Cavignac has been a proud provider of surety solutions for over thirty years. As a full-service insurance agency, we often have insurance clients who run into surety (or bonding) obligations. Since many insurance brokerages also sell surety bonds, it is a common misconception that purchasing a surety bond is the same as purchasing an insurance policy. There are actually some significant differences between an insurance policy and a surety bond – the most notable being, a surety bond is a financial instrument that requires underwriting the applicant’s overall credit profile. The overview that follows is meant to increase your general awareness of a surety bond relationship, the different class types and some examples of some of the more common bonds written in the industry.
Parties to a Bond:
- Principal – the party providing the bond / entering into a contract. Typically, a General Contractor, Developer, or possibly a Subcontractor. Note the Principal signs a General Indemnity Agreement with the Surety – surety is designed as a “no-loss” industry, meaning the surety would look to the Principal (or its owner) for reimbursement if a claim is paid.
- Obligee – the party receiving the benefit of the bond / guarantee. Typically, the Owner of a project or possibly a General Contractor (if requiring bonds of their subcontractors).
- Surety – the third party providing the guarantee – an insurance company.
There are generally two classes of bonds:
Contract Bonds – simply put, a bond that guarantees performance of a contract. These are almost always related to construction, but could present in other industries as well. The surety would step into the shoes of the contractor to complete the contract (various remedies exist) if a valid claim is made on the bond.
Commercial Bonds – bonds that provide a guarantee to another party when there isn’t necessarily a contract. Judicial Bonds, License & Permit Bonds and Subdivision Bonds (generally) fall into this category. These bonds guarantee something will be done (i.e. compliance with laws, make a payment, etc.) when there isn’t necessarily a written document outlining what needs to be done.
Within these two classes, there are various types of bonds that may be required. Contract bonds typically consist of:
Bid Bond – a form of bid “security” that provides a guarantee to the owner that if the contractor is awarded the contract, they will sign the contract and provide the required Performance & Payment bonds, Insurance, etc. These bonds are most commonly written for 10% of the total amount bid – the intention is this 10% amount will cover the spread between the first and second bidder if the first fails to enter into the contract. Note that GSA bid bonds (Federal Government) are written for 20% of the amount bid or $3,000,000, whichever is less. No premium is charged for bid bonds (no cost).
Performance Bond – a bond required to ensure the contractor performs the contract (price, time, etc.). These bonds are almost always written for 100% of the contract amount – Caltrans is the most common exception, with Performance Bonds written for 50% of contract price. Premium is calculated as a percentage of the bond amount. Most standard construction accounts have a sliding scale that decreases the overall price as contracts get larger. In general, well-qualified contractors will pay between 0.5% and 2.5% for premium – less-qualified contractors can pay upwards of 3% or more.
Payment Bond – also known as a Labor & Materials Bond. This bond is written to ensure subcontractors and suppliers are paid. In the event the GC fails to pay a sub/supplier, that sub/supplier can request the bond information from the owner of the project and make a claim with the surety. After investigation, the surety may pay the sub/supplier for a valid claim. The surety would then look to the GC for whom they wrote the bond for reimbursement of any amounts paid. When issued with a Performance Bond, there is no cost for the Payment Bond (it will say “premium is included in the performance bond”). These bonds are required for government projects because subs/suppliers cannot lien federal/state-owned property as they could in a private project scenario.
Final Bonds – common shorthand for Performance & Payment Bonds issued for the same contract. It is a statutory requirement government entities (federal, state, local) require Final Bonds for their projects if it exceeds a certain dollar amount (currently $150,000 for federal projects; $25,000 in California).
Commercial Bonds could include (there are many others):
Completion Bond – this bond is similar to a Performance Bond; however, these typically come into play when another party (i.e. lender) is requiring bonds. These bonds tend to be more hazardous than a standard Performance Bond because the Completion Bond guarantees completion of an entire project – a Performance Bond guarantees completion of a contract. This increases the amount of variables that may result in failure to complete a project and ultimately, a claim on the bond – meaning these bonds are underwritten more cautiously than a Performance Bond.
For example, a bank may require a developer to post a Completion Bond to enhance the underwriting of the construction loan. In that case, the developer is guaranteeing to the bank the project will be completed. One challenge that may present is that the construction loan may end up being insufficient to complete the project (think material price increases, delays, increased labor costs, etc.). If the developer is unable to find additional funds from another source to complete the project, the bank could make a claim on the bond.
Subdivision Bond – bonds required by a local municipality to ensure completion of various elements of development. The most common Subdivision Bonds are written to guarantee Grading and/or Improvements. When a developer builds a new community, they need to build roads and utility infrastructure to support the community, which will ultimately be dedicated back to the municipality for operation (water districts, cities, etc.). Someone building a new residence may also be required to post a Grading Bond to obtain their grading permit and move forward with the project. Premiums for these bonds are typically charged at flat rates (rather than tiered) ranging from 1% to 3%.
Judicial Bonds – there are dozens of judicial bonds, which are typically written to guarantee something in litigation. Someone may be required to post a Temporary Restraining Order (TRO) Bond since their lawsuit inhibits another party from doing something. If the TRO ultimately is unjustified, the party providing the bond may be required to pay damages – if they are unable to pay, the injured party could make a claim on the bond. Another common Judicial Bond is an Appeal Bond. When a party receives an unfavorable verdict – say they are ordered to pay the other party $1,000,000 – a bond needs to be posted to ensure they pay that amount if their appeal is unsuccessful. These bonds can be hazardous, and the surety will typically require collateral in the form of cash or an irrevocable letter of credit (can be 0-100% of the bond amount).
Public Official Bonds – a type of bond that serves as a statutory obligation requiring faithful performance, fidelity, and integrity of a public official’s duties to the public. This is essentially a compliance bond ensuring the elected official will comply with governmental rules and regulations. These bonds are most commonly required for public officials who handle public funds.
License & Permit Bonds – compliance bonds required by government agencies / regulatory authorities. The most common L&P Bonds include Contractor’s License Bonds ($25,000; CA Contractors State License Board), Mortgage Lender/Originator Bonds, Insurance Broker Bonds, Notary Bonds – among many others. The general rule of thumb regarding which businesses require a L&P Bond is when a service is being offered to the public by a presumably qualified contractor or professional, the license bond will be required as a means of protection for consumers subjecting themselves to the service. Premiums for these bonds can vary but are generally nominal and based on the credit score of the qualifying individual.
When you run into a bonding requirement, it’s best to work with a knowledgeable surety broker, with the experience and relationships, to underwrite the request and obtain the most competitive terms and conditions available in the market. Bonded obligations can be complex, and having an advisor to not only obtain the bond, but educate you on the implications of providing a bond is critical to the success of any business. At Cavignac, our vision is a community where every business is protected from risk, including financial risks – please reach out if you are evaluating a surety bond obligation we can assist with.