A surety bond is an instrument under which one party guarantees to another that a third will perform a contract. Surety bonds used in construction are called contract bonds.
There are three types of bonds used in construction.
Federal law (the Miller Act) mandates surety bonds for all public works contracts in excess of $100,000. Federal procurement officials may, at their own discretion, require bonds on projects below that amount. All states have laws requiring bonds on public works too (known as Little Miller Acts). Owners of private construction projects are recognizing the wisdom of requiring surety bonds to protect company and shareholders from the enormous costs of contractor failure.
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 an owner. The owner receives grantees from a financially responsible surety company licensed to transact suretyship.
Surety bonds, through the surety companies' rigorous prequalification of contractors, protect the owner and offer assurance to the lender, architect, and everyone else involved with the project that the contractor is able to translate the project's plans into a finished project. Before issuing a bond the surety needs to be fully satisfied, among other criteria, that the contractor is:
With a surety bond, the owner can be satisfied that a risk transfer mechanism is in place. The risks of construction are shifted away from the owner to the surety. If the contractor defaults, the surety may pay for a replacement contractor, or provide technical and/or financial assistance.
To bond a project, the owner merely includes the bonding requirement in the plans and specifications for the project. Obtaining bonds and delivering them to the owner is the responsibility of the contractor who will consult with an independent surety agent who will assist them with securing the bond.