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Why Construction Professionals Must Understand the Intricacies of Surety Bonds

Today’s guest post is courtesy of Sara Eisenberg, Director of Educational Outreach at SuretyBonds.com.

Although many professionals might not understand what surety bonds are and how they function, they usually know they must purchase this unique type of insurance to work within their chosen industry. For construction professionals, however, the bonding process is more complicated than it is for brewery owners, auto dealers and mortgage brokers. Why? Because cities and states have their own unique bond requirements. Furthermore, there are two categories of surety bonds that construction professionals usually need before work can begin on a project. Differentiating between these bond types — contractor license bonds and contract bonds — can be difficult for even the most seasoned contractor or construction project owner.

To understand the difference between contractor license bonds and contract bonds, one must first understand what a surety bond is and how it functions. A surety bond is a legally and financially binding contract that brings together three parties: a principal, an obligee and a surety.

  • The principal is the professional who purchases the bond and, by doing so, pledges to adhere to laws that regulate the local construction industry
  • The obligee is the government agency or other developer that requires the principal to purchase the bond. In most cases, the bond protects the obligee in the event of a principal’s inability to fulfill expectations.
  • The surety is the underwriter that produces the bond and, therefore, backs up the principal’s pledge. If the principal breaches the contract, the obligee can make a claim on the bond to recover losses. The surety will then require the principal to reimburse it for any claims paid out.

Contractor license bonds — known more simply as “contractor bonds” — are required by a city or state government agency to guarantee that the local industry’s licensing laws are followed. In most cases, these bonds are fairly affordable and easy to qualify for, especially when working with a reputable surety producer that can issue license and permit bonds quickly.

Contract bonds — also called “construction bonds” — aren’t as cut-and-dry as contractor bonds. For starters, there are several bond types that fall into the contract bond category. The most common types are bid bonds, performance bonds and payment bonds. Other types of contract bonds include supply bonds, maintenance bonds, site improvement bonds and subdivision bonds. The type of bond a construction professional needs depends on the project owner/developer’s unique requirements and the project at hand. If the contracted party fails to fulfill the contract’s terms, the project owner/developer can file a claim on the bond to recover financial losses.

One of the most common misconceptions about construction bonds is that they’re just as easy to obtain as contractor license bonds. Unfortunately, this isn’t the case, primarily because there’s a large amount of contractual risk associated with construction bonds. Typically, a contractor’s bond eligibility will depend on several of the following factors:

  • the type of construction project at hand;
  • the contractor’s bid amount for the project;
  • the bond amount required by the project developer/owner;
  • whether the construction company has been in business for at least one year;
  • the contractor’s revenue over the past calendar year;
  • whether the contractor has been bonded before; and
  • the contractor’s personal credit score

A variety of insurance companies underwrite construction bonds, and each has a different set of approval requirements. For example, most require applicants to have a credit score of at least 680 to qualify for relatively small bonds. Some companies require contractors to provide financial documents prepared by a licensed CPA while others refuse to bond contractors working on residential projects. Because so many stipulations factor into a surety’s decision to issue a contract bond, the bonding process often proves to be more challenging than contractors anticipate. Unfortunately for some contractors, getting approved for a contract bond could be impossible.

As a professional contractor, it’s important to understand the bond that’s required of you — whether by your city and/or state or the project owner/developer — before you submit a bid. By purchasing a surety bond, you pledge that you’re a skilled, reputable and credible construction professional who will complete your job according to contract (a.k.a. on time and on budget). By fulfilling your contract, your reputation will become more established and your eligibility to be bonded in the future will increase.

Sara Aisenberg is the director of educational outreach at SuretyBonds.com. Through her writing, Sara strives to educate professionals of all types about the importance of understanding what surety bonds are and how they work. Because bonds pertaining to the construction industry tend to be more confusing than those for other industries, Sara makes it a point to maintain a strong working knowledge of contractor and construction rules and regulations. Keep up with Sara on Google+.