National Association Of Surety Bond Producers ANSWERS TO 32 QUESTIONS

Who a proper claimant is under a payment bond is typicallyrestricted or limited by the language in the applicable statute,the contract, or the bond. Most payment bonds require aclaimant that does not have a contract with the principal togive the principal or surety, or both, written notice of its claimwithin a specific period of time after furnishing the labor ormaterials for which the claim is made.\A payment bond does not directly benefit an owner,but it provides indirect benefits by ensuring that unpaiddownstream laborers and suppliers are unlikely to stopwork during a project or, on private projects, file a lien,encumbering title to the project.Act, which requires a performance bond and a paymentbond for state contracts over a certain amount, called thebond threshold. Most municipalities require performance andpayment bonds as well.In the private sector, there is no mandate for the use ofbonds on construction projects. Understanding the value ofcontract surety bonds, however, many private owners requirecontract surety bonds on their construction projects for thesame reasons the government does. In the same manner, asa risk management tool, prime contractors will often electto require that their subcontractors obtain performance andpayment bonds. Sometimes construction lenders requirebonds on projects as a condition for receiving financing.What is a warranty bond?8A warranty bond, sometimes called amaintenance bond, guarantees the owner thatany workmanship and material defects found in the originalconstruction will be repaired during the warranty period.They are typically used when an owner wants coverage fora warranty period beyond one year. A warranty period canbe extended for an annual fee, but sureties are reluctant toprovide warranty protection for more than two years afterproject completion. If the contractor is unable to resolvethe warranty issue or is not in business during the specificwarranty period, the warranty bond provides the owner witha remedy.Sometimes owners will require long-term warranties,such as five or more years. A long-term warranty periodimposed on a contractor presents considerable problemsfor a surety. Sureties are usually comfortable with warrantyobligations of two years. Durations longer than two yearsincrease substantially the uncertainty regarding underwritingprojections about the contractor’s future viability. Longterm warranty obligations also reduce competition from thestandpoint of eliminating from the bidder/proposer pool allbut the largest contractors, since only large contractors canshoulder the higher risks inherent in such contracts. Thishas the effect of reducing the bidder pool, which, in turn,translates into higher prices paid for the project by the owner.A long-term warranty requirement precludes many highlyqualified bidders, lowering bid and price competition.9Are bonds required on public projectsor private projects, or both?Contract surety bonds are required in mostinstances by the federal government, state governments,and local governments; and private owners and generalcontractors often require surety bonds, recognizing theirimportance in project risk management.Under the federal Miller Act and certain regulations, anyfederal construction contract valued at 150,000 or morerequires a performance bond and a payment bond. Eachstate has a “Little Miller Act,” similar to the federal Miller10Who are individual sureties and whatdo I need to know about them?In the United States, almost all surety bonds arewritten by insurance companies regularly engaged in thebusiness of acting as a surety. Surety companies typically areauthorized and qualified to do business by the state insurancecommissioner where they are domiciled and in the jurisdictionwhere the bond is issued. The state departments of insuranceregulate surety companies, which must meet minimumcapital requirements, file periodic financial reports in thosejurisdictions where they are authorized to do business, andare subject to market conduct investigations, among otherregulatory requirements and actions.Almost all state insurance laws allow natural persons, not justcompanies, who wish to act as a surety on bid, performance,and payment bonds to obtain a license or certificate ofauthority from the state insurance department.The history of individual surety use is replete with case law ofindividual surety deceptions, to the detriment of contractors,subcontractors, suppliers, and public and private owners. Asnoted in a report issued in 2013 by Maryland’s Departmentof Insurance, Final Report on the Analysis of the Practicesof Corporate Sureties and Individual Sureties in Maryland,individual sureties have engaged in misleading conduct,creating the illusion of a corporate form, misleading thepublic into believing that the same safeguards in place forcorporate sureties exist for individual sureties.The federal government does accept bonds from individualsureties—if they adhere to specific regulations governingtheir assets. Nonetheless, unlike the evaluation of corporatesureties by the Treasury Department, there is no central entityto evaluate individual sureties or their bonds.11What are the advantages to the ownerand contractor in contract bonds v.bank letters of credit?Project owners sometimes consider requiring bank letters ofcredit (LOCs) in lieu of bonds to provide financial protection 4 32 Questions Public and Private Owners Ask About Contract Bonding www.SuretyLearn.org

