History
Surety Bonds have provided financial security dating back as far as 2750 B.C. Scholars have traced the oldest known example of suretyship to a clay tablet found in the Mesopotamian region, wherein a farmer who was drafted into the service of the King was unable to tend his fields. The farmer contracted with another farmer to meet his contractual obligations in the event he was unable to tend said fields in exchange for half of the proceeds of the contract. As guarantor, a local merchant provided assurance with regard to the second farmers guarantee to step in when and if needed, in accordance with the underlying contract.
Other examples of suretyship in history, in written form, include:
- The Code of Hammurabi - 1792-1750 B.C
- A Babylonian contract of financial guarantee dating 670 B.C, the oldest known surviving written surety contract.
In or around 150 A.D. the Roman Empire established the laws of surety which are the principal laws that exist in suretyship today.
Historically speaking, suretyship has a long standing history of providing financial assurances and guarantees in contractual obligations. It wasn’t until somewhere in the 19th Century that the establishment of corporate surety bond guarantees were established. This new industry caught the attention of the U.S. Government and they realized a need to protect the public and its taxpayers from contractor failure and caused Congress to enact one of many acts and laws to govern the industry.
- The Heard Act of 1894 required that all federally funded projects to be bonded
- The Miller Act of 1935 mandated all Federal Public Works contracts greater than $100,000.00 must be bonded with payment and performance bonds. For Federal Public Works contracts greater than $25,000, it is mandated that a payment bond secure the contract.
The Miller Act of 1935 is the current law and has been adopted by almost all 50 states, the District of Columbia, Puerto Rico and is commonly known in each as “Little Miller Acts”.
While these laws require bonds on government projects, surety bonds are commonly required in private contracts.
Surety, much like that of its counterpart insurance, is a means of transferring risk from one party to another. That being said, Surety is NOT insurance!
Surety Bonds are underwritten on the theory of zero loss, meaning that if underwritten and evaluated properly, surety credit will only be extended to accounts that qualify and have the ability to perform the contract without default or loss. The premiums charged are historically based upon underwriting expense, not upon projected or expected losses. Surety Companies are traditionally a subsidiary of or owned by an insurance company.
Insurance however is based upon the theory of pooled risk, wherein the insurance company will combine like risks and estimate an amount of loss based upon the premiums they can charge for the insurance policy. They are able to predict based upon historic data the amount of loss they expect.
Risk Analysis and Qualification
A surety bond is a means of extending the surety companies credit on behalf of the contractor for the benefit of a third party. In the underwriting process, the applicant will be evaluated on the following:
- Personal Credit
- Business Credit
- Personal Financial Statements
- Business Financial Statements
- Banking Relationships
- Resumes of owners and key operating personnel
- Past and present project references
- Supplier references
- Evaluation of their current work on hand
- Evaluation of the underlying contract and its terms
- Evaluation of the required bond forms
It is the underwriter’s responsibility to establish the Character, Capitol and Capacity of the applicant off the submitted information in order to see if it fits within the surety company’s appetite.
Types of Surety Bonds in Construction
There are several types of Contract Surety Bond available to guarantee contractual obligations, the three primary types are:
- Bid Bonds – Often required to guarantee that the contractor will honor the contract in accordance with his bid, and to provide the required performance and payment bonds required in the contract.
- Performance Bonds – Provides protection to the owner from financial loss due to the failure or default of the contractor to perform in accordance with the terms and conditions of the underlying contract.
- Payment Bonds – Provides protection to the owner from financial loss due to the failure of the contractor to pay all subcontractors, laborers and or material suppliers who have worked on or provided material for the project. Also known as Labor and Material Bonds
Other types of construction related bonds:
- Maintenance Bonds – Guarantee against defective workmanship or materials, however they will sometimes incorporate an obligation guaranteeing “efficient or successful operation” or other obligations of like intent and purpose.
- Supply Bonds – Provides protection to the owner/general contractor for materials and/or supplies that do not become part of the project until after the delivery is completed and thus the contract is completed.
- Subdivision Bonds – A performance guarantee for that provide assurances that the developer will complete and install the required project improvements.. Also known as Off Site Improvement Bonds, On Site Improvement Bonds, Completion Bonds, and Site Improvement Bonds.
- Sub-Contractor Performance & Payment Bonds – These are similar to standard Performance & Payment Bonds, however they are provided by the sub-contractor to the general contractor and thus the project owner
- Commercial Contract Surety Bonds – For projects that are not typical “construction related”, such as software contracts or installation only contracts
- Contractor's license bonds – Required by city, county, state or other municipality to guarantee the contractor will comply with the laws of the requiring entity.
The Benefits of Surety Bonds far outweigh the cost.
For a nominal fee, typically ½%-3% of the overall contract price, the owner and/or general contractor can safeguard themselves from financial loss by utilizing or requiring a surety bond of all parties that are contracted.
- Bonds provide Financial Security in the event of a default or error on behalf of the contractor.
- Bonds provide assurance that the project will be completed in accordance with the terms of the contract
- Surety Pre-qualifies the contractor based on their financial strength, creditworthiness, capacity to perform, ability to perform as well as their character or their historic performance.
- Mechanics Liens are relatively non-existent on projects that have a payment bond, due to the fact that the suppliers/laborers can simply file a claim on the bond if they are not paid.
- The effect of a default by the contractor is mitigated by the fact that the surety company will complete the project or otherwise fulfill the contract in the event of a default.
- Historically speaking, contractors that are bonded are more likely to complete a bonded project than a non-bonded project. This may be for moral reasons or due to the indemnity agreement that is provided to the surety company when the bond is executed.
Alternative security methods have been used in construction contracts to attempt to protect the owner from financial loss due to the failure of the contractor, however no single method can provide the protection afforded by surety bonds. History has shown the viability of surety as a means of minimizing/eliminating the typical risks associated with construction projects. Surety Bonds provide unmatched Financial Security and Construction Assurance.
Whether you are a contractor or a project owner, call A1SuretyBonds.com today and let one of our seasoned underwriters help you establish a surety line of credit or explain how bonds can protect your interests.