The quick answer is government contracts require surety bonds to ensure the contractor businesses and/or people contracted with any given government buyer either perform and complete the job as expected, or there’s a third-party (the surety/bond company) on the hook to pay for another contractor to step in and finish the job (or make it right).
As a fast overview, let’s first describe and define exactly what we’re talking about with contractor bonds.
Generally speaking, at least within this context, there are two types of bonds, SURETY BONDS and FIDELITY BONDS. Surety bonds typically have three key parties to the transaction. (in overly simply terms) The Principal, the obligee (ex the State, City, or other party paying for the contractor’s services), and the insurer (aka surety company). The surety company guarantees the performance of the contract with the obligee. If the Principal fails, the surety company may have to write a check to make up the differences.
*I could go down the rabbit hole of describing the parties with attorney old school legal terms, such as obligor, obligee, beneficiary, albeit much better to keep this simple while also retaining the essence of the discussion. I bring this up so you are able to connect the dots if you’re trying to understand a given bond’s language.
I find the most common bonds I write are required by a City, State, and the Federal Government (or a sub-division of one of them), however, companies often require them for larger projects too. I find it interesting that many companies would likely benefit from requiring a performance bond and simply choose to not make it mandatory, maybe because they don’t want to raise the price, they trust who they’re working with, or simply don’t know.
Fidelity Bonds (added for the sake of distinction)
Fidelity bonds, on the other hand, protect businesses from financial losses caused by the dishonest or fraudulent acts of their employees. These bonds are a form of insurance coverage that compensates the business (the insured) in the event of employee theft, embezzlement, or other forms of dishonesty.
The legal distinction between surety bonds and fidelity bonds lies in their purpose, coverage, and the parties they protect.
- Purpose: Surety bonds guarantee the performance of a principal’s contractual obligations to an obligee, while fidelity bonds protect businesses from financial losses resulting from employee dishonesty.
- Coverage: Surety bonds cover the financial losses incurred by an obligee if the principal fails to meet their contractual obligations, whereas fidelity bonds cover the financial losses incurred by a business due to the dishonest acts of its employees or contractors.
- Parties protected: Surety bonds primarily protect the obligee (project owner or government entity), while fidelity bonds protect the insured business from financial losses.
Bid and Performance Bonds: Definitions and The Roll Each Has
A. Bid Bonds
A bid bond is a type of surety bond that guarantees the project owner (obligee) that the contractor (Principal) will honor their bid if awarded the contract. It serves as a financial guarantee, ensuring that the contractor will enter into a contract with the project owner and provide the required performance and payment bonds. These bonds typically are provided to the contractor at no cost, and allow the contractor to bid on various projects without the expense of paying for each bid bond. It’s important for new contractors to know that while they may not have a cost, the contractor generally must be pre-approved for the performance bond if awarded the contract. AND if the contractor is bidding on more than one contract at a time, which may cause the contractor to be awarded more than one contract, the total aggregate of the contracts bided on generally must be within the pre-approved limits allowed by the bond provider (surety).
B. Performance Bonds
A performance bond is the meat of the matter here. It is a type of surety bond that guarantees the contractor (Principal) will complete the project according to the contract’s terms and conditions. In the event of a contractor’s default, also known as breach of contract, the performance bond compensates the project owner for the cost of completing the project using another contractor and/or often other financial losses incurred due to the default.
While a bid bond is often provided at no cost based on the contractor buying the performance bond, performance bonds do have a cost. For general government bonds, if the contractor has good credit, I typically see a premium equal to about 3% of the contract award. If the contractor’s credit isn’t as solid, the contract includes language making the risk higher, or some other factor makes it unusual, 4% or 5% (or higher) of the contract final award size isn’t uncommon.
III. The Difference Between Contractor Bonds and General Liability Insurance
A. Contractor Bonds
Contractor bonds, specifically bid and performance bonds, provide a financial guarantee to the project owner that the contractor will fulfill their contractual obligations. These bonds are usually required for public construction projects and sometimes for private projects as well. The bond is backed by a surety company, and may or may not be the same insurance company that also writes other types of insurance, which acts as a third-party guarantor to ensure that the contractor will complete the project or pay the project owner if they fail to do so. I often get questions from relatively new contractors and/or contractors working with government contracts for the first time if they need to have a bond since they already have general liability. As a result, I am including a basic over-simplification of commercial business general liability insurance as well.
B. General Liability Insurance
General liability insurance, on the other hand, protects contractors from claims resulting from property damage, bodily injury, or personal injury caused by their and their employee’s work. Not to be confused with professional liability (aka E&O – Errors and omissions liability), which protects against financial harm caused by a client harmed from advice or professional opinion. It is essential for contractors to have general liability insurance to cover potential legal fees, settlements, or judgments resulting from these claims.
