Bonding 101

Surety bonding is primarily needed in the construction industry on publicly funded projects. 

How can a public agency using the low-bid system in awarding public works contracts be sure the lowest bidder is dependable?

How can private sector construction project owners manage the risk of contractor failure?

A surety bond is considered a part of the insurance industry, but it shares some characteristics with the credit industry. The surety company's primary duty is not to lend the contractor money. Instead, the surety company uses its financial resources to stand behind, or back, the contractor's commitment and ability to complete a contract.

How risk on construction projects is evaluated, managed and how fiscally responsible decisions are made to ensure timely project completion are keys to success. Most developers and project owners will not gamble on a contractor whose level of commitment or qualification is uncertain or who could become bankrupt halfway through the job. These can be costly decisions.

Surety bond companies charge a premium for pre-qualifying or underwriting the contractor. Unlike insurance companies, surety companies do not charge deductibles based on the probability of loss, because surety companies do not expect a loss to occur. 

Surety bonds provide financial security and construction assurance by assuring project owners that contractors will perform the work and pay specified subcontractors, laborers and other suppliers. A surety bond is a risk transfer mechanism where the surety company assures the project owner (obligee) that the contractor (principal) will perform a contract in accordance with the contract documents.

Types of Bonds

There are three basic types of contract surety bonds:

• The bid bond assures that the bid has been submitted in good faith and that the contractor will enter into the contract at the price bid and provide the required performance and payment bonds.
• The performance bond protects the owner from financial loss should the contractor fail to perform the contract in accordance with its terms and conditions.
• The payment bond assures that the contractor will pay specified subcontractors, laborers, and material suppliers on the project.

The Miller Act

Recognizing the need to protect taxpayers from contractor failure, Congress passed the Heard Act in 1894, which required surety bonds on all federally funded projects. The Miller Act of 1935 (40 U.S.C. Section 270a et. seq.) was the last major change in public sector surety, and is the current federal law mandating surety bonds on federal public works.

It requires performance bonds for public work contracts in excess of $100,000 and payment protection, with payment bonds the preferred method, for contracts in excess of $25,000. Almost all 50 states, the District of Columbia, Puerto Rico, and most local jurisdictions have enacted similar legislation requiring surety bonds on public works. These generally are referred to as “Little Miller Acts.”