in the event of contractor default. Owners should be awareof the important distinctions between surety bonds andLOCs. A bank LOC is a cash guarantee to the owner, whocan call on the LOC on demand. The LOC is converted to apayment to the owner and an interest-bearing loan for thecontractor that arranged it. While performance and paymentbonds protect the owner from non-performance and protectcertain subcontractors and suppliers from nonpayment shouldthe contractor default, the performance of the contractor hasno bearing on the bank’s obligation to pay on the LOC.Contract surety bonds and LOCs both provide financialprotection to the owner; but bonds are superior to LOCs intheir effect on borrowing capacity, duration, coverage, cost,contractor qualification, and claims. Bonds do not diminishthe contractor’s borrowing capacity; bank LOCs do diminisha contractor’s line of credit, which could adversely affect thecontractor’s cash flow.Surety bonds remain in place for the duration of the contact,plus a warranty period, subject to the terms and condition ofthe bond, the contract documents, and governing statutes.An LOC is usually date-specific, often for one year. They maycontain “evergreen” clauses for automatic renewal, withassociated fees.A performance bond is 100% of the contract amount forproject completion; a payment bond is 100% of the contractamount to protect certain subcontractors and materialsuppliers. An LOC can be obtained for a percentage of thecontract amount, but 5%-10% of the contract amount istypical. An LOC provides no protection that subcontractorsand suppliers will be paid in the event of contractor default.They may file liens on private projects.The cost for both the performance and payment bonds isgenerally 0.5%-3% of the contract price and is included inthe contractor’s bid price. The cost of an LOC is generally 1%annually of the LOC amount. The cost of an LOC is includedin the contractor’s bid price.A surety company analyzes a contractor’s operations, financialresources, experience, organization, workload, management,and profitability to determine that the contractor is capableof performing the contract, in order to avoid default. Abanker examines the quality and liquidity of the contractor’scollateral in the event there is a demand on the LOC.Other than determining if the contractor can reimburse thebank if demand is made on the LOC, there is no furtherprequalification performed by the banker.If the owner declares a contractor in default and the surety,after its independent investigation, determines that thecontractor defaulted, the surety will select a completionoption for performance and pay the rightful claims ofsubcontractors and suppliers, up to the penal sum of the100% performance and payment bonds. With LOCs, thebank will pay an LOC on demand if made prior to theexpiration date; but the owner must administer completionof the contract and determine the validity of claims and theamounts of payment to the subcontractors and suppliers.12What are the advantages to theowner in using bonds rather thansubcontractor default insurance?Subcontractor default insurance (SDI) is a two-party,catastrophic insurance policy that provides generalcontractors with insurance coverage for direct and indirectcosts of trade contractor default. Some general contractors,generally those with subcontract volume exceeding 50million, that are eligible for SDI coverage see it as analternative to the purchase of subcontract bonds. Unlikesubcontract bonds, SDI is traditional insurance that presumessome level of losses; and general contractors that purchaseSDI must bear a significant level of self-insurance for suchrisks through high deductibles and co-payments. Little or nolosses in the SDI program might translate into higher marginsfor the insured general contractor. It is critical to understand,however, that SDI, as a product, is very different from suretybonds and is never a replacement for statutory federal, stateor local bond requirements.SDI can put a much bigger burden on the prime contractorthan subcontractor bonds. With subcontract bonds,the surety performs the prequalification of potentialsubcontractors; in the event of default, provides completerisk transfer from the general contractor to the surety, withfirst-dollar coverage; manages the subcontractor default; andprovides payment protection for lower-tier subcontractorsand suppliers. With SDI, the general contractor performsthe prequalification of the potential subcontractors; in theevent of default, retains a portion of the risk through highdeductibles and co-payments; manages the subcontractordefault, including completion of the subcontractor’swork; and there is no payment protection for lower-tiersubcontractors and suppliers.Accordingly, significant losses can jeopardize the operationsof the insured general contractor, which will bear theexpenses of the deductibles and co-payments and the burdenof administering claims. The benefits of SDI flow only toinsured general contractors, while the benefits of subcontractbonds flow not only to general contractors but also tosubcontractors and suppliers and, indirectly, to owners.The following chart is a broad overview of the features andpurposes of subcontract bonds and SDI, with key aspectsof each:www.SuretyLearn.org 32 Questions Public and Private Owners Ask About Contract Bonding 5

