1. Contract Surety Bonds 101:
The Basics of Bonding

2. What is a Surety Bond? Principal Obligee Surety
Surety is a unique form of insurance in which the surety company’s financial resources back the contractor’s commitment to enter into a contract with an owner.
In order to obtain a surety bond, the contractor must qualify – that is meet the surety’s comprehensive underwriting standards.
Bonds are a three-party agreement among the owner (referred to as the obligee), the contractor (referred to as the principal), and the surety company, and the surety company is obligated to both the obligee and the principal.

3. Surety Bonds Mandated on Public Works
Federal
Heard Act (1894)
Miller Act (1935)
State & Local
“Little Miller Acts”
Surety bonds are required on most public works projects let by federal, state, or local government agencies. An increasing number of private owners and construction lenders require surety bonds as well.
In 1894, Congress passed the Heard Act to protect federal projects from contractor default and to protect subcontractors from nonpayment by contractors. The Heard Act was supplanted by the Miller Act in 1935, which basically requires performance and payment bonds on projects (currently in excess of $150,000) and payment protection for contracts between $35,000 and $150,000. Most states have similar legislation, known as “Little Miller Acts,” although the bond threshold varies from state to state.

4. Types of Bonds Bid Performance Payment
There are three basic types of contract surety bonds in construction:
The bid bond provides financial assurance that the bid has been submitted in good faith and that the contractor intends to enter at the price bid and provide the required performance performance and payment bonds.
The performance bond assures the owner that the contractor is capable and qualified to perform the contract and protects the owner from financial loss should the contractor fail to meet the terms and conditions of the contract. A qualified, bonded contractor is more likely to complete the project according to the contract provisions. Default is not in the best interest of the surety, contractor, or owner. When problems occur, the surety may offer financial, technical, or managerial assistance to the contractor in order to prevent default.
The payment bond, sometimes called a labor and material bond, assures that the contractor will pay certain subcontractors, laborers, and material suppliers associated with the project.

5. Traditional Insurance
Fundamentals of Surety Bonds
Surety Bonds
Traditional Insurance
Regulated by state insurance departments
Prequalification intended to prevent loss
Spreads fortuitous losses among a large group of similar risks
Three-party agreement
Two-party agreement
Coverage is project-specific
Coverage usually term-specific and renewable
Bond forms are standard or may be negotiated by owner or surety and contractor
Policy forms vary by insurance company
Coverage: 100% of the contract price for performance and 100% for payment, up to penal sum of bond
Coverage up to policy limit, less the deductible
Claims – Surety has right to contract balance and indemnity from contractor (contractor remains primarily liable)
No right to insured’s assets, however, companies can subrogate against a third party or another insurer
Bonds are required by law in public projects and voluntarily by private owners
Buying insurance is a voluntary way of managing risk of loss for the insured
Surety bonds and traditional insurance are provided by insurance companies and both are licensed and regulated by state insurance departments. However, surety is a unique form of insurance in which the surety company’s financial resources back the contractor’s commitment to enter into a contract with an owner.
The contractor must meet the surety’s comprehensive underwriting standards in order to obtain a bond.
Bonds are a three-party agreement among the owner, the contractor, and the surety company, and the surety company is obligated to both the obligee and the principal. Traditional insurance is a two-party agreement between the insurance company and the insured. With surety bonds, the premium is a fee based on actuarial analysis that takes into consideration the potential for claims payment—for the surety’s prequalification services. With insurance, the premium is based on expected loss. There is no deductible on a surety bond, although the surety may require the contractor to reimburse the surety in the event of claims payment.

6. Role of the Producer Surety Company Contractor Prequalification
Attorneys
Producer
Lenders
Auditors
Advisory Group
Prequalification
Process
The surety bond producer plays an essential role in helping the contractor obtain surety bonds. The surety bond producer is an integral part of the contractor’s external advisory group, which includes attorneys, lenders, and accountants. By using his or her specialized knowledge of the construction industry, the producer prepares the contractor for the surety company’s prequalification process and helps the contractor establish a business relationship with the surety company.

