once the Surety has paid a loss under the bond, they will seek reimbursement from the Principal including exercising the Surety's rights over letters of credit, escrows, or personal assets that have collateralized the bond.

Regulations & Statutes

The Miller Act

The Miller Act enacted by Congress in 1935, replaced the Heard Act of 1894, and applies to federal government construction projects with a contract amount in excess of $100,000. This law provides the exclusive remedy for labor and materials providers who have not received payment in full within ninety days from the date of the aggrieved sub-contractor or supplier's last service. The Payment Bond covers first tier sub-contractors and suppliers and second-tier contractors. First tier sub-contractors may bring claims in the form of litigation directly under the Payment Bond, while second tier subcontractors must formally notify the prime contractor of their intent to bring a claim within ninety days of their last unpaid service or supply of materials.

A claim for any unpaid balance is achieved by filing a lawsuit, between ninety days and one year from the date of the last service was provided. The lawsuit must be brought in the name of the United States for the benefit of the party bringing the action. The suit is filed in federal court in the jurisdiction where the contract was performed.

Construction Industry Payment Protection Act of 1999

This federal law became effective August 1999, amending the Miller Act in several ways, including substituting the following provision for the mathematical formula that originally capped the maximum bond amount to $2.5 million notwithstanding the size of the project:

The amount of the payment bond shall be equal to the total amount payable by the terms of the contract unless the contracting officer awarding the contract makes a written determination supported by specific findings that a payment bond in that amount is impractical, in which case the amount of the payment bond shall be set by the contracting officer. In no case shall the amount of the payment bond be less than the amount of the performance bond.

The Federal Acquisition Regulation ("FAR")

Found at Title 48 of the U.S. Code of Federal Regulations, FAR regulates the federal government's processes for procurement of goods and services. Part 28 of the FAR entitled Bonds and Insurance sets forth the related specifications. Below are some relevant excerpts of Section 28 of the FAR that detail the requirements for construction contract payment protections:

Performance and payment bonds and alternative payment protections for construction contracts. 28.102-1 General

(a) The Miller Act requires performance and payment bonds for any construction contract exceeding $100,000, except that this requirement may be waived-

(1) By the contracting officer for as much of the work as is to be performed in a foreign country upon finding that it is impracticable for the contractor to furnish such bond; or

(2) As otherwise authorized by the Miller Act or other law.

(b)(1) Pursuant to U.S.C. 3132, for construction contracts greater than $30,000, but not greater than $100,000, the contracting officer shall select two or more of the following payment protections, giving particular consideration to inclusion of an irrevocable letter of credit as one of the selected alternatives:

(i) A payment bond.

(ii) An irrevocable letter of credit (ILC).

(iii) A tripartite escrow agreement. The prime contractor establishes an escrow account in a federally insured financial institution and enters into a tripartite escrow agreement with the financial institution, as escrow agent, and all of the suppliers of labor and material. The escrow agreement shall establish the terms of payment under the contract and of resolution of disputes among the parties. The Government makes payments to the contractor's escrow account, and the escrow agent distributes the payments in accordance with the agreement, or triggers the disputes resolution procedures if required.

(iv) Certificates of deposit. The contractor deposits certificates of deposit from a federally insured financial institution with the contracting officer, in an acceptable form, executable by the contracting officer.

(v) A deposit of the types of security listed in 28.204-1 and 28.204-2.

(2) The contractor shall submit to the Government one of the payment protections selected by the contracting officer.

(c) The contractor shall furnish all bonds or alternative payment protection, including any necessary reinsurance agreements, before receiving a notice to proceed with the work or being allowed to start work.

28.102-2 Amount required.

(a) Definition. As used in this subsection-

"Original contract price" means the award price of the contract; or, for requirements contracts, the price payable for the estimated total quantity; or, for indefinite-quantity contracts, the price payable for the specified minimum quantity. Original contract price does not include the price of any options, except those options exercised at the time of contract award.

(b) Contracts exceeding $100,000 (Miller Act)-

(1) Performance bonds. Unless the contracting officer determines that a lesser amount is adequate for the protection of the Government, the penal amount of performance bonds must equal-

(i) 100 percent of the original contract price; and

(ii) If the contract price increases, an additional amount equal to 100 percent of the increase.

(2) Payment bonds.

(i) Unless the contracting officer makes a written determination supported by specific findings that a payment bond in this amount is impractical, the amount of the payment bond must equal-

(A) 100 percent of the original contract price; and

(B) If the contract price increases, an additional amount equal to 100 percent of the increase.

(ii) The amount of the payment bond must be no less than the amount of the performance bond.

(c) Contracts exceeding $30,000 but not exceeding $100,000. Unless the contracting officer determines that a lesser amount is adequate for the protection of the Government, the penal amount of the payment bond or the amount of alternative payment protection must equal-

(1) 100 percent of the original contract price; and

(2) If the contract price increases, an additional amount equal to 100 percent of the increase.

(d) Securing additional payment protection. If the contract price increases, the Government must secure any needed additional protection by directing the contractor to-

(1) Increase the penal sum of the existing bond;

(2) Obtain an additional bond; or

(3) Furnish additional alternative payment protection.

(e) Reducing amounts. The contracting officer may reduce the amount of security to support a bond, subject to the conditions of 28.203-5(c) or 28.204(b).

In 2004, Congress enacted a provision requiring inflation-based readjustment of the acquisition related threshold requirements every five years. The last adjustment was in 2007, which increased the minimum bond requirement threshold for federal projects from $25,000 to $30,000.

"Little Miller Acts"

Every state, the District of Columbia and Puerto Rico passed statutes governing surety Performance and Payment Bond requirements for state government construction projects. These statutes contain provisions specifying the threshold contract amount under which Surety Bonds are not required. Below we provide relevant excerpts of the Little Miller Acts enacted in New York, New Jersey and Connecticut.

