Surety Bonds - What Contractors Need To Know
Surety Bonds have been around in one form or another for millennia. Some may view bonds as an
unnecessary business expense that materially cuts into profits. Other firms view bonds as a passport
of sorts that allows only qualified firms access to bid on projects they can complete. Construction
firms seeking significant public or private projects understand the fundamental necessity of bonds.
This article, provides insights to the some of the basics ofsuretyship, a deeper look into how surety
companies evaluate bonding candidates, bond costs, warning signs, defaults, federal regulations, and
state statutes affecting bond requirements for small projects, and the critical relationship dynamics
between a principal and the surety underwriter.
The short answer isSuretyshipis a form of credit wrapped in a financial guarantee. It is not insurance
in the traditional sense, hence the name Surety Bond. The purpose of the Surety Bond is to ensure
that the Principal will perform its obligations to theObligee, and in the event the Principal fails to
perform its obligations the Surety steps into the shoes of the Principal and provides the financial
indemnification to allow the performance of the obligation to be completed.
There are three parties to a Surety Bond,
Principal - The party that undertakes the obligation under the bond (Eg. General Contractor)
Obligee- The party receiving the benefit of the Surety Bond (Eg. The Project Owner)
Surety - The party that issues the Surety Bond guaranteeing the obligation covered under the bond
will be performed. (Eg. The underwriting insurance company)
How Do Surety Bonds Differ from Insurance?
Perhaps the most distinguishing characteristic between traditional insurance andsuretyshipis the
Principal's guarantee to the Surety. Under a traditional insurance policy, the policyholder pays a
premium and receives the benefit of indemnification for any claims covered by the insurance policy,
subject to its terms and policy limits. Except for circumstances that may involve advancement of
policy funds for claims that were later deemed to not be covered, there is no recourse from the
insurer to recoup its paid loss from the policyholder. That exemplifies a true risk transfer mechanism.
Loss estimation is another major distinction. Under traditional forms of insurance, complex
mathematical calculations are performed by actuaries to determine projected losses on a given type
of insurance being underwritten by an insurer. Insurance companies calculate the probability of risk
and loss payments across each class of business. They utilize their loss estimates to determine
appropriate premium rates to charge for each class of business they underwrite in order to ensure
there will be sufficient premium to cover the losses, pay for the insurer's expenses and also yield a
As strange as this will sound to non-insurance professionals, Surety companies underwrite risk
expectingzerolosses. The obvious question then is: Why am I paying a premium to the Surety? The
answer is: The premiums are in actuality fees charged for the ability to obtain the Surety's financial
guarantee, as required by theObligee, to ensure the project will be completed if the Principal fails to
meet its obligations. The Surety assumes the risk of recouping any payments it makes to
theObligeefrom the Principal's obligation to indemnify the Surety.
Under a Surety Bond, the Principal, such as a General Contractor, provides an indemnification
agreement to the Surety (insurer) that guarantees repayment to the Surety in the event the Surety
must pay under the Surety Bond. Because the Principal is always primarily liable under a Surety
Bond, this arrangement does not provide true financial risk transfer protection for the Principal even
though they are the party paying the bond premium to the Surety. Because the
Principalindemnifiesthe Surety, the payments made by the Surety are in actually only an extension of
credit that is required to be repaid by the Principal. Therefore, the Principal has a vested economic
interest in how a claim is resolved.
Another distinction is the actual form of the Surety Bond. Traditional insurance contracts are created
by the insurance company, and with some exceptions for modifying policy endorsements, insurance
policies are generally non-negotiable. Insurance policies are considered "contracts of adhesion" and
because their terms are essentially non-negotiable, any reasonable ambiguity is typically construed
against the insurer. Surety Bonds, on the other hand, contain terms required by theObligee, and can
be subject to some negotiation between the three parties.
Personal Indemnification & Collateral
As discussed earlier, a fundamental component of surety is the indemnification running from the
Principal for the benefit of the Surety. This requirement is also known as personal guarantee. It is
required from privately held companyprincipalsand their spouses because of the typical joint
ownership of their personal assets. The Principal's personal assets are often required by the Surety to
be pledged as collateral in the event a Surety is unable to obtain voluntary repayment of loss caused
by the Principal's failure to meet their contractual obligations. This personal guarantee
andcollateralization, albeit potentially stressful, creates a compelling incentive for the Principal to
complete their obligations under the bond.
