About surety bonds
What are surety bonds?
A surety bond is an agreement in which the endorser (usually an insurance company) guarantees the obligee (usually the client) that the principal (the contractor) will perform the work and fulfill all of its contractual obligations.
As such, a surety bond is more a financial tool than an insurance product. Unlike insurance contracts, surety bonds always involve three parties: the endorser, the obligee and the principal.
What is the origin of surety bonds?
The use of surety bonds became widespread in 1935 when the Miller Act required the U.S. government to obtain guarantees for all public works construction contracts worth more than $2,000. This requirement was later adopted by other American states and municipalities. A similar situation exists in Canada. Consequently, the majority of public sector clients require that construction contracts be bonded.
In the public sector, surety bonds are mainly required to ensure prudent management of the public funds used to finance construction projects.
The use of surety bonds is not as widespread in the private sector as in the public sector. However, private sector clients are realizing that a surety bond can be a useful tool for managing risks inherent to construction. As such it represents an important benefit for a very reasonable cost. Furthermore, lenders involved in construction projects are more likely to require their clients to obtain a surety bond.
What are the advantages of surety bonds for contractors?
Bonded contractors have greater flexibility to negotiate more advantageous prices and credit terms with subcontractors and suppliers since payment is guaranteed.
As opposed to other guarantees such as certified cheques or a bank's letter of credit, surety bonds allow contractors to adjust tender prices up to the last minute. They can be used as a development tool enabling access to sectors of the market that are usually reserved.
The qualification and certification process contractors go through in order to obtain a surety bond may facilitate their access to an operating line of credit from the bank.
What are the advantages of surety bonds for clients?
Essentially, the surety bonds used by the construction sector provide assurance to clients that the lowest compliant bidder will perform the work for the quoted price and that the work will be completed and the suppliers paid, regardless of any financial difficulties that the contractor may have.
Surety bonds also facilitate the client's negotiations with a lender, since the "construction cost" portion of a project feasibility study is guaranteed by the bonding company in the event of the contractor's inability to absorb any unforeseen cost overruns. In these situations, it is reassuring for the lender to know that any legal hypothecs registered on the building under construction by unpaid suppliers will be settled by the bonding company, thereby protecting the lender's hypothec guarantee received for granting the loan.
What are the advantages of surety bonds over certified cheques?
The personal guarantees required by the insurance company that issues the bond are the same as those required by your financial institution. The bonding service fees are approximately the same as those for a certified cheque.
What are surety bond risk factors?
The fundamental reason for the use of surety bonds in the construction sector is the risky nature of this industry. There are many reasons why construction contractors can experience problems leading to insolvency, rendering them incapable of fulfilling contractual commitments. It's important to realize that the majority of construction companies are small- or medium-sized businesses that are vulnerable to the many risk factors inherent to the construction industry.