1. Informed Decisions: Surety bonds or bank letters of credit
Contract surety bonds and bank letters of credit are very different forms of risk management. The differences between these two products are especially apparent when examining:
the prequalification process
effect on borrowing capacity
type and duration of coverage
how they are obtained
cost
claims
2014

2. What Is A Surety Bond? Surety Principal Obligee
Surety bonds, like traditional insurance, are provided by insurance companies and 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.
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. Three 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 into the contract at the price bid and provide the required 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.

4. What Are Bank Letters of Credit?
Cash guarantee to owner
Called on demand
Payment to owner & loan for contractor
No guarantee of project completion
Irrevocable
A bank letter of credit is a cash guarantee to the owner. The owner can call on the letter of credit on demand without cause, at which time it then converts to a payment to the owner and an interest-bearing loan for the contractor. A letter of credit has no guarantee of project completion. The performance of the underlying contract has no contractual bearing on the bank’s obligation to pay on the letter of credit. Most letters of credit are irrevocable, meaning non-cancellable. Changes must be documented by an amendment agreed by all involved parties.

5. Prequalification Surety Bonds Capital Capacity Character
Letters of Credit
Single focus
Quality & liquidity of collateral
By examining the details of each, the differences between these two products become clear. The prequalification process undertaken by a surety company differs greatly from the method used by banks. The 3 “C”s (capital, capacity and character) of a contractor all are scrutinized by the surety. The surety underwriter assesses the contractor’s entire business operation, checking for adequate financial resources, necessary experience, organization, existing workload, and its profitability and management skills to carry on the business and successfully complete the project for which the bond is required. When it issues a bond, the surety company has concluded that, in its opinion, the contractor is capable of performing the job for the stated price and in the time allotted. This process is designed to disqualify contractors who are unable or unqualified to complete the project for any number of reasons. Contractors who do not qualify for a surety bond but may be able to get a letter of credit may not possess all of the necessary capabilities to perform the work successfully to completion.
While a surety examines a multitude of components to prequalify a contactor, banks focus primarily on the financial aspects of a contractor’s business. The banker examines the quality and liquidity of the collateral available to the bank in case there is a demand on the letter of credit. If the banker is satisfied that the contractor can reimburse the bank if demand is made upon the letter, there may be no further prequalification.

6. Borrowing Capacity Surety Bonds Issued on unsecured basis
Does not diminish borrowing capacity
Credit enhancement
Letters of Credit
Assets used as collateral
Diminish existing line of credit
Can affect cash flow
In terms of borrowing capacity, with few exceptions, performance and payment bonds are issued on an unsecured basis. That is, they usually are provided on the overall strength and capability of the construction company and the owner’s personal indemnity. The issuance of bonds does not diminish the contractor’s borrowing capacity.
Bank letters of credit frequently are secured by pledging specific assets. Bank letters of credit usually diminish an existing line of credit and are reflected in the contractor’s financial statement as a contingent liability. Having assets tied up, or an available line of credit diminished, can be counter-productive to both the owner and contractor. The contractor’s cash flow in funding initial stages of construction and retention amounts throughout a contract term can be adversely affected when liquid assets are pledged to a bank or the bank reduces the borrowing capacity available to the contractor as a result of the issuance of a letter of credit.

7. Duration Surety Bonds Duration of contract Maintenance period
Letters of Credit
Date-specific
“Evergreen” clauses
Contract surety bonds remain in force for the duration of the contract plus a maintenance period, subject to the terms and conditions of the bond, the contract documents, and underlying statutes for one fee.
In contrast, a letter of credit usually is date-specific, generally lasting for one year. Letters of credit may contain “evergreen” clauses for automatic renewal unless canceled, with related annual fees.