Types of Surety Bonds
Surety bonds come in several variations. For the purposes of this discussion we will concentrate upon
the three types of bonds most commonly associated with the construction industry: Bid Bonds,
Performance Bonds and Payment Bonds.
The "penal sum" is the maximum limit of the Surety's economic exposure to the bond, and in the case
of a Performance Bond, it typically equals the contract amount. The penal sum may increase as the
face amount of the construction contract increases. The penal sum of the Bid Bond is a percentage of
the contract bid amount. The penal sum of the Payment Bond is reflective of the costs associated
with supplies and amounts expected to be paid to sub-contractors.
Bid Bonds - Provide assurance to the project owner that the contractor has submitted the bid in good
faith, with the intent to perform the contract at the bid price bid, and has the ability to obtain required
Performance Bonds. It provides economic downside assurance to the project owner (Obligee) in the
event a contractor is awarded a project and refuses to proceed, the project owner would be forced to
accept the next highest bid. The defaulting contractor would forfeit up to their maximum bid bond
amount (a percentage of the bid amount) to cover the cost difference to the project owner.
Performance Bonds - Provide economic protection from the Surety to theObligee(project owner)in the
event the Principal (contractor) is unable or otherwise fails to perform their obligations under the
Payment Bonds - Avoids the potential for project delays and mechanics' liens by providing
theObligeewith assurance that material suppliers and sub-contractors will be paid by the Surety in the
event the Principal defaults on his payment obligations to those third parties.
How Are Surety Bonds Underwritten?
Surety underwriters have a complex and continuing responsibility of assessing Principals seeking a
bond. Companies that rely upon bonding to win projects fully understand the importance of
establishing a maintaining a strong relationship with their Surety companies. Surety underwriters are
required to place the Principal through a rigorous underwriting process prior to issuing a bond, and
will continue to monitor the progress of the Principal's projects in order to identify any warning signs of
potential default. The information required from firms seeking a surety bond is perhaps the most
detailed of any "insurance" application process. Companies that will require bonds are well advised to
maintain a current portfolio of the required documents in order to facilitate and expedite the
The underwriting Questionnaire or application form the Principal completes is supplemented by the
following information required by underwriters:
• Most recent annual audited financial statement,
• Year-to date unaudited financial statement, including cash flow,
• Last three years' audited financial statements,
• List of bank credit lines and other forms of credit relationships,
• Bank or lender's letter of reference,
• An inventory of all work-in progress,
• Accounting and cost controls,
• Personal (unaudited) current financial statements of the individual Principals
• Proposed Project information, plans, etc..
• Summary of all prior experience with similar projects,
• Labor required for the project, quality of sub-contractors,
• Equipment required for the project,
• Project Management Plan,
• Summary of all past and pending bonded and non-bonded projects,
• Summary of potential future projects,
• Continuity Plan,
• Resume of individual Principals
Reputation & Relationships:
• Lending institutions,
• Project Owners,
Cost of Surety Bonds
Every Surety company's rates differ, however there are general rules of thumb:
Bid Bonds are typically provided at either a nominal cost or on a complementary basis as the Surety
is seeking to underwrite the Performance Bond should the contractor be awarded the project.
Performance Bond premium or fees can range anywhere from 0.5% of the contract's final amount to
2.0% or greater. The two main factors affecting pricing are the amount of the bond as higher amounts
usually have lower rates, and the quality of the risk. For example, a performance bond in the amount
of $250,000 might carry a 2.5% rate translating to a fee of $ 6,250 versus a $30 million bond at a rate
of 0.75% which would cost $225,000.
Even experienced contractors sometimes operate under the misconception that bond costs are fixed
at the time of their issuance. In fact, a bond premium or fee will often adjust with the final value of the
contract. The final value is typically, but not exclusively, greater than the initial contract amount as a
result of work change orders during the construction process. It is important for contractors to realize
the potential for a negative surprise represented as an increased cost of their bonds. This realization
should initially occur during the bid preparation process, and whenever possible, during the contract
negotiation process contractors should explore the feasibility of addressing any incremental increase
in bond cost that will result from increased contract values due to change orderseffectuatedby the
A Surety's main purpose is to screen out those contractors that may be well-intentioned, but simply
not completely qualified in all aspects of their business to take on certain projects. Surety
underwriters are always on the lookout for warning signs both prior to issuing the bond and after its
Factors That Concern Bond Underwriters include:
• Poor project management and accounting systems
• Excessively rapid expansion
• Key Management changes
• Material change in historical business focus
• Quality issues with sub-contractors
• Shortage of labor and/or supplies
• Cost overruns
• Failure to require sub-contractors to secure their own surety bonds
• Unreasonable project contract terms
• Catastrophic weather related delays
• Adverse macro-economic conditions
What Happens in the Event of a Contractor's Default?
