Construction is a risky business. One-half of all construction firms in business today will be out of business six years from now, according to the Associated General Contractors of America. An economic downturn, labor difficulties, material shortages, equipment problems, and a host of other problems can cause a contractor's business to fail leaving projects at a standstill.

No construction project owner, public or private, can afford to gamble on a contractor whose responsibility is uncertain or who could end up bankrupt halfway through the job. And how can a public agency, which uses the low-bid system in awarding public works, be sure the lowest bidder will be dependable?

The needed assurance is provided by surety bonds. Performance bonds protect taxpayers against financial loss should the contractor default or fail to complete the job according to the contract.

Payment bonds guarantee that the contractor will make payments for the labor, material, and subcontractors associated with the project.

These are only two types of surety bonds. A surety bond is a risk transfer mechanism: the risk of contract default is shifted from the project owner (the government or a private party) to the surety. If a contractor does fail, it is the surety company that pays, not the government or the tax payer.

When a contractor provides a surety bond the public can be assured that the contractor has met the rigorous standards of an independent third party -- the surety bond company. After all, the surety bond company is committing its assets to guarantee a contractor's performance and that the contractor will pay laborers, material suppliers, and subcontractors. Because of this evaluation, the project owner can be comfortable knowing that the contractor runs a well-managed, responsible, and fiscally-sound enterprise and has the experience necessary for the specific project. This protection through pre-qualification is a significant benefit of the bonding process that is often overlooked.

Although surety bonding is considered a line of insurance, it has many characteristics of bank credit. The surety does not lend the contractor money, but it does allow the surety's financial resources to be used to back the commitment of the contractor, thus enabling the contractor to acquire a contract with a public or private owner.

The owner receives guarantees from a financially-responsible surety company licensed to transact suretyship. Bonds perform the following functions:

  1. Guarantee that the bonded project will be completed.
  2. Guarantee that the laborers, suppliers, and subcontractors will be paid even if the contractor defaults. This often results in lower prices and expedited deliveries.
  3. Relieve the owner from the risk of financial loss arising from liens filed by unpaid laborers, suppliers, and subcontractors.
  4. Smooth the transition from construction to permanent financing by eliminating liens.
  5. Reduce the possibility of a contractor diverting funds from the project.
  6. Provide an intermediary, the surety, to whom the owner can air complaints and grievances.
  7. Lower the cost of construction in some cases by facilitating the use of competitive bids.