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Private Construction Projects are Starting to Require Surety Bonds – Learn Why

For public building projects, having a surety bond is a requirement. Bonds operate as a sort of insurance for the government, shielding it from project failure or contractor embezzlement. In fact, since the late 1890s, surety bonds have been required for all federal public works projects. 

But these days, bonds are becoming more and more necessary for private development initiatives. The disruption brought on by the pandemic is the main factor why. 

A few factors are supply chain problems, material shortages, and rising construction material costs brought on by the COVID-19 crisis. Another is the competitive labor market, where subcontractors occasionally fail to show up for work. When these elements are considered collectively, private owners and their investors seek protection. 

They receive that from surety bonds. Private owners are reducing their exposure to risk as public owners did in the past: by issuing bonds in an environment where they may experience constrained cash flow and have difficulty securing financing. 

A Construction Bond: What Is It? 

Investors in building projects often utilize a specific kind of surety bond called a construction bond. A particular type of surety bond called a “construction bond” guards against delays or financial loss brought on by a contractor’s inability to finish a job or adhere to the terms of the contract. These bonds guarantee that the costs of a construction project will be covered. 

KEY LESSONS 

What distinguishes a surety bond from insurance? 

Insurance is necessary whether you establish a business or expand an existing one for liability concerns. While sureties typically work directly with insurance companies or are a part of them, the two are different. A surety bond shields the investor in the construction project from any errors, omissions, or subpar work that you and your team perform, whereas insurance covers you, the business owner. The surety bond is more of a contract or agreement that assures both parties are pleased with the project’s scope and results. 

An insurance claim is made if something unfortunate happens to you or another team member while working on a construction project. The project’s owner may file a claim against your bond to recover costs for the project and assure no financial loss if you don’t finish it up to the standards specified in the contract.

The Function of a Construction Bond 

A construction project must have a bond, sometimes called a contractor license bond. A contractor must possess construction bonds for almost all government and public works projects. A contract or construction bond is typically needed for a contractor applying for a construction assignment. 

The construction bond gives the project owner peace of mind that the contractor will carry out the conditions of the contract. On larger projects, construction bonds may come in two parts: one to guard against overall job failure and the other to protect against nonpayment of labor and materials from subcontractors. 

A building bond typically involves three parties: 

A government agency that identifies a contractual job it needs to be done is often the project owner or investor. All contractors must post bonds by the obligee to lessen the possibility of financial loss. Since investors want to spend as little money as possible on any contract, the contractor chosen for the job is typically the one with the lowest bid price. 

A principal, or the party supervising the construction work, certifies their ability to complete the job in accordance with the contractual policy by filing a construction bond. In addition to assuring the obligee that he has the financial resources to oversee the project, the principle guarantees that the construction will be completed to the highest required standard. The contractor buys a construction bond from a surety who, before approving a bond, thoroughly investigates the contractor’s background and financial situation.

How Private Project Owners Are Reducing Risk 

The following recent instances show how and why surety bonds are still utilized today on private projects: 

Impact of COVID-19: The owner of the $50 million privately owned recreational complex initially dismissed the idea of issuing bonds because it thought they were intended for public projects. However, to safeguard the project against the danger of supply chain delays, the owner chose to seek payment and performance surety from its contractors due to COVID-19.

A mixed-use project’s developer once made the mistake of aggressively requiring the builder to post a bond. This resulted from a negative experience the developer had on a previous project, where a poorly performing unbonded contractor left several liens. 

Why Surety Bonds are Used 

A surety bond is a formal contract that ensures performance, compliance, or payment. All surety bonds for construction involve three parties: the surety, the contractor, and the project owner. 

The performance and payment bonds are two of the most crucial for building projects. 

Performance Guarantee 

The performance bond guarantees the project’s completion. 

The owner calls on the contractor’s surety to finish the job under the performance bond if the contractor is rendered unable to perform or is properly terminated by the owner.

The performance bond can also aid in keeping a project moving forward by giving the contractor the necessary cash flow. In other circumstances, the surety may employ a different contractor to finish the job or offer construction management assistance to keep the contractor on schedule. 

Even if the contractor stops working, the surety will still pay the project owner the bond’s penal sum, which equals the contract’s total plus any applicable change orders. 

Payment Guarantee 

The payment bond ensures that the project’s suppliers, subcontractors, and vendors will be paid. 

This bond shields the contractor from liens, material delivery delays or refusals, and walk-off subcontractors by guaranteeing payment. 

If the contractor fails to pay subcontractors on the job, it safeguards the project owner. Subcontractors, vendors, and suppliers may then submit a claim against the payment bond. The surety pays those claims after investigating to confirm that the labor or supplies were used for the bonded project and not purchased by the contractor. 

A mechanic’s lien may also be the cause of a payment bond. The surety then covers the expense of releasing the lien. Then, suppliers, vendors, and subcontractors ask the surety for payment directly. 

Pros and Drawbacks of Bonding 

Bonding has advantages for contractors in addition to owners. For instance, a mid-sized contractor looking for contracts with higher price values can offer.

After that, they can use the success of each project to leverage greater premium rates and increased bonding capacity to expand. The surety aids the contractor in avoiding defaults and claims if a project encounters difficulties. 

However, the expense of having surety bonds is a drawback. The bond premium is typically 1 percent to 3 percent of the bond amount, making the bond amount equal to the contract value.

However, the owner, who is the ultimate benefactor, typically bears this cost. Although the bond is an added cost, having it can ultimately save a lot of money, particularly if a project starts to fall apart. 

Takeaways 

Contractors would be wise to grasp the benefits and drawbacks of surety bonds as they are used more frequently on private projects. 

Surety bonds can be expensive, especially in the current environment of escalating costs, but when contrasted with projecting failure, they’re a steal.

Why the Construction Industry Needs Bonds 

It should be obvious why bonds are essential for the construction business now that we know all the various contract bonds available. They are intended to support a contractor’s quality of work further and protect project owners. For business owners, bonds may make or break their success. There is a good chance that you will require some form of a bond if you own a business, whether you work in the construction industry or something completely different. Contact our office right away with any questions or needs you may have regarding bonds! 

We can write any bond, in any state, for almost anyone because we are a national surety. We can write bonds when other sureties can’t since we have specialty programs and connections with some of the top businesses. Let us be the guarantee that we can advance your company.

 

August 22nd, 2022
Surety Place