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Seizing opportunity with contract surety bonds

Contract surety bonds are one way to mitigate risk before, during, and after a construction project.

07/17/2023 · 5 minute read

Reducing risk exposures so that projects can stay on track is vital in the construction sector. Today, significant labor force and supply chain challenges are affecting construction companies and their projects. It is therefore important that all parties involved prepare for, assess, and alleviate risk.

Contract surety bonds are one way to mitigate risk before, during, and after a construction project. They can provide financial security and construction assurance to a project owner (obligee) that the contractor (principal) will fulfill the terms and conditions of their contract. This includes performing the work and securing payment for [sub]contractors, laborers, and materials. If the contractor defaults, the surety company is typically obligated to find another contractor to complete the contract, or compensate the project owner for the financial loss incurred.

The use of contract surety bonds is expected to expand given the growth in public construction worldwide, driven by a surge in government spending, rising populations, rapid urbanization, and the drive towards a sustainable future. However, despite this positive outlook, the construction industry is confronted with rising costs of construction materials, supply chain pressures, and labor shortages. These challenges can put lead times, costs, and schedules at risk.

The uses and advantages of contract surety bonds

Contractors generally require contract surety bonds in connection with the construction of buildings, roads, bridges, and improvements associated with real property. Contract bonds are typically used by:

  • Large construction companies with multiple project;
  • General contractors with one or more projects;
  • Individual contractors with a single project;
  • Trade contractors, such as electricians and plumbers;
  • Subcontractors of the government.

A supply bond is a type of contract bond which manufacturers or mining companies may be required to post in connection with the supply of products or raw materials. Recently, this has become especially prevalent due to material shortages, with concrete suppliers frequently required to post supply bonds to general contractors who are reliant on concrete supply to perform their work.

With both contract bonds and surety bonds, the obligation of the bond is determined primarily by the underlying construction contract or purchase order.

The most common types of contract surety bonds are:

  • Bid bonds provide financial protection to the owner if a bidder is awarded a contract, but fails to sign the contract or provide the required performance and payment bonds
  • Performance bonds provide an owner with a contractual guarantee that, in the event of a contractor’s default, the surety will complete, or cause to be completed, the contract.
  • Payment bonds ensure that certain subcontractors and suppliers will be paid for labor and materials incorporated into a construction contract.
  • Warranty bonds guarantee to the owner that any workmanship and material defects found in the original construction will be repaired during the warranty period. Warranty and/or maintenance bonds can also be purchased for additional coverage years, as the standard warranty period is one year and is provided free of charge by the surety.

Marsh services can help you build resilience

The surety industry has experienced sustained success driven by a disciplined underwriting approach and continuous development and adoption of a suite of related services.

For instance, Marsh specialists offer a range of risk advisory services that can help project owners manage risk in the construction space:

  • Co-surety arrangements as a way for surety companies to spread risk.
  • Capacity and rate negotiations with Marsh benchmarking comparing the contractor to groupings of other clients in similar industries and risk profiles to help the contractor achieve competitive rates and capacity to meet their business goals.
  • Contract review services to help clients meet contractual requirements and governmental regulations.
  • Private equity surety, which can include syndicating a program across multiple markets demonstrating a risk appetite for private equity owned contractors.
  • Joint ventures (JVs) review, including that of teaming agreements, operating agreements, surety relationship/capacity, and facilitating the issuance of prequalification letters and bonds.
  • Coordinating mergers and acquisitions (M&A) activity, including, but not limited to, the onboarding of acquired companies into the client’s bonding program and obtaining additional capacity.
  • Marsh’s MSurety system enables clients to request bonds and generate reports, and requires approvals of certain types of bonds outside the standard bid/payment and performance (P&P)/maintenance bonds that contractors frequently use.
  • Bank-fronted surety for controlled insurance program (CIP) collateral replacement.
  • Customized client bond request forms and rate calculators.
  • Monthly bond reporting that allows clients to see outstanding bond liability by the carrier.

These approaches have proven to be successful in mitigating risk for large-scale construction projects. For example, with one client, Marsh undertakes nearly 40 contract reviews per month to identify potentially problematic terms and conditions within the projects’ contract language. 

Marsh also recently negotiated with a surety on a construction client’s behalf to lower the cost of a large appeal bond. This included developing terms favorable to the client, ultimately saving the client over US$150,000 in annual premium.

Managing the risk

The instruments mentioned above help to ensure that the contractor has a vested interest in performing their contract, while providing a potential form of financial recourse for the project owner in the event of non-performance. No two projects are identical, as such, the characteristics of a specific project will help to identify the appropriate solution(s).

In spite of the positive outlook for the construction industry, the economic environment remains challenging, bringing new risk scenarios to the forefront. Continued risk management and monitoring will be key to ensure projects stay on track, and the support and protection offered by contract surety bonds present a growth opportunity for companies in the construction sector.

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