Performance Bonds for Construction Explained

Performance bonds provide a guarantee that a contractor will fulfill all of their obligations under a construction agreement. Performance bonds are a subset of contract bonds and guarantee that a contractor will fulfill the terms of the contract. If they fail to do so, the Surety company is responsible for completing the contract obligations, either by securing a new contractor to complete the job or by financial compensation.  

There are many types of bonds and insurance used in construction to mitigate risk. The owner (or obligee) may require performance bonds to protect themselves from contractor default, especially with large-scale and public projects.   

Read on for more details about how performance bonds work, why performance bonds are important and how to secure a performance bond as a contractor.

How performance bonds work

Performance bonds, which are secured by a contractor before the beginning of a project,  provide a guarantee to the project owner that contract obligations will be fulfilled. If the contractor fails to complete work according to the contract terms, the property owner may be financially compensated. 

Every bond has a specific amount that it guarantees. A performance bond is generally issued for the full amount of the contract, and premium is typically calculated at about 1–3% of the total contract amount. However, there are a lot of factors that could affect the price and amount of a performance bond. Anything in a company's credit, loss or organizational history could affect the premium on a bond.

Contractors can take certain actions to reduce their surety bond costs. Some of these actions may help them increase their bond limit as well, enabling them to take on bigger projects. A qualified surety broker or agent can help to advise different courses of action.  

But how exactly does this work? Take a closer look at the parties involved to see how performance bonds work.

Property owners

The property owner, also called the obligee, may require a performance bond for the prime contractor on a project. Ultimately, the bond protects the property owner against the risk of a job not being finished by the contractor due to default, bankruptcy or other failures to perform.

General or prime contractors

The general or prime contractor, also called the principal, secures a performance bond to work on the project. The bond serves as an incentive for the contractor to fulfill the project since they'll have to pay back any expenditures the surety company outlays on their behalf, if they don't fulfill the contract terms. Before a bond can be secured, the principal indemnifies the surety company from all losses and/or expenses. This means that any loss on a bond must be repaid by the principal.  The indemnity agreement secures the surety companies place in line and gives them access to secure assets for repayment, if necessary.

Surety companies

The financial institution that provides the bond, known as a surety company, prequalifies contractors to mitigate their own risk. They are essentially evaluating the company to ensure that they can complete the contract obligations that they are entering into and that they are financially secure. If the contractor does not complete the contract, the surety has to provide funds to the property owner until the GC pays back the surety. As a result, the surety has a financial incentive to only provide bonds to qualified contractors.

Generally, a performance bond exists to lower risk for project owners while providing financial incentives for general contractors. Ultimately, performance bonds help make sure jobs get done – either by the original contractor or by the surety stepping in to ensure completion.

What happens if a contractor does not fulfill the contract?

The owner can file a claim against the performance bond if the contractor fails to perform. If there is a valid claim, the bond surety takes corrective action.

If the project owner files a claim, the surety will conduct an investigation. This is to determine if there's an actual default. The surety will assess the work that needs to be completed, the cost of any changes and determine if they will complete the project by hiring another contractor or paying the owner up to the pre-determined bond limit. Generally, a performance bond claim accompanies the termination of the prime contractor. However, termination is not always a cut-and-dry scenario.

The owner may arrange to avoid termination. Terminating a contractor can be an expensive and costly process for all parties involved. Reducing the scope of work, supplementing the workforce or advancing payments to keep the project moving can avoid this. If not, the surety will have to step in.

Every bond has specific terms that must be followed for a claim to be valid. This can include a timely notice of default. If notice isn't provided according to the terms, the surety has every right to deny the claim.

While the performance bond is in place to protect the owner from contractor default, the surety has a lot of power in determining a remedy for the situation. In some cases, they can reinstate the defaulting contractor, with or without the consent of the owner.

How surety companies respond after a contractor defaults

If the contractor is ultimately in default, then it's time for the surety company to decide how to proceed. There are a few options for sureties to resolve the claim.

1. Payout. The surety will pay either the amount of the bond limit, or the cost of completing the work – whichever is lower.
2. Financing. A surety may decide the contractor was so close to completion, that they will finance the contractor's completion of the work.
3. Arrangement. Here, the surety and the client will work together to finish the contract performance. Typically the client will select a replacement contractor, and the surety will absorb any additional costs.
4. Takeover. The surety will assume full responsibility for finding and funding a replacement contractor to complete the remaining work.

At the end of the day, the contractor still must compensate the surety for any money that is paid out. That's why communication is so important when dealing with bond claims. Contractors should always try to find alternative solutions when experiencing problems before the issue becomes too serious, and well before a claim is made.

From a contractor's perspective, avoiding a claim requires not defaulting on a contract. But even the most qualified contractor can run into unanticipated problems. So what should a contractor do if they sense they might not be able to perform? Pick up the phone. Reach out to their Surety Broker so they can help navigate the right path with the surety company.. After all, they are trained to deal with these types of scenarios, and may be able to resolve the situation before the owner files a claim.

Defence is the best offence, as they say, and that applies to bond claims as well. The best way to avoid a claim is to prequalify contractors before hiring them for a contract, and that may involve requiring a bond.

Why are performance bonds important?

Performance bonds are important for lowering the risks associated with many types of construction projects – and in the case of public projects, these bonds are often legally required.

While performance bonds are typically not required on private projects, they're increasingly common, especially for large and complex commercial jobs.

Performance bonds, along with several other types of bonds, provide incentives for many parties to work together without the fear of unfulfilled contracts. Often, performance bonds and payment bonds work together: The performance bond protects the property owner from a job not getting completed, while payment bonds protect subcontractors and material suppliers from not getting paid for their work. 

Without performance bonds, project owners risk non-completion of contracts if the contractor doesn't fulfill their end of the bargain. In short, the system of bonds that are common in construction help make sure that projects get completed and everyone gets paid. 

How to get a performance bond

The first step in securing a performance bond is finding a reputable surety broker. For performance bonds in particular, it's important to get the bond from a surety company that has experience in the type of construction you are performing. In case of default, the surety company may step in to manage the situation. They will need to be intimately familiar with all of the moving parts of a project, the work required to finish the job and how to find and assess qualified contractors.

Performance bonds benefit everyone

When a prime contractor fails to complete performance, things can spiral out of control quickly. For project owners, they are guaranteed that the contract will be fully performed. For subs and suppliers, this can keep the project moving forward and the cash flowing without having to deal with delays or filing payment bond claims.

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