Construction Bonding: What You Need to Know
If you work as a contractor, it’s essential that you know how construction bonding work. The more you know, the better you’ll be positioned to land big jobs that require construction bonds as part of the process.
Why they exist
Construction bonds are used to manage risk on large construction projects and government/public sector projects. They are required by investors in order to protect themselves. Specifically, bonds protect investors against disruptions or financial loss due to a contractor’s failure to complete the project or to meet contract specifications.
There is risk associated with any construction project. Large construction projects involve significant financial investment. Successful completion of a project requires the orchestration of many elements: technical design, materials, construction practices, many suppliers and complicated operations. Logistically, it’s complicated.
The operational risks that come with these types of projects are compounded by a complex commercial component involving multiple contracts and payment processes. So, it’s not surprising that mistakes are made and disputes arise. The resulting claims can have a devastating effect on the project and the businesses involved.
What they are not
There is an important distinction to be made between bonds and insurance. Bonds are different than insurance and need to be purchased separately.
Bonds are similar, however, to insurance in the sense that they provide financial protection—primarily for a project’s owner—in the event of particular types of non-performance.
How they work
When a contractor vies for a large construction job, he or she is usually required to put up a construction bond. The construction bond provides assurance to the project owner that the contractor will perform according to the terms stated in the agreement.
On bigger projects, construction bonds may come in two parts: the first protects against overall job incompletion and the second part protects against non-payment of materials from suppliers and labour from subcontractors.
There are usually three parties involved in a construction bond—the investor/project owners, the party or parties building the project, and the surety company that backs the bond.
- The project owner or investor, also known as the obligee, is typically a government agency that lists a contractual job that it wants to be done. To reduce the likelihood of a financial loss, the obligee requires that all contractors put up a bond. The contractor selected for the job is typically the one with the lowest bid price.
- The principal, or the party managing the construction work, is stating that he or she can complete the job according to the contractual policy. The principal provides assurance to the obligee that not only does he or she have the financial means to manage the project but that the construction will be carried out to the highest quality specified.
- The contractor purchases a construction bond from a surety which runs extensive background and financial checks on them. If everything checks out, the surety will issue the contractor a construction bond.
Types of Bonds
The three most common forms of bonds on a construction project are bid bonds, performance bonds, and labour and material bonds.
Bid bond
Typically, a bid bond is a condition of the procurement process. Project owners require this protect themselves during the procurement phase of the project.
A bid bond is a guarantee that you, the contractor, have the capacity to take on and implement the project after you’ve been chosen for the job. The bond is triggered if you do win a contract and cannot move ahead with the work for whatever reason. The surety that issued the bid bond would pay the difference in the price between your bid and the next highest bidder who ultimately enters into the contract.
The surety can then seek to recover this amount from the contractor who defaulted on his bid.
Performance Bond
A bid bond is replaced by a performance bond when a contractor accepts a bid and proceeds to work on the project. Performance bonds protect the owner during a project’s construction phase. The bond is triggered if the contractor fails to complete the work or is unable to deliver the project as per the contract. It also protects the owner from financial loss if the contractor’s work is not in accordance with the terms and conditions laid out in the agreed contract.
In most cases, a performance bond is triggered because the contractor becomes financially distressed or insolvent and is unable or unwilling to complete the project.
Important note: The performance bond is not to be confused with liability insurance. Liability insurance responds to a claim for improper or defective work. Performance bonds are designed to deal with unfinished work.
Payment bond
Project owners are responsible for securing payment bonds, also known as Labour and Material Payment Bonds (unlike bid and construction bonds which are secured by the contractor). L&M bonds are required and paid for by the project owner because it protects them from claims and builders liens, and facilitate the timely completion of the project.
A L&M bond protects workers, suppliers, and subcontractors from non-payment by the general contractor.
A claim is triggered if the general contractor does not pay a subcontractor or supplier. The subcontractor or supplier can make a claim directly against the surety that issued the L&M bond.
With all the moving parts in a large construction project, many things can go wrong. That’s why construction bonds are almost always a mandatory prerequisite of projects beyond a certain size and on almost all government and public works projects. Do you have the protection you need?
There are more details on construction bonding than we could possibly cover in this blog post. With his many years of experience in the construction field, Dave Laking is happy to discuss various construction bonds and answer any questions you might have. Give him a call at 613-932-0083 or e-mail him at info@leomartininsurance.com.