ISSUEPERFORMANCE AND PAYMENTBONDSSUBCONTRACTOR DEFAULTINSURANCEPrequalification Process Conducted by the surety, aknowledgeable third party(extensive and ongoing)Conducted by the general contractor, nota third partyStructure3-party agreement (generalcontractor, subcontractor, and surety)2-party agreement (general contractorand insurer)RegulationSureties are regulated by stateinsurance departmentsSurplus lines basisRiskComplete risk transfer from generalcontractor to surety, with first-dollarcoverage of 100% performance bondand 100% payment bondGeneral contractor retains a portion of riskthrough high deductibles andco-paymentsPayment Protectionfor Subcontractors andSuppliers100% payment bond, withfirst-dollar payment benefit forsubcontractors and suppliersNo payment benefit for subcontractorsand suppliersSubcontractorDefaultManagementIf subcontractor defaults, suretycompletes, arranges for, or pays forsubcontract completion up to bondamountGeneral contractor must managesubcontractor default, includingcompletion of subcontractor’s workPayment of LossesSurety pays losses after independentinvestigationGeneral contractor must pay firstlosses and then submit documentation torecover from the insurerLegal PrecedentsExtensive history of case law/legalprecedentsLittle or no case law/legal precedentsConfidentiality ofSubcontractorInformationSubcontractor has confidential andon-going relationship with suretySubcontractors are uncomfortableproviding sensitive financial data to thegeneral contractor (who might be theircompetitor bidding on the next project)PremiumCost calculated based on contractamount, depending on size and type ofprojectCost is calculated on generalcontractor’s program costs and thedeductibles and co-payments selectedCancellationThe bonds cannot be cancelledSDI can be cancelled by the insurerIndemnitySubcontractor is incented to performby its indemnification obligation to thesuretySDI provides no such incentive other thanfor the subcontractor not to be sued bythe insurerLimitsCombined performance andpayment bonds are equal to 200% ofthe contract amountPolicy subject to aggregate limit and perloss limit; sublimits also may apply, such asthree or four times the subcontract valueUnseen AssistanceSureties, with the expectation of no Insurers, with an expectation of losses,losses, provide assistance to bonded provide no assistance to subcontractorssubcontractors through financing,engineering, and operational services 6 32 Questions Public and Private Owners Ask About Contract Bonding www.SuretyLearn.org

What is the cost of the bonds?13The cost of a bond is based on rates filed byinsurance companies with the state insurancedepartment and is based on the contract amount. The cost ofa bond can vary, from less than 0.5% to as much as 3% ofthe contract price. For a small and emerging contractor withminimal experience, a contractor can expect to pay 2-3% ofthe contract price. There are adjustments to the bond costbased on the final contract price. If the price increases, there’san increase in premium; and if the price decreases, the cost isreduced as well. A contractor should always include the costof its bond in its change orders, no matter how small. Severalsmall change orders over time can turn into a large increasein the contract, which will result in an increase in cost.14When are bond premiumstypically paid?Bonds must be paid when they are executed.Bonds are non-cancelable.15How extensive is the surety’sprequalification process?Contractor prequalification, as performed bysurety underwriters, involves a thorough and continuingprocess of reviewing and evaluating balance sheets,work-in-progress schedules, and financial statements. Suretyunderwriters will also evaluate factors such as the risk underthe specific contract for which the contractor seeks a bond,the contractor’s entire work portfolio, past performance,experience, operational efficiency, managerial skills, businessplan, and reputation for integrity.Obtaining bonds is more like obtaining bank credit thanpurchasing insurance. Different sureties will stress varyingfactors during the underwriting process, but almost all willconsider the following factors: Financial capacity16What is a general agreement ofindemnity?A general agreement of indemnity, or GIA, isa contract between a surety company and a contractor.The GIA is a powerful legal document that obligates thecontractor and other indemnitors to protect the suretycompany from any loss or expense that the surety has as aresult of having issued bonds on behalf of the bond principal.In this manner, the contractor and other indemnitors have“skin in the game” for each contract, as the contractor’s GIAincents the contractor from walking away from a bondedcontract. Under a GIA, if the contractor fails to fulfill itsbonded obligation under a contract and the surety suffers anyloss, the indemnitors are legally bound to indemnify, or payback, the surety for its losses.A fundamental concept of suretyship is that the surety willnot sustain a loss. The surety expects to be indemnified(that is, paid back) and reimbursed for any payments orlosses by the principal and indemnitors under the indemnityagreement. Therefore, the GIA is needed before the suretyissues any bonds on behalf of the principal. The GIA willapply to all bonds issued by the surety for the principal.The GIA is an extremely powerful document that encouragescontractors to