Surety bonds

Insurance protects against accidents. A surety bond protects against a different risk: that the contractor will not do what it promised. If a contractor abandons a job, becomes insolvent or fails to pay its subcontractors and suppliers, a surety bond puts a financially strong third party, the surety, behind the contractor's promise. Public owners in both countries require bonds on most construction contracts, and many private owners do too. CON-320 lesson 11 explains how sureties assess a contractor's finances and set bonding capacity. This lesson explains what the bonds are, what they guarantee, how they are priced and how standard forms differ between Canada and the United States. Lesson 10 covers subcontractor default, subcontractor default insurance and how claims on bonds work.

How suretyship differs from insurance

A surety bond involves three parties. The principal is the contractor whose performance is guaranteed. The obligee is the party protected, usually the owner. The surety is the insurer or bonding company that guarantees the principal's obligations up to the penal sum of the bond.

Although sureties are usually insurance companies or their subsidiaries, a bond is not insurance in the ordinary sense. An insurer expects some losses and prices premiums to pay for them across many policyholders. A surety expects no losses: it bonds only contractors it believes can perform, and if it does pay, it expects to recover from the contractor and its owners under a general indemnity agreement, often backed by personal guarantees. The premium is therefore closer to a fee for lending the surety's credit and for its prequalification work than to a payment for expected losses.

Types of bonds

The bid bond is often accompanied in Canada by a consent of surety or agreement to bond, in which the surety confirms it will issue the performance and payment bonds if the bidder wins. A contractor that cannot obtain a consent of surety cannot bid on bonded work, which is why bonding capacity limits how much public work a contractor can take on (CON-320 lesson 11).

Canadian practice

In Canada, performance and labour and material payment bonds are commonly set at 50 % of the contract price each, a practice that grew from the public sector and the industry's standard forms. The Canadian Construction Documents Committee publishes CCDC 220 (bid bond), CCDC 221 (performance bond) and CCDC 222 (labour and material payment bond), and most public owners use these or similar forms. The Surety Association of Canada represents the industry. Ontario's Construction Act made bonds mandatory on public contracts. Under section 85.1, a contractor on a public contract with a price of $500,000 or more must provide a performance bond and a labour and material payment bond, each covering at least 50 % of the contract price, in the forms prescribed by regulation; on P3 and alternative financing and procurement projects the required amount is capped at $50 million. The requirement applies to procurements that began on or after 1 July 2018. Other provinces rely mainly on owner policy, and federal departments set contract security requirements in their tender documents, often offering a choice between bonds and a security deposit.

Because the Canadian labour and material payment bond benefits subcontractors and suppliers who are not parties to it, the bond names the owner as obligee in trust for claimants, and claimants must give written notice within strict time limits, typically 120 days after their last work or supply, and sue within a further period, often one year. Lesson 10 covers the claims process.

Standard bond forms

The wording of the performance bond matters a great deal when a contractor defaults. Some forms require the owner to declare the contractor in default and terminate the contract before the surety must act, and they give the surety a list of options. Others are more demanding of the surety. Owners who write their own bond forms often impose short response times and waive defences, which can make sureties reluctant to bond the project or raise the price. Lesson 10 discusses the surety's options on default.

Pricing bonds

Bond premiums are usually charged on a sliding scale based on the contract price, with a lower rate for larger amounts. Rates depend on the contractor's financial strength, experience and record, and on the type of work. For strong contractors, performance and payment bonds together often cost somewhere around 0.5 to 1.5 % of the contract price, less on very large contracts; weaker or newer contractors pay more. In Canada, where bonds are 50 % rather than 100 %, the premium is still usually calculated on the contract price, not the penal sum. Bid bonds are often provided at no charge to established clients as part of the bonding relationship.

# Bond premium on a sliding scale (illustrative rates, on the contract price)
def premium(price, scale):
    total, lower = 0.0, 0
    for upper, rate in scale:
        band = min(price, upper) - lower
        if band <= 0:
            break
        total += band * rate
        lower = upper
    return total

scale = [(500_000, 0.0150), (2_500_000, 0.0100), (5_000_000, 0.0075),
         (7_500_000, 0.0070), (float("inf"), 0.0060)]
for price in (1_000_000, 10_000_000, 48_000_000):
    p = premium(price, scale)
    print(f"Contract {price:>12,.0f}: premium {p:>9,.0f} ({p / price:.2%})")

Contract    1,000,000: premium    12,500 (1.25%)
Contract   10,000,000: premium    78,750 (0.79%)
Contract   48,000,000: premium   306,750 (0.64%)

The effective rate falls as the contract grows: the illustrative scale gives about 1.25 % on a $1 million contract and about 0.65 % on the $48 million Kingfisher Wharf contract. Contractors include the bond cost in their bid, usually as a general requirement or as part of markup (CON-300). Change orders that increase the contract price also increase the penal sum and the premium, so the cost of bonds should be included in change order pricing.

What bonds do and do not cover

A performance bond guarantees completion of the contract, up to the penal sum, if the contractor defaults. It does not guarantee that the project will be on time if the contractor is merely slow, does not cover the owner's own breaches, and usually does not cover delays or defects that the owner could have avoided by acting promptly. A payment bond protects those who supplied labour and materials to the project, within the claimant definitions of the bond: usually subcontractors and suppliers to the contractor, and often sub-subcontractors, but not remote suppliers further down the chain. Neither bond protects against a contractor's poor workmanship that falls short of default, which is addressed through the contract and warranty.

For owners, bonds have value beyond the money. The surety's prequalification of the contractor screens out firms that are overextended or financially weak, which is one reason public owners require bonds even on contracts where they could recover losses in other ways. For subcontractors and suppliers, especially on public work where liens may be unavailable against public land in some jurisdictions, the payment bond is often the only reliable security for payment.

Alternatives to bonds

Bonds are not the only way to secure a contractor's performance. Owners sometimes accept an irrevocable standby letter of credit from the contractor's bank, a cash security deposit, a parent company guarantee or, on private work, increased holdback or retainage. Each has different strengths. A letter of credit pays on demand without the investigation a surety carries out, which owners like, but it uses the contractor's bank credit line and reduces its working capital, which contractors dislike. A parent company guarantee is only as good as the parent's balance sheet. Holdback or retainage protects the owner and the payment chain but ties up the contractor's cash (CON-310 lesson 11 and CON-320 lesson 10).

Federal contracts in both countries allow some of these alternatives, and private owners choose among them according to the size of the project and the contractor's financial strength. For a contractor, the cost of each option should be compared not only in fees but in the working capital and borrowing capacity it consumes, because the same capacity is needed to pursue the next project.