When selecting a contractor for a job, it is important to choose the most fiscally responsible one for the construction project in order to mitigate and manage risk and ensure its timely completion.
Failing to do so puts your company at risk of economic devastation as you are gambling on a contractor or subcontractor whose level of commitment is uncertain or who could become bankrupt part way into the job. However, there is a solution to decrease your risk, says Jack Gaugler, vice president, surety bond specialist, at SeibertKeck Insurance Agency Inc. and the Jack Kohl Agency.
“Surety bonds offer an optimal solution. By providing financial security and construction assurance, they guarantee project owners that contractors are capable of performing the contract and paying specified subcontractors, laborers and material suppliers,” says Gaugler.
Smart Business spoke with Gaugler about how surety bonds can help protect you from a devastating loss.
What is a surety bond?
A surety bond is a three-party agreement in which a surety company assures the obligee (the owner) that the principal (the contractor) will complete a contract as promised.
There are three primary types of contract surety bonds: a bid bond, a performance bond and a payment bond.
A bid bond assures that a bid has been submitted in good faith, that the contractor intends to enter into the contract at the price bid and will provide the required performance and payment bond if awarded the contract. A performance bond protects a company from financial loss in the event that the contractor fails to perform in accordance with the terms and conditions of the contract. A payment bond assures that a contractor will provide certain workers, subcontractors and material suppliers and guarantees they will be paid for work performed under the contract.
Even if a contractor has been in business for 100 years and has a good reputation, past performance is no guarantee of future results. Risk lies in the uncontrollable, unpredictable and the unknown and it is never a good idea to gamble on something that could jeopardize your company’s future. The relationship that an owner has with a contractor is arm’s length, while the surety agent and bond company relationship is a day-to-day partner. A surety has a much greater insight as to contractor’s abilities to perform than an owner.
How is a contractor prequalified?
Surety companies back the performance bonds with their own assets, so they conduct a careful, rigorous prequalification review of the contractor. The goal for the contractor is to get a bond line set up. The bond underwriter’s analyses look at criteria including financial strength, annual and interim financial statements, investment strategies, cost control mechanisms, work in progress (both bonded and nonbonded), cash flow, net worth, working capital and bank and other credit relationships. The underwriter will also look at ability to perform, prior experience on similar projects, equipment and personnel — including strength of management and its structure, past and current workloads and a continuity plan. Finally, it will consider the contractor’s reputation with project owners, subcontractors, suppliers and lenders.
Weakness in any of these areas can cause a contractor to fail. Evaluating each of these areas allows the underwriter to become comfortable guaranteeing that a contractor will be able to complete the job as promised.
Who requires contract surety bonds?
Congress passed a law more than 100 years ago to protect taxpayers from contractor failure by guaranteeing payment from the primary contractor to subcontractors and suppliers. An update to this law, called the Miller Act of 1935, is the current federal law that mandates surety bonds on federal public work projects valued at $100,000 or more. The act removes the risk from the subcontractors involved in the project and places it on the surety company that issues the bond.
State and local governments also require these bonds on public construction projects and each state has its own ‘Little Miller Acts.’
Surety bonds for private projects, while not required by law, are highly recommended. Every major project that could potentially cripple an individual company or a financial institution should require a bid and performance bond for protection. The cost of the performance bond ranges from 0.5 percent to 3 percent of the total contract amount. There is no other risk transfer mechanism that guarantees a construction contract will be completed.
When compared with the cost of contractor failures, surety bonds are a low-cost investment, considering the protection that is provided by them. Thousands of contractors, whether they have been in business for two years or 100, whether they are large or small, fail each year, leaving behind unfinished construction projects with billions of dollars in losses to project owners.
What happens if a claim is made on a surety bond?
The surety company will first investigate the alleged contractor default by working with the principal to make a decision on whether it must perform under the terms of the bond.
Once it has determined default of a contractor under the performance bond, it could conduct a takeover in which it will hire a completion contractor. It could also perform a tender, where a new contractor will be provided to the obligee (owner).
Other options include retaining the original contractor and providing technical and/or financial assistance, or the surety could reimburse the owner by paying the penal sum of the bond.
Without the protection of a surety bond, none of these actions would be possible. To minimize your risk when dealing with contractors, seek the advice of an expert to help maximize your protection.
Jack Gaugler is vice president, surety bond specialist, at SeibertKeck Insurance Agency Inc. and the Jack Kohl Agency. Reach him at (330) 294-1352 or [email protected]
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