honor their bonded obligations.17Who typically signs the generalagreement of indemnity?If a surety company decides that a contractorshould be extended surety credit, the surety company willrequire that the contractor, as well as others, sign a contract,the GIA, before it will issue bonds on behalf of the contractor.A surety company that issues bonds on behalf of a contractoralmost always requires that the principal, the individualswho own and/or control the company, their spouses, andoften affiliated companies sign the GIA. Both the principaland the third-party indemnitors can be individuals, smallbusiness entities and partnerships, and large internationalcorporations. Net worth Cash flow Assets18 Credit score Work in progress Work history, including expertise and experience Banking relationship Nature of project to be bonded Character of the contractorSurety underwriting is an ongoing evaluation process, whichincludes the principal’s entire work program.What determines a contractor’sbonding capacity?Bonding, like bank credit, is dependent onstrong financials and adequate liquidity for a contractor toundertake the backlog of construction projects. Contractorsneed to have sufficient cash flow in terms of cash andworking capital to be able to upfront the costs for insurance,bonding, labor, materials, and overhead for 60 to 90 daysuntil they receive the first payment certification from theowner. Multiple projects require organization, cash flow, andplenty of managerial experience.www.SuretyLearn.org 32 Questions Public and Private Owners Ask About Contract Bonding 7

Under similar circumstances, bonding capacity willalways favor those contractors that have superb financialinformation, which can be provided to surety companieson a transparent and timely basis, showing organization,commitment, and security that problems arising during thenormal and customary business environment will be identifiedand dealt with immediately. Other important factors includea successful track record for the same types of projects,experienced personnel and subcontractors, on-time accountsreceivable collection (that is, no collection problems), andsufficient bank lines of credit to assist in case of a temporarysituation where the contractor may not collect certificationson time.Although bonding is as much an art as a science, the betterorganized a contractor is in terms of project constructionand administration matters, the higher the chances arethat bonding capacity will match or exceed the contractor’sexpectations.19Why are sureties uncomfortable withlong-term warranties? Do extendedwarranties cost extra or affect theavailability of bonds?Yes, extended warranties do cost extra; and, yes, they doaffect the availability of bonds. A lengthy warranty period,such as one of 5 or more years, imposed on a contractor orsubcontractor poses considerable problems from a suretyunderwriting perspective. Sureties are usually comfortablein covering a warranty obligation of up to two years.“Certainty” is a word that sureties like. Durations longerthan two or three years increase substantially the uncertaintyregarding underwriting projections about the contractor’sfuture viability. In other words, sureties cannot gaugethe soundness and financial wherewithal of a particularconstruction company for periods extending toofar into the future.Long-term warranty obligations also reduce competition fromthe standpoint of eliminating from the bidder/proposer poolall but the largest contractors, since only large contractorscan shoulder the higher risks inherent in such contracts. Thishas the effect of reducing the bidder pool, which, in turn, cantranslate into higher prices paid for the project by the owner.Such longer warranty requirements effectively preclude manyhighly qualified contractors, significantly lowering bid andprice competition on such projects.Construction projects typically involve a number of differentwarranties, both of workmanship and of items incorporatedinto the work, such as roofing systems and equipment. Thosewarranties provided by a contractor, as opposed topass-through warranties from the manufacturer to the owner,need to be of limited duration.20If the general (or prime) contractorrequires its subcontractors to bebonded, is the owner protected, too?When a general contractor requires bonds from itssubcontractor, the subcontractor’s performance bondprovides protection to the general contractor for thesubcontractor’s failure to perform the bonded subcontract.The subcontract performance bond provides no directprotection to the owner; however, the owner indirectlybenefits by having the general contractor address itsdownstream risks through subcontract bonds. Subcontractbonds do not address the performance risks of the generalcontractor to the owner; only the general contractor’sperformance bond addresses that risk. Without aperformance bond from the general contractor, the ownerhas no direct protection if the general contractor defaultsunder the prime contract.21Are standardized constructioncontracts used in the constructionindustry?Yes. There are a n

Bonds written by an insurance company for construction projects are referred to as contract surety bonds. The main types of contract surety bonds are: bid bonds, performance bonds, payment bonds, and warranty bonds (sometimes called maintenance bonds).The two basic functions of these bonds are: Prequalification—assurance that the bonded