New York Little Miller Act:

New York Consolidated Laws, State Finance Law, Article 9, Contracts, Section 137 states in part:

Provided, however, that all performance bonds and payment bonds may, at the discretion of the head of the state agency, public benefit corporation or commission, or his or her designee, be dispensed with for the completion of a work specified in a contract for the prosecution of a public improvement for the state of New York for which bids are solicited where the aggregate amount of the contract is under one hundred thousand dollars and provided further, that in a case where the contract is not subject to the multiple contract award requirements of section one hundred thirty-five of this article, such requirements may be dispensed with where the head of the state agency, public benefit corporation or commission finds it to be in the public interest and where the aggregate amount of the contract awarded or to be awarded is less than two hundred thousand dollars.

New Jersey Little Miller Act:

New Jersey Revised Statutes, Title 2A, Administration of Civil and Criminal Justice, Chapter 44, Sections 2A:44-143 through2A:44-148 states in part:

(2) When such contract is to be performed at the expense of the State and is entered into by the Director of the Division of Building and Construction or State departments designated by the Director of the Division of Building and Construction, the director or the State departments may: (a) establish for that contract the amount of the bond at any percentage, not exceeding 100%, of the amount bid, based upon the director's or department's assessment of the risk presented to the State by the type of contract, and other relevant factors, and (b) waive the bond requirement of this section entirely if the contract is for a sum not exceeding $200,000. (3) When such a contract is to be performed at the expense of a contracting unit or school district, the board, officer or agent contracting on behalf of the contracting unit or school district may: (a) establish for that contract the amount of the bond at any percentage, not exceeding 100%, of the amount bid, based upon the board's, officer's or agent's assessment of the risk presented to the contracting unit or school district by the type of contract and other relevant factors, and (b) waive the bond requirement of this section entirely if the contract is for a sum not exceeding $100,000.

Connecticut Little Miller Act:

Connecticut General Statutes, Title 49, Mortgages and Liens, Chapter 847, Liens, Sections 49-41 through 49-43 staes in part:

Sec. 49-41. Public buildings and public works. Bonds for protection of employees and materialmen. Performance bonds. Limits on use of owner-controlled insurance programs. (a) Each contract exceeding one hundred thousand dollars in amount for the construction, alteration or repair of any public building or public work of the state or a municipality shall include a provision that the person to perform the contract shall furnish to the state or municipality on or before the award date, a bond in the amount of the contract which shall be binding upon the award of the contract to that person, with a surety or sureties satisfactory to the officer awarding the contract, for the protection of persons supplying labor or materials in the prosecution of the work provided for in the contract for the use of each such person, provided no such bond shall be required to be furnished (1) in relation to any general bid in which the total estimated cost of labor and materials under the contract with respect to which such general bid is submitted is less than fifty thousand dollars, (2) in relation to any sub-bid in which the total estimated cost of labor and materials under the contract with respect to which such sub-bid is submitted is less than fifty thousand dollars, or (3) in relation to any general bid or sub-bid submitted by a consultant, as defined in section 4b-55. Any such bond furnished shall have as principal the name of the person awarded the contract.

(b) Nothing in this section or sections 49-41a to 49-43, inclusive, shall be construed to limit the authority of any contracting officer to require a performance bond or other security in addition to the bond referred to in subsection (a) of this section, except that no such officer shall require a performance bond in relation to any general bid in which the total estimated cost of labor and materials under the contract with respect to which such general bid is submitted is less than twenty-five thousand dollars or in relation to any sub-bid in which the total estimated cost of labor and materials under the contract with respect to which such sub-bid is submitted is less than fifty thousand dollars.

The Critical Importance of a Strong Principal - Surety Relationship

A surety underwriter is responsible for evaluating the Principal's overall capability to profitably complete a project based upon: their financial condition, their historical performance, their current workload-in progress, their ability to manage, and their reputation with other stakeholders.

Differences of opinion arise periodically between the Principal and the Surety over its willingness to provide bonding capacity. Principals view this as an indirect undermining of their ability to conduct business. Underwriters view their decision as being in the interest of the Principal because by withholding the bonding capacity, an underwriter may be preventing a Principal from jeopardizing their personal assets. When these situations arise, the insurance broker should be particularly attentive to the underwriter's concerns, and work with the Principal to provide any additional information that may alleviate or ameliorate the underwriter's concerns.

Building a sound surety relationship requires continuing diligence, candor, and active dialogue between the Principal and Surety. Perhaps the best way to build the trust that is so important to the relationship is through providing agreed upon scheduled job status reports of work-in-progress, including the profit and loss statements of each bonded (and non-bonded) project, the owner's payment activity, unapproved change orders, and the firm's periodic financial statements. A proactive insurance broker will arrange an annual in-person meeting upon completion of the audited financials. The participants would includes the Principal, Surety, the Principal's CFO and possibly the external auditor. This meeting affords an opportunity to further build upon the "paper relationship" and is a venue for candidly discussing potential issues and future prospects.

Although it may seem counterintuitive, Principals that apprise a Surety of potential issues also create a high level of trust. Proactively providing required information sends a strong signal to the Surety about the Principal's business character and management, also providing the Surety with the firm's business plans for the upcoming twelve to twenty-four month period will serve to gain the underwriter's trust and flexibility when those situations arise that may require the underwriter to demonstrate some additional flexibility in order for the Principal to realize their business objectives. Surety companies can provide valuable resources to Principals to assist them in overcoming temporary business challenges before a default occurs. These resources include: construction attorneys, engineers and accountants.