Upon notification, and if after conducting a thorough investigation, and the Surety determines the
Principal has defaulted, it may:
• Provide the defaulting contractor with additional resources or economic assistance to complete the
• Select a replacement contractor to complete the project, or,
• Arrange for a re-bidding process to complete the project,
• Pay theObligee(project owner) the "penal sum" of the Performance Bond
The Surety is required by law to conduct a diligent investigation of a potential default so as not to
prematurely or improperly declare a contractor in default. Once the Surety has paid a loss under the
bond, they will seek reimbursement from the Principal including exercising the Surety's rights over
letters of credit,escrows, or personal assets that havecollateralizedthe bond.
Regulations & Statutes
The Miller Act
The Miller Act enacted by Congress in 1935, replaced the Heard Act of 1894, and applies to federal
government construction projects with a contract amount in excess of $100,000. This law provides
the exclusive remedy for labor and materials providers who have not received payment in full within
ninety days from the date of the aggrieved sub-contractor or supplier's last service. The Payment
Bond covers first tier sub-contractors and suppliers and second-tier contractors. First tier sub-
contractors may bring claims in the form of litigation directly under the Payment Bond, while second
tier subcontractors must formally notify the prime contractor of their intent to bring a claim within
ninety days of their last unpaid service or supply of materials.
A claim for any unpaid balance is achieved by filing a lawsuit, between ninety days and one year from
the date of the last service was provided. The lawsuit must be brought in the name of the United
States for the benefit of the party bringing the action. The suit is filed in federal court in the jurisdiction
where the contract was performed.
Construction Industry Payment Protection Act of 1999
This federal law became effective August 1999, amending the Miller Act in several ways, including
substituting the following provision for the mathematical formula that originally capped the maximum
bond amount to $2.5 million notwithstanding the size of the project:
The amount of the payment bond shall be equal to the total amount payable by the terms of the
contract unless the contracting officer awarding the contract makes a written determination supported
by specific findings that a payment bond in that amount is impractical, in which case the amount of
the payment bond shall be set by the contracting officer. In no case shall the amount of the payment
bond be less than the amount of the performance bond.
The Federal Acquisition Regulation ("FAR")
Found at Title 48 of the U.S. Code of Federal Regulations, FAR regulates the federal government's
processes for procurement of goods and services. Part 28 of the FAR entitled Bonds and Insurance
sets forth the related specifications. Below are some relevant excerpts of Section 28 of the FAR that
detail the requirements for construction contract payment protections:
Performance and payment bonds and alternative payment protections for construction contracts.
(a) The Miller Act requires performance and payment bonds for any construction contract exceeding
$100,000, except that this requirement may be waived-
(1) By the contracting officer for as much of the work as is to be performed in a foreign country upon
finding that it is impracticable for the contractor to furnish such bond; or
(2) As otherwise authorized by the Miller Act or other law.
(b)(1) Pursuant to U.S.C. 3132, for construction contracts greater than $30,000, but not greater than
$100,000, the contracting officer shall select two or more of the following payment protections, giving
particular consideration to inclusion of an irrevocable letter of credit as one of the selected
(i) A payment bond.
(ii) An irrevocable letter of credit (ILC).
(iii) A tripartite escrow agreement. The prime contractor establishes an escrow account in a federally
insured financial institution and enters into a tripartite escrow agreement with the financial institution,
as escrow agent, and all of the suppliers of labor and material. The escrow agreement shall establish
the terms of payment under the contract and of resolution of disputes among the parties. The
Government makes payments to the contractor's escrow account, and the escrow agent distributes
the payments in accordance with the agreement, or triggers the disputes resolution procedures if
(iv) Certificates of deposit. The contractor deposits certificates of deposit from a federally insured
financial institution with the contracting officer, in an acceptable form, executable by the contracting
(v) A deposit of the types of security listed in 28.204-1 and 28.204-2.
