What Are Construction Bonds? A Complete Guide

The school board was excited to move forward with the new elementary school, but time was of the essence. The building needed to be open in two years, when the huge subdivision on the west side of town would start to sprout homes. When the bids were open, the low bidder was a general contractor nobody recognized. How could the board award a bid on a time-sensitive project to a company they didn’t know?

The answer is what’s known as a construction surety bond.

What Are Construction Bonds?

What is a construction bond? In simple terms, a surety bond is essentially a legal promise that you’ll accomplish what you say you’re going to in a way that meets the other party’s expectations. A construction bond assures the school board that if the contractor fails to live up to the terms of the contract in any way, and if that failure leads to added costs, all of the project’s bills will be paid.

How Do Construction Bonds Work?

Also known in some areas as contractor license bonds, construction bonds assure the project owner that the contractor will do everything called for in the agreement -- from materials that will be used, to labor standards, to the quality of contraction, to that all-important completion date.

Construction Bonds Basics

Construction bonds most often come into play with public works and other government projects. In most states, such projects are awarded through a bidding process in which the bidder who meets all the requirements (what’s often called the “most responsive” bidder) at the lowest price is selected.

One of the requirements of the typical bidding process is for the contractor to obtain a construction bond. In this case, that bond assures the school board that they’ll be financially reimbursed if the contractor doesn’t complete the project, provides poor-quality work that must be replaced, or fails to pay for materials or its subcontractors’ wages.

How Do Construction Bonds Function?

When you submit a construction bond with your bid, you’re making a legal commitment to complete the requirements of the contract. The surety -- an insurance company -- will look into your company, its finances, and your experience to verify you’re capable of meeting the project’s requirements. If they’re comfortable, they’ll issue the bid bond.

In a way, a construction bond provides an incentive for the contractor to perform high-quality work in a timely fashion. Insurance companies will provide a limited amount of construction bonds to any one contractor (what’s known as “bonding capacity”). If a large part of the contractor’s bonding capacity is tied up in disagreements about one large project, the contractor may not have adequate bonding capacity to bid on other projects.

Types of Construction Bonds

What do construction bonds cover? Insurance bond construction uses are broad, with many different specialized types. We’ll examine the most common.

Surety Bond

“Surety bond” is the descriptive term for all of the types of bonds that follow, just as “insurance” can refer to many different types of construction coverage.

Bid Bond

What is a bid bond in construction? It’s a special type of surety bond that’s used in competitive bidding, such as the public works and government projects mentioned earlier. As we noted, bid bonds give the project owners the confidence a contractor will be able to complete the project.

Performance Bond

What is a performance bond? Once the project owner (or general contractor) accepts a bid for a project, the bid bond will end and be replaced by a performance bond, which provides continued assurance for the project owner throughout the construction phase and handover of the finished project. If the contractor’s work proves to be defective based on what was specified in the contract, the bond allows the owner to recoup the cost of correcting the problem. For example, if the contract calls for six inches of concrete in a parking lot and the contractor only pours four inches, the bond will cover the cost of bringing the lot to the proper depth.

Payment Bond

What’s also referred to as a labor and material payment bond provides a guarantee that a construction company has the financial ability to pay suppliers, workers and any subcontractors on the project. It’s often required along with bid bonds and performance bonds. Is it possible to only get a payment bond instead of a performance bond? That may seem to be a simpler solution, but most project owners won’t settle for just a payment bond.

Maintenance Bond and Warranty Bond

Whether you call them maintenance bonds or warranty bonds, they serve the same purpose. These construction bond types deliver assurance that the finished project will remain free of defects and other problems for a set length of time. This type of bond is often required on public works projects such as new sewer lines, where the owner needs confidence in reliable operation. If a defect or other problem does develop within the bonding period and the contractor fails to make a suitable repair, the bond will cover the cost to restore proper operation.

Mechanics Lien Bond

A lien bond definition is a type of instrument protecting the owner if contractors file a mechanics lien on the project property, such as if there’s a payment dispute. The mechanics lien bond shifts the claim from the property to the bond itself. That can prevent major headaches if the building is sold in the future. An active mechanics lien can delay a sale.

Subdivision Bond

When working on a project in a legal subdivision such as a new housing development, owners and local governments want solid assurances that the contractor will meet agreed-upon standards. For example, a community may require a certain sidewalk width or easements. The government with jurisdiction will determine a bond amount and a date by which the work must be finished. If the contractor fails to live up to the standards, the jurisdiction may pursue a construction claim.

Supply Bond

A supply bond definition is a promise to provide the appropriate materials or supplies needed for the project. A supplier obtains the bond and gives it to the project owner (or general contractor). A supply bond is frequently expected on public projects to ensure there are no delays because materials are unavailable.

Completion Bond

A completion bond is given to the owner to guarantee that the project will be finished when planned at the agreed-upon price, and without any issues such as mechanics liens from subcontractors. They may be required in addition to a performance bond.

Retention Bond

A common practice on many projects is what’s known as retainage, in which the owner refuses to make a payment (often the final payment) until all work is completed. A contractor can use a retention bond to promise the owner the work will be done, which allows the owner to release the retainage, providing much-needed funds to the contractor.

Construction Bond Considerations

Is a construction bond something your business needs? That depends upon a variety of factors.

Who Should Consider Getting a Construction Bond?

If your company performs work on public works or government projects, or you handle high-value, time-sensitive projects, the appropriate use of construction bonds helps both you and the owner. How are construction bonds beneficial for contractors? They make it possible for the contractor to be considered for projects they might not otherwise qualify for.

Requirements for Construction Bonds

The surety company will want to verify your company is financially healthy and trustworthy. As noted earlier, insurance companies will provide a limited amount of construction bonds to any one contractor. They refer to that as bonding capacity, and it applies both to one single bond and the maximum they’ll allow if you have multiple bonds. If you’re already close to your bonding capacity, you may not be able to bid on new projects until you finish the current ones.

How to Apply for a Construction Bond

The process of obtaining a construction bond is similar to applying for other types of insurance coverage. You’ll share your needs with the bond issuer and they’ll provide a quote. If you decide to proceed, you’ll complete a formal application. It’s a good idea to develop an ongoing relationship with a single issuer, so they can get to know your business and respond more quickly when you need a bond.

Thanks to the existence of construction bonds, the contractor was able to win the bid for the elementary school project and earn the school board’s confidence before the first shovel of dirt was turned. The project will earn praise from local residents, and other school districts will start inviting the contractor to bid on their projects, too.

Hylant’s dedicated construction insurance team works with contractors, construction companies, CMs and project owners to address all aspects of their insurance, including the use of various surety bonds to build confidence and provide protection. Contact Hylant today to discuss your construction bond needs.

The above information does not constitute advice. Always contact your insurance broker or trusted advisor for insurance-related questions.