What Are Surety Bonds?
Contract surety bonds provide assurance to the project owner that a contractor is capable of completing a project according to contract specifications.

Suretyship is a loss-avoidance mechanism to prequalify contracting firms based on their credit strength, experience, and capability to successfully complete contracts. The economic risk of contractor default stays with the bonded contractor, who must sign an indemnity agreement holding the surety harmless. When it issues a surety bond, the surety company has prequalified the contractor and offers assurance to a project owner that the contractor is capable of performing the contract according to its terms and conditions. Furthermore, the surety company guarantees that the contractor will pay certain laborers, subcontractors, and suppliers associated with the project.

How Does a Surety Bond Work?
Contract surety bonds are three-party agreements whereby one party (the surety company) guarantees another party (the owner) that a third party (the contractor) will perform the contract. The owner specifies the bond requirement in the contract documents. It is the contractor’s responsibility to secure the bonds.

Because of the intricacy of the bonding process, and the fact that each surety company has its own unique underwriting standards and practices, contractors turn to surety bond producers to secure the surety bond on their behalf. The contractor includes the cost of the bond premium in his/her bid price. The surety company typically charges only for the final bond(s) when the contractor is awarded the contract.

Bonds are required on most public work projects. Most public works contracts are awarded under a competitive, sealed, open competition bidding system where the work is awarded to the lowest responsive bidder.

To protect tax-payer dollars from irresponsible bidders and incapable contractors, Congress passed the Heard Act in 1894, which required contractors to obtain surety bonds on public work. The Heard Act was later replaced by the Miller Act of 1935, which mandates performance and payment bonds on all federal public work contracts in excess of $100,000. Most state and local governments have adopted similar legislation (often referred to as "Little Miller Acts"). The requirements stipulated by "Little Miller Acts" vary by state.

Types of Contract Surety Bonds
The bid bond provides financial assurance that the contractor is capable of performing the contract at the price bid, and will comply with the conditions of the bid, including entering into a final contract if the successful bidder. It also assures the owner that the surety company will issue the requisite payment and performance bonds. If the contractor is awarded the contract but fails to enter into the agreement, the surety may be required to pay the difference between the awarded bid and the next lowest bid or pay the bond penalty.

The performance bond protects the owner from financial loss should the contractor fail to meet the terms and conditions of the contract. If the contractor defaults, the surety will respond in accordance with the terms of the bond.

A payment bond guarantees that the contractor will pay certain laborers, materials suppliers, and subcontractors. Payment bonds issued by themselves only guarantee that the project will remain lien free for the obligations assumed by the principal. If the contractor fails to pay amounts properly due, the surety will make the payments up to the penal amount of the bond (stipulated in the contract). Generally, payment bonds are supplied at no additional cost when purchased in conjunction with a performance bond.

Benefits of a Bond

• Greater pool of qualified contractors bidding for jobs, resulting in greater likelihood of timely project completion and less likelihood of contractor failure
• Payment protection for subcontractors, suppliers, and laborers (Subcontractors and suppliers may submit more competitive prices if they know they’re protected by a payment bond)
• Technical, management, and/or financial assistance for the contractor to keep project on schedule;
  No liens from unpaid subs and suppliers covered by the payment bond, which will smooth transition from construction to permanent financing
• Guarantees correction of defects as a result of faulty material or workmanship for at least one year.

Contractors Must Qualify for Surety Bonds
The process of obtaining bonds is more like obtaining bank credit than purchasing other types of insurance. When obtaining bank credit, the financial institution will provide the loan only if it determines the party is capable of repaying it in full with interest. With traditional insurance, premiums are paid based upon deductibles and expected losses. Surety companies, however, do not expect a loss. Sureties should not bond a contractor that does not meet their prequalification standards. The primary service of the surety is prequalification. Therefore, the surety bond premium is primarily a fee for service and granting of surety credit, although sureties may employ loss cost and severity studies.

The Prequalification Process
The surety company’s prequalification process (also referred to as underwriting) carefully analyzes the contractor’s entire business operation, because the surety is backing the promise of that contractor to perform the contract. The surety company evaluates the contractor’s capacity to perform this particular contract as well as other contracts already written, determines his/her financial strength, reviews his/her character, and may ask for personal or corporate indemnity. The surety bond producer’s role is to assist the contractor with the prequalification, as described in “Surety Bond Producer” later in this guide.

Capacity to Perform - typically includes analysis of:

• Resumes of the contractor and key personnel
• Contractor’s track record of successfully completed work
• Adequacy of the contractor’s equipment and tools required to perform the contract
• Rationale for why the contractor is undertaking the project
• Continuity plan that illustrates how the company will continue performing its obligations in the event of the demise or departure of key personnel
• Contractor’s future plans, short and long-term goals, objectives, and growth strategies

Financial Strength - typically includes analysis of:

• Detailed financial statements for the past 3-5 years. Accounting methods should comply with Generally Accepted Accounting Principles (GAAP). Financial statements should include: Balance Sheet, Statement of Earnings, Statement of Changes in Owner’s Equity, Statement of Cash Flow, Notes to Financial Statements, and Contract Schedules. The surety may ask for interim financial statements. Requirements for interim statements vary, but a six-month statement usually is the minimum
• Contract schedules that typically include a summary of completed contracts and contracts in progress. Sureties also will require a schedule of work in progress (usually quarterly). This schedule should list each job by name and indicate the total contract price including: change orders, amount billed to date, cost incurred to date, revised estimate of the cost to complete, estimated gross profit, and the anticipated completion date
• Cost records that account for the financial status of the contractor’s jobs
• Credit reports demonstrating how the contractor handles payment of debts
• A bank line of credit showing unsecured credit that can be used as short-term working capital

Character - Surety companies may review trade references from owners, architects, subcontractors, general contractors, material suppliers, etc., with whom the firm has worked to get a sense of the contractor’s reputation for fair, businesslike dealings.