THETHE IMPORTANCE IMPORTANCE OFOF BONDS SURETYIN BONDS IN CONSTRUCTION

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Historical Perspective Types of Bonds Surety bonds have been a valuable tool for centuries. The There are three basic types of surety bonds: first known record of contract suretyship was an etched clay tablet from the Mesopotamian region around 2750 • The bid bond assures that the bid has been submitted BC. According to the contract, a farmer drafted into the in good faith and that the contractor will enter into service of the king was unable to tend his fields. The the contract at the price bid and provide the required farmer contracted with another farmer to tend them un- performance and payment bonds. der the condition they split the proceeds equally. A local • The performance bond protects the owner from finan- merchant served as the surety and guaranteed the sec- cial loss should the contractor fail to perform the con- ond farmer’s compliance. tract in accordance with its terms and conditions. • The payment bond assures that the contractor will Suretyship was addressed in the first known written legal pay specified subcontractors, laborers, and material code, the , around 1792-1750 BC. A suppliers on the project. Babylonian contract of financial from 670 BC is the oldest surviving written surety contract. The Roman Financial & Construction Empire developed of surety around 150 AD that ex- Assurance ist in the principles of suretyship today. Although surety bonds are mandated by on pub- lic works projects, the use of surety bonds on privately While suretyship has a long history, it wasn’t until the owned construction projects is at the owner’s discretion. 19th century that corporate surety bonds were used. Alternative forms of financial security, such as letters of Recognizing the need to protect taxpayers from contrac- credit and self-, do not provide the 100% per- tor failure, Congress passed the Heard Act in 1894, which formance protection and 100% payment protection of required surety bonds on all federally funded projects. surety bonds nor do they assure a competent contractor. The Miller Act of 1935 (40 U.S.C. Section 270a et. seq.) With surety bonds, the risks of project completion are was the last major change in public sector surety, and shifted from the owner to the surety company. For that is the current federal law mandating surety bonds on reason, many private owners require surety bonds from federal public works. It requires performance bonds for their contractors to protect their company and share- public work in excess of $100,000 and payment holders from the enormous cost of contractor failure. To protection, with payment bonds the preferred method, bond a project, the owner specifies the bonding require- for contracts in excess of $25,000. Almost all 50 states, ments in the contract documents. Obtaining bonds and the District of Columbia, Puerto Rico, and most local juris- delivering them to the owner is the responsibility of the dictions have enacted similar requiring surety contractor, who will consult with a surety bond produc- bonds on public works. These generally are referred to as er. Subcontractors may also be required to obtain surety “Little Miller Acts.” bonds to help the prime contractor manage risk, partic- Risky Business ularly when the subcontractor is a significant part of the job or a specialized contractor that is difficult to replace. How one evaluates and manages risk on construction projects and makes fiscally responsible decisions to Most surety companies are subsidiaries or divisions of ensure timely project completion is key to success. To insurance companies, and both surety bonds and tra- gamble on a contractor whose level of commitment or ditional insurance policies are risk transfer mechanisms qualification is uncertain or who could become bankrupt regulated by state insurance departments. However, tra- halfway through the job can be a costly decision. How ditional insurance is designed to compensate the insured can a public agency using the low-bid system in award- against unforeseen adverse events. The policy premium ing public works contracts be sure the lowest bidder is is actuarially determined based on aggregate premiums dependable? How can private sector construction project earned versus expected losses. Surety companies oper- owners manage the risk of contractor failure? ate on a different business model. Surety is designed to prevent loss.The surety prequalifies the contractor based Surety bonds provide financial security and construction on financial strength and construction expertise. The assurance by assuring project owners that contractors bond is underwritten with little expectation of loss. will perform the work and pay specified subcontractors, laborers, and material suppliers. A surety bond is a risk Prequalification of the Contractor transfer mechanism where the surety company assures are able to accept the risk of contractor failure the project owner (obligee) that the contractor (principal) based on the results of a thorough, rigorous, and profes- will perform a contract in accordance with the contract sional process in which sureties prequalify the contrac- documents. tor. This prequalification process is an indepth look at the contractor’s business operations.