8. How to Obtain Surety Bonds Issued through surety bond producers
Letters of Credit
Issued through banking or lending institution
When a construction project owner specifies a surety bond in the construction contract, the contractor is responsible for obtaining the bond. Most surety companies issue bonds through surety bond producers, also called agents or brokers. A list of surety bond producers is available through the National Association of Surety Bond Producers (NASBP) at

9. Cost Surety Bonds Letters of Credit 0.5%-3% of contract price
Includes performance, payment & warranty
Letters of Credit
Annual charge of 0.5%- 2.5% x (5%-10% of contract amount) x number of years of contract
Interest charge applies if contractor draws on LOC
Surety bond rates are based on actuarial analysis and contemplate the potential of loss. They also act as a fee for the surety’s extensive underwriting and prequalification service.
Generally, surety bonds cost 0.5% to 3% of the contract price (usually closer to 3% if the Small Business Administration Bond Guarantee Program is used). The bond is project-specific and covers the duration of the contract. The premium includes a 100% performance bond and 100% payment bond. Normally the contract and therefore the bond also provides a one-year warranty period.
Bank letters of credit operate on a different pricing structure. The cost of bank letters of credit generally ranges (based on the credit quality of the contractor) from 0.5% to 2.5% of the contract amount covered by the LOC (usually 5%-10%). This is an annual charge—e.g., if the LOC covers 10% of the contract, cost=1% x (10% x contract amount) x years of contract. The cost is included in the contractor’s bid. In addition, in the event there is a draw on the LOC, the contractor (borrower) must pay interest charges.

10. Coverage Surety Bonds 100% performance 100% payment
100% warranty (typical)
Letters of Credit
Typically 10% of contract
No protection for unpaid subs
In terms of coverage offered, surety bonds typically assure 100% of the contract amount. Additionally, a 100% payment bond protects certain subcontractors, laborers, and materials suppliers and protects the owners of private projects against liens. With payment bonds subcontractors and materials suppliers may be more willing to provide labor and supplies and bid a lower price when they know they are protected – especially on public projects where liens are prohibited.
To achieve equal monetary coverage with performance and payment bonds, a letter of credit would need to be in the amount of 200% of the contract. However, an owner typically obtains a letter of credit for only 5-10% of the amount of the contract. In contrast to surety bonds, there is no protection/guarantee that subcontractors, laborers, and materials suppliers will be paid in the event of contractor default. These parties may file liens on private projects but not on public projects. The letter of credit has no mechanism for addressing subcontractor/supplier claims.
Surety bonds also typically offer an additional protection in the form of coverage for defects in material or workmanship for the first year after completion per the contract requirements. Said cost is included in the performance bond premium, while letters of credit offer no such warranty coverage.

11. Claims Surety Bonds Surety investigates claim of default
Surety’s options
Surety pays rightful claims of certain parties
The manner in which the claims process is handled by sureties and banks also differs greatly. If the contractor and owner disagree on contract performance issues and the owner declares the contractor in default, the surety must investigate the claim. The surety has several ways to respond should the contractor be in default, subject, of course, to the terms of the bond:
Finance the original contractor or provide support necessary to allow the contractor to finish the project;
Take over the contract for completion;
Tender a new contractor to the owner to complete the contract; or
Pay the excess costs of completion.

12. Claims Surety Bonds Surety investigates claim of default
Surety’s options
Surety pays rightful claims of certain parties
Letters of Credit
Payable on demand
Owner determines validity of claims by subs & suppliers
A bank will pay on a letter of credit upon demand of the holder. The holder or beneficiary, however, must make a demand prior to the expiration date since no funds are available after the expiration date, even for liabilities incurred prior to expiration. This then impacts the contractor’s bank accounts and balance sheet.
While a surety company has a number of options to assure completion of a contract, there is no completion clause in a letter of credit – the task of administering completion of the contract is left to the owner.
With payment bonds, the surety pays the rightful claims of certain subcontractors, laborers, and suppliers. In contrast, with letters of credit, the owner must determine the validity of claims by subcontractors, laborers, and materials suppliers. If there is not enough money from the letter of credit to pay all of the claims, then the owner has to decide which claims will be paid in addition to covering cost of completion.
From , surety companies have paid over $13 billion in claims, plus additional billions in claim expenses. (SOURCE: The Surety & Fidelity Association of America)

13. Conclusion Informed decisions on risk management
After focusing on the prequalification process, the effect on borrowing capacity, the type and duration of coverage, how they are obtained, cost and claims, the differences between these two risk management products become clear. Armed with the necessary information, contractors, project owners, bankers, and design professionals can make informed decisions about risk management and exposure on construction projects.

14. For More Information Surety Information Office (SIO)|
SIO is a joint initiative of The Surety & Fidelity Association of America (SFAA) and National Association of Surety Bond Producers (NASBP).
For more information about contract surety bonds, visit the Surety Information Office online at SFAA’s website is and NASBP’s website is