(2) The contractor shall submit to the Government one of the payment protections selected by the
(c) The contractor shall furnish all bonds or alternative payment protection, including any necessary
reinsurance agreements, before receiving a notice to proceed with the work or being allowed to start
28.102-2 Amount required.
(a) Definition. As used in this subsection-
"Original contract price" means the award price of the contract; or, for requirements contracts, the
price payable for the estimated total quantity; or, for indefinite-quantity contracts, the price payable for
the specified minimum quantity. Original contract price does not include the price of any options,
except those options exercised at the time of contract award.
(b) Contracts exceeding $100,000 (Miller Act)-
(1) Performance bonds. Unless the contracting officer determines that a lesser amount is adequate
for the protection of the Government, the penal amount of performance bonds must equal-
(i) 100 percent of the original contract price; and
(ii) If the contract price increases, an additional amount equal to 100 percent of the increase.
(2) Payment bonds.
(i) Unless the contracting officer makes a written determination supported by specific findings that a
payment bond in this amount is impractical, the amount of the payment bond must equal-
(A) 100 percent of the original contract price; and
(B) If the contract price increases, an additional amount equal to 100 percent of the increase.
(ii) The amount of the payment bond must be no less than the amount of the performance bond.
(c) Contracts exceeding $30,000 but not exceeding $100,000. Unless the contracting officer
determines that a lesser amount is adequate for the protection of the Government, the penal amount
of the payment bond or the amount of alternative payment protection must equal-
(1) 100 percent of the original contract price; and
(2) If the contract price increases, an additional amount equal to 100 percent of the increase.
(d) Securing additional payment protection. If the contract price increases, the Government must
secure any needed additional protection by directing the contractor to-
(1) Increase the penal sum of the existing bond;
(2) Obtain an additional bond; or
(3) Furnish additional alternative payment protection.
(e) Reducing amounts. The contracting officer may reduce the amount of security to support a bond,
subject to the conditions of 28.203-5(c) or 28.204(b).
In 2004, Congress enacted a provision requiring inflation-based readjustment of the acquisition
related threshold requirements every five years. The last adjustment was in 2007, which increased
the minimum bond requirement threshold for federal projects from $25,000 to $30,000.
"Little Miller Acts"
Every state, the District of Columbia and Puerto Rico passed statutes governing surety Performance
and Payment Bond requirements for state government construction projects. These statutes contain
provisions specifying the threshold contract amount under which Surety Bonds are not required.
Below we provide relevant excerpts of the Little Miller Acts enacted in New York, New Jersey and
New York Little Miller Act:
New York Consolidated Laws, State Finance Law, Article 9, Contracts, Section 137 states in part:
Provided, however, that all performance bonds and payment bonds may, at the discretion of the head
of the state agency, public benefit corporation or commission, or his or her designee, be dispensed
with for the completion of a work specified in a contract for the prosecution of a public improvement
for the state of New York for which bids are solicited where the aggregate amount of the contract is
under one hundred thousand dollars and provided further, that in a case where the contract is not
subject to the multiple contract award requirements of section one hundred thirty-five of this article,
such requirements may be dispensed with where the head of the state agency, public benefit
corporation or commission finds it to be in the public interest and where the aggregate amount of the
contract awarded or to be awarded is less than two hundred thousand dollars.
New Jersey Little Miller Act:
New Jersey Revised Statutes, Title2A, Administration of Civil and Criminal Justice, Chapter 44,
Sections2A:44-143 through2A:44-148 states in part:
(2) When such contract is to be performed at the expense of the State and is entered into by the
Director of the Division of Building and Construction or State departments designated by the Director
of the Division of Building and Construction, the director or the State departments may: (a) establish
for that contract the amount of the bond at any percentage, not exceeding 100%, of the amount bid,
based upon the director's or department's assessment of the risk presented to the State by the type
of contract, and other relevant factors, and (b) waive the bond requirement of this section entirely if
the contract is for a sum not exceeding $200,000. (3) When such a contract is to be performed at the
expense of a contracting unit or school district, the board, officer or agent contracting on behalf of the
contracting unit or school district may: (a) establish for that contract the amount of the bond at any
percentage, not exceeding 100%, of the amount bid, based upon the board's, officer's or agent's
assessment of the risk presented to the contracting unit or school district by the type of contract and
other relevant factors, and (b) waive the bond requirement of this section entirely if the contract is for
a sum not exceeding $100,000.