In a simple summary, contractor bonds protect the project owner by guaranteeing the contractor’s performance, while general liability insurance protects the contractor from claims arising from their work.
IV. The Cost of Contractor Bid and Performance Bonds
I touched on the cost of contractor bonds above, and to dive a little deeper, the cost of contractor bid and performance bonds varies based on several factors, including the project’s size, the contractor’s financial strength, and the surety company’s underwriting guidelines. Contractors should understand that from the surety company’s point of view, it’s very similar to giving a loan to the contractor, because the performance bond is essentially guarantying the financial ability of the contractor to perform its obligations. A contractor can expect to provide company (and sometimes personal) financial information, a history of the work performed, resumes of the officers, and how many insurance claims/lawsuits the contractor has been involved in. As you can imagine, the amount of information is often way more than initially anticipated by my contractor clients.
All of that can take a considerable amount of time to put together, to process by my insurance agency staff to present to the insurance surety company(s), and finally for the surety underwriters to respond to. There are a lot of moving parts, and depending on what information the contractor has available, the size and scope of the project/contract, and timing, it can take two to three weeks to have everything ready to go for a contractor to have a bid and bid bond to be submitted in hopes of obtaining a government contract for the first time. The good news is that once a contractor has one or two successful bids and completions performed, the process may only take a day to turnaround future bid bond requests. For this reason, it’s often advisable to jump through the ho0ps early so you know how much you can bid on and not be in a rush to do so.
V. How to Obtain Contractor Bid and Performance Bonds
Before obtaining a bid or performance bond, contractors must first go through a prequalification process with a surety company. As stated above, this process involves a thorough review of the contractor’s financial stability, credit history, work experience, and management capabilities. Really not much different than if you went to the bank ans asked for a loan. Prequalification serves to assess the contractor’s ability to complete the project successfully and on time, which is crucial for the surety company to minimize risk when issuing a bond.
B. Choose a Reputable Surety Company
Selecting a reputable surety company is vital for obtaining bid and performance bonds. This is where I step in with 1 Reason Insurance. We look for and work with surety companies that have a strong financial rating and a track record of successful bonding projects. Working with an experienced surety agent or broker can also help navigate the bonding process and ensure a smooth experience.
If you have your other business insurance with 1 Reason, this will make the bonding process move along with less effort because we already have a relationship and know your business. If you don’t already work with 1 Reason Insurance, this is a great time to try us out and see what the level of service and business knowledge we have to offer you.
Quick pro-tip, if you’re using a primarily home and auto agent for your business insurance, there’s a really good chance you’re either having to teach the agent about your business and its insurance needs (never ever a good thing/idea), and a higher probability if you have a claim/loss, things are going to go sideways for you. Regardless, if you get insurance from me or not, make sure your agent is able to teach you, and not the other way around if you want to avoid future problems.
C. Gather Necessary Documentation
To obtain a bid or performance bond, contractors must provide various documentation to the surety company, including:
- Financial statements: Surety companies will review the contractor’s financial statements to assess their financial health, which is a critical factor in determining bonding capacity.
- Work history: A contractor’s past work experience demonstrates their ability to complete projects successfully and on time, which is essential for obtaining a bond.
- References: Positive references from past clients or subcontractors can help establish the contractor’s credibility and reliability, making it easier for the surety company to approve the bond application.
- Business plan: A well-developed business plan shows the contractor’s understanding of the project’s scope, timeline, and budget, which can improve their chances of obtaining a bond.
D. Submit the Bond Application
Once the necessary documentation is gathered, contractors can submit their bond application to the surety company. The surety company will review the application, evaluate the contractor’s qualifications, and determine whether to issue the bond.
E. Obtain the Bond
If the surety company approves the bond application, the contractor will need to pay the bond premium to obtain the performance bond (again, generally bid bonds don’t have a cost). Once the premium is paid, which may be to the agency (called agency billed), or to the surety company directly (direct billing), the surety company will issue the performance bond, which the contractor can then submit to the project owner or government agency as required with the other paperwork and documents with the bid.
Contractor bid and performance bonds play a crucial role in the construction industry by providing financial security to project owners and ensuring that contractors fulfill their contractual obligations. Understanding the differences between city, state, and federal bonds, as well as how they differ from general liability insurance, is essential for contractors and project owners alike. By familiarizing themselves with the costs and processes associated with obtaining these bonds, contractors can better navigate the complex world of construction bonding and improve their chances of successfully completing projects.
We would love to be your go-to source for bid and performance bonds, and feel free to give us a call.