How Do Surety Bonds Work?

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A surety bond is a contractual agreement between a project owner, contractor and a surety company to ensure the project will be completed as per contract terms. Be it federal construction project or a service contract, contractors are required to obtain surety bonds from surety bonding companies. After performing a rigorous pre-qualification process and analyzing the contractor’s financial position, a surety issues the bond to the project owner. Here are various types of surety bonds which may be issued.

  • A Bid Bond assures the contractor will enter into a contract for the price quoted in his bid. This bond prevents the contractor from increasing the bid price on the project after entering into a contract with a project owner or not entering into the project if low.
  • A Performance Bond guarantees the contractor will perform the work as per the terms of the contract.
  • A Payment Bond guarantees the contractor will pay all suppliers and subcontractors as per the terms of the contract.
  • A Maintenance Bond guarantees the contractor will solve all maintenance issues during a specified maintenance period after the completion of the project.
  • A Warranty Bond assures the contractor will repair any defects in the project during the warranty period.

The surety company calculates the surety bond cost based on the contract amount based on the contractor’s financial credentials. Most surety bonds don’t require collateral or security but a contractor must pay bond premiums. Once a contractor obtains a surety bond, the surety company assures the contractor will perform the contract, and this increases the contractor’s ability to obtain work.

The Three “C’s” of Surety Underwriting

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How are surety bonds underwritten by a surety? Contractors understand the importance of obtaining surety bonds before and after winning a bid for a particular construction project. But do they know the three C’s of surety underwriting criteria to increase their ability to get bonded?

Surety companies perform a rigorous pre-qualification process before issuing a surety bond. Generally, surety companies follow three “C’s” when determining whether or not a contractor qualifies for a surety bond.

  • Capacity: Does the contractor (principal) have the necessary skills, knowledge, manpower, and ability to complete the project? For this, the surety analyzes the previously completed projects of the contractor.
  • Capital: Does the principal have financial stability? A surety company carefully scrutinizes the financial strength of the principal by looking at their tangible net worth, working capital, debt load, credit score, non-construction investments, and contingent liabilities.
  • Character: What is the contractor’s standing and reputation in the market? This includes the contractor’s personal history, the firm’s professional history, any previous legal disputes, and banking relationships.

Surety bonds are required for contractors working on public works projects and private contracts. If the contractor is lacking any of these qualities, the surety company may not issue a surety bond.

Maximizing Bonding Capacity: A Guide for Contractors

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Where does your construction contracting firm stand? Have you assessed your bonding capacity? Bonding capacity is an important issue for contractors because it determines which construction projects they can pursue or bid for. Discover new ways to increase your firm’s bonding capacity to bid for the projects you want.

  • Understand your financial position: As a contractor, understand your true financial position as the surety sees you. Working capital, total net worth, balance sheet, and fiscal year- end financial statements will provide you more information about your firm’s financial strength.
  • Work with your CPA: To increase your surety limits, work closely with your certified public accountant (CPA) or financial advisor, who’s focus is construction, on preparing financial statements and tax planning.
  • Improve your credit score: If you don’t know your credit score, it’s time to find out. A good CPA or financial advisor will help you improve your personal and firm’s credit score.

A surety company always analyzes the financial stability of a contractor, such as cash flow, capital, and bank relationship, before issuing a surety bond. Since surety bonds secure contractors on construction contracts, surety bonding companies thoroughly review their financial statements and bonding capacity. Maximize your bond limits to increase opportunities for getting surety bonds.

Differences between Contract Bonds and Commercial Bonds

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Contract and Commercial Bonds are the two main categories of surety bonds. Although both bond types are issued by a surety company, they are distinct in their usage and application.

  • Contract Surety Bonds
    Contract bonds are exclusively secured by firms guaranteeing a contract. It is a contractual agreement between three parties: project owner, contractor, and a surety. The surety company guarantees the contractor will complete the project as per the specifications of the contract. There are several types of contract bonds including Bid Bond, Performance Bond, Payment Bond, Maintenance Bond, Warranty Bond, and Advance Payment Bond.
  • Commercial Surety Bonds
    Commercial bonds are required on the basis of a legal statute. A commercial bond is a guarantee of financial performance. These bonds are required by municipalities or public authorities to protect the general public against loss in the event of violation of regulations. Commercial bonds are comprised of several types of bonds including a license and permit bond, court/judicial bond, tax preparer bond, notary bond, process server bond, and other miscellaneous types of bonds.

Both contract and commercial surety bonds are underwritten by a surety company. It is important for you to work closely with a surety bonding company to make sure you receive the right surety bond at the best terms.