Connecticut Little Miller Act:
Connecticut General Statutes, Title 49, Mortgages and Liens, Chapter 847, Liens, Sections 49-41
through 49-43staesin part:
Sec. 49-41. Public buildings and public works. Bonds for protection of employees andmaterialmen.
Performance bonds. Limits on use of owner-controlled insurance programs. (a) Each contract
exceeding one hundred thousand dollars in amount for the construction, alteration or repair of any
public building or public work of the state or a municipality shall include a provision that the person to
perform the contract shall furnish to the state or municipality on or before the award date, a bond in
the amount of the contract which shall be binding upon the award of the contract to that person, with
a surety or sureties satisfactory to the officer awarding the contract, for the protection of persons
supplying labor or materials in the prosecution of the work provided for in the contract for the use of
each such person, provided no such bond shall be required to be furnished (1) in relation to any
general bid in which the total estimated cost of labor and materials under the contract with respect to
which such general bid is submitted is less than fifty thousand dollars, (2) in relation to any sub-bid in
which the total estimated cost of labor and materials under the contract with respect to which such
sub-bid is submitted is less than fifty thousand dollars, or (3) in relation to any general bid or sub-bid
submitted by a consultant, as defined in section4b-55. Any such bond furnished shall have as
principal the name of the person awarded the contract.
(b) Nothing in this section or sections49-41ato 49-43, inclusive, shall be construed to limit the
authority of any contracting officer to require a performance bond or other security in addition to the
bond referred to in subsection (a) of this section, except that no such officer shall require a
performance bond in relation to any general bid in which the total estimated cost of labor and
materials under the contract with respect to which such general bid is submitted is less than twenty-
five thousand dollars or in relation to any sub-bid in which the total estimated cost of labor and
materials under the contract with respect to which such sub-bid is submitted is less than fifty
The Critical Importance of a Strong Principal - Surety Relationship
A surety underwriter is responsible for evaluating the Principal's overall capability to profitably
complete a project based upon: their financial condition, their historical performance, their current
workload-in progress, their ability to manage, and their reputation with other stakeholders.
Differences of opinion arise periodically between the Principal and the Surety over its willingness to
provide bonding capacity. Principals view this as an indirect undermining of their ability to conduct
business. Underwriters view their decision as being in the interest of the Principal because by
withholding the bonding capacity, an underwriter may be preventing a Principal from jeopardizing
their personal assets. When these situations arise, the insurance broker should be particularly
attentive to the underwriter's concerns, and work with the Principal to provide any additional
information that may alleviate or ameliorate the underwriter's concerns.
Building a sound surety relationship requires continuing diligence, candor, and active dialogue
between the Principal and Surety. Perhaps the best way to build the trust that is so important to the
relationship is through providing agreed upon scheduled job status reports of work-in-progress,
including the profit and loss statements of each bonded (and non-bonded) project, the owner's
payment activity, unapproved change orders, and the firm's periodic financial statements. A proactive
insurance broker will arrange an annual in-person meeting upon completion of the audited financials.
The participantswould includesthe Principal, Surety, the Principal's CFO and possibly the external
auditor. This meeting affords an opportunity to further build upon the "paper relationship" and is a
venue for candidly discussing potential issues and future prospects.
Although it may seem counterintuitive, Principals that apprise a Surety of potential issues also create
a high level of trust. Proactively providing required information sends a strong signal to the Surety
about the Principal's business character and management, also providing the Surety with the firm's
business plans for the upcoming twelve to twenty-four month period will serve to gain the
underwriter's trust and flexibility when those situations arise that may require the underwriter to
demonstrate some additional flexibility in order for the Principal to realize their business objectives.
Surety companies can provide valuable resources to Principals to assist them in overcoming
temporary business challenges before a default occurs. These resources include: construction
attorneys, engineers and accountants.
The U.S. Department of the Treasury publishes a list of approved sureties. TheTreasury Listis located
Highly effective construction companies have mastered the art and science of managing successful
surety relationships. Engaging an experienced insurance professional who can work effectively with
both internal and external financial and operational personnel to manage the process of securing
bonds in a timely manner is a critical component to maintain access to stable surety lines.
Connecticut Contractors Insurance Forms