Before issuing a bond the surety company must be fully satisfied that the contractor has, among other criteria: Building, Heavy/Highway, and • Good references and reputation; Specialty Trade Contractors • The ability to meet current and future obligations; • The experience matching the contract requirements; In Business Survivors Failure Rate • The necessary equipment to do the work or the abili- 2002 2004 ty to obtain it; • The financial strength to support the desired work 853,372 610,357 28.5% program; 2004 2006 • An excellent credit history; and • An established bank relationship and line of credit. 850,029 649,602 23.6% 2006 2008 The surety company must be satisfied that the contractor runs a well-managed, profitable enterprise, keeps prom- 1,155,245 919,848 20.4% ises, deals fairly, and performs obligations in a timely 2009 2011 manner. Surety bonds have played an important role in the construction industry’s success, allowing the industry 897,602 702,618 21.7% to sustain its position as one of the largest contributors 2011 2013 to the nation’s economic stability and growth. 986,057 735,159 25.4% Contractor Failure 2014 2016 Construction is a risk-filled enterprise, and even capa- 1,021,350 722,281 29.3% ble and well-established contractors can ultimately fail. Source: BizMiner According to BizMiner, of the 1,021,350 general contrac- protecting public owners, private owners, lenders, and tors and operative builders, heavy construction contrac- prime contractors from the potentially devastating tors, and special trade contractors operating in 2014, only expense of contractor and subcontractor failure. 722,281 were still in business in 2016—a 29.3% failure rate. Despite the surety’s rigorous prequalification pro- Benefits of Bonds cess and best about the qualifications of the After analyzing the risks involved with a construction contractor, sometimes contractor default is unavoidable. project, consider how surety bonds protect against However, when a contractor fails on a bonded project, it those risks. Owners, lenders, taxpayers, contractors, and is the surety company that remedies the default—not the subcontractors are protected because: project owner and not at taxpayers’ expense. • The contractor has undergone a rigorous prequali- In the unfortunate event that a bonded contractor does fication process and is judged capable of fulfilling the default, the surety has legal obligations to the project obligations of the contract; owner and the contractor. First, the owner must formally • Contractors are more likely to complete bonded proj- declare the contractor in default. Then the surety com- ects than non-bonded projects since the surety com- pany conducts an impartial investigation before settling pany may require personal or corporate any claim. This protects the contractor’s ability to pursue from the contractor; legal recourse in the event that the owner improperly • Subcontractors have no need to file mechanic’s liens declares the contractor in default. When there is a proper on a private project when a payment bond is in place, default, the surety’s options often are spelled out in the and because mechanics’ liens cannot be placed against bond. These options may include the right to re-bid the public property, the payment bond may be the only job for completion, bring in a replacement contractor, protection these claimants have if they are not paid for provide financial and/or technical assistance to the exist- the goods and services they provide; ing contractor, or pay the penal sum of the bond. • Bonding capacity can increase a contractor’s or sub contractor’s project opportunities; Bond Rates • The surety bond producer and underwriter may be Surety bond premiums vary from one surety to another, able to offer technical, financial, or management but can range from 0.5% to 3% of the contract amount, assistance to a contractor; depending on the size, type, and duration of the project • The surety company fulfills the contract in the event of and the contractor. Typically, there is no direct charge for contractor default. a bid bond. In many cases, a performance bond incorpo- rates the payment bond and a maintenance period. Any contractor—whether in business for one year or 100, large or small, experienced or novice—can experi- The contractor includes the bond premium amount in ence serious problems. Through the years surety bonds the bid and the premium generally is payable upon exe- have held fast as a comprehensive and reliable instru- cution of the bond. If the contract amount changes, the ment for minimizing the risks in construction. premium may be adjusted for the change in contract price. Contract surety bonds are a wise investment— SURETY AND FIDELITY BONDS: PROTECTING CONSUMERS, TAXPAYERS AND BUSINESSES

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The Surety & Fidelity Association of America (SFAA) is licensed as a rating or advisory organization in all states and it has been designated by state insurance departments as a statistical agent for the reporting of fidelity and surety experience. SFAA serves as a trade association of more than 420 insurance companies that write the vast majority of surety and fidelity bonds in the U.S.