7. Prequalification Financial Statements Capacity Organization References
Credit
History
Once the contractor’s file is completed by the surety bond producer, it is submitted to a surety company for review. The surety underwriter may meet with the contractor, who should be prepared to discuss all aspects of the construction company’s current operations and future plans. The surety company conducts the prequalification process to verify that, in its opinion, the contractor can perform the contract. While each surety company has its own underwriting standards and requirements, there are fundamentals common to underwriting practices. The surety will need:
Complete financial statements
An explanation of the capacity to perform the contract
An organization chart that shows key employees and their responsibilities
Detailed resumes of key employees
References from subcontractors and suppliers and letters of recommendation from project owners, architects, and engineers
Credit history

8. Prequalification Financial Statements Capacity Organization References
Credit
History
For prequalification, the surety also will need:
Documented banking relationships and evidence of a line of credit at a bank (Sureties generally look for an unsecured line of credit that can be used to meet short-term cash requirements.)
A strategic business plan outlining the type of work the construction company does, how it obtains its jobs, the geographic area where it operates and growth and profit objectives
A description of work in progress, both bonded and non-bonded, along with past projects and plans for future work
A plan outlining how the business will continue in the event of the owner’s or a key employee’s death or disablement.
In short, prequalification provides assurance to the owner that the contractor runs a well-managed, profitable enterprise, deals fairly and performs obligations as agreed. Even after issuing the bond, the surety may monitor the contractor’s financial statements, request job status reports from the owner or architect and meet regularly with the contractor to discuss the project.
Banking
Relationships

9. Financial Statement Analysis
Opinion Page
Balance Sheet
Income Statement
Cash Flow Statement
Account Schedules
Financial statements are vital to any business that grants credit, and sureties are no exception. Depending on how long the contractor has been in business, the surety will want to see fiscal year-end statements for the past 3 to 5 years.
The financial statement should include:
Accountant’s opinion page, which discloses whether the statements were prepared according to audit, review, or compilation standards.
Balance sheet, which shows assets, liabilities, and net worth of the company. This helps the surety assess the working capital and overall financial condition of the construction company.
Income statement, which measures how well the business performed. The surety will asses gross profit on contracts, operating profit, and net profit before and after tax provisions.
Statement of cash flow, which discloses the cash flow movements from operating, investing, and financing activities.
Accounts receivable and payable schedules
Schedules of work in progress and contracts completed, which show the financial performance of each contract and provides insight into the potential for future earnings from contracts in progress.
A schedule of general and administrative expenses, which reveal how well overhead expenses are controlled and managed.
Explanatory notes that the accountant may have included with the financial statement.
Financial Statement

10. General & Administrative Expenses
Financial Statement Analysis
Opinion Page
Balance Sheet
Income Statement
General & Administrative Expenses
Cash Flow Statement
Account Schedules
Schedules of work in progress and contracts completed, which show the financial performance of each contract and provide insight into the potential for future earnings from contracts in progress.
A schedule of general and administrative expenses, which reveals how well overhead expenses are controlled and managed.
Explanatory notes that the accountant may have included with the financial statement.
A management letter, which conveys the CPA’s findings, observations, and recommendations about the contractor’s business. (Not all CPAs provide management letters.)
Contract Schedules
Explanatory Notes
Management Letter
Financial Statement

11. Benefits of Bonds Financial security Construction assurance
The primary benefits of bonds can be summarized by detailing what surety bonds provide: financial security and contract assurance.

12. Benefits of Surety Bonds
Provide capable and qualified contractors
Assure project completion
Offer financial security
Technical, managerial, or financial assistance
Surety Bonds
There are many benefits of contract surety bonds.
As an impartial third party, the surety prequalifies the contractor to verify that the contractor is capable and qualified.
The owner has assurance of project completion. A capable contractor is less likely to default on a project. However, there are many things that can cause contractors to default, and in that event, the surety bond offers protections against financial loss.
If the contractor requests help, the surety may offer technical, managerial, or financial assistance. This can help the project move forward and significantly reduce the likelihood of default.

13. Benefits of Surety Bonds
Reduce risk of liens filed by subcontractors, laborers and suppliers
Protect taxpayer dollars
Smoother transition from construction to permanent financing
Lower costs
Surety Bonds
Surety bonds relieve the private project owners from risk of liens filed by unpaid subcontractors and suppliers. They also protect taxpayer dollars on public projects.
In the absence of liens, the transition from construction to permanent financing is much smoother.
When subcontractors and suppliers know they are protected by a payment bond, they may present lower quotes since they no longer have to absorb the risk of nonpayment.

14. Cost of Surety Bonds Bid Bond
No charge if performance and payment bonds are required
Performance Bond
0.5%-3% of contract price
Payment Bond
Price included with performance bond
Rates vary from company to company and also depend on the size and type of project, as well as the contractor’s bonding capacity. The contractor includes the premium in the bid, so the owner pays the bond premium.
There usually is no cost for the bid bond.
The performance bond premium generally is 0.5% to 3% of the contract price (closer to 3% if the SBA Surety Bond Guarantee Program is used; otherwise, premiums generally range between 0.5-2%).
There generally is no charge for the payment bond when it is purchased in conjunction with the performance bond.

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