How does a construction bond work?

Though they may have new applications, construction bonds themselves are not new: they’ve been around since 2,750 BC. The Romans then updated the laws of surety in trade around 150 AD, and those principles survive today.

As with all bonds, the construction bond guarantees the principal will act in accordance with certain laws or to the contract between the principal (the construction company) and the obligee (the beneficiary of the surety bond). If the principal fails to perform the contract in this manner, the bond will cover any sums stipulated up to the maximum amount mentioned in the surety bond.

In this article, Robbert Langhorst, our Group Head of Global Surety Distribution, explains what a construction bond is, tells us how a construction bond works, and how this tried-and-true solution is an important bulwark against unforeseen events in a changing world. 

A construction bond is a type of surety bond  (aka a guarantee) used by investors in large infrastructure or
construction projects. To complete this construction bond definition, we can say the construction bond provides protection against disruptions or financial loss due to a contractor's failure to complete a project or failure to meet project specifications.

A construction bond can also be defined in its simplest form as an agreement or document to guarantee compliance, payment or performance of a contractual or legal obligation as part of a construction project.

Guarantees and sureties are terms often used interchangeably. However, they are two different legal entities, each with their own rights and obligations for the parties involved.

A guarantee is an independent commitment of the insurer or bank, separate from the main obligation. It means that the guarantor cannot invoke the exceptions of the principal debtor based on the underlying contract. Even if the underlying obligation is nil, the guarantor has to fulfil its obligation – the only exception being a “manifest abuse of rights.” This is a big difference with a surety bond.

A surety bond is an accessory security, which means it follows the main obligation. The guarantor insurer or bank promises the same performance as the principal debtor for the main obligation. The object is to ensure the performance of the obligation towards the principal within the limits of the main obligation.

Concretely, a construction surety bond – like any other surety – can only exist for a valid agreement. When it is used, the guarantor can oppose payment in case of disagreement until a final judicial decision has been reached in favour of the beneficiary, or when the principal has failed and is no longer able to perform its obligations.

Robbert explains: “In the case of construction projects, the construction bond definition includes a three-party agreement that legally binds together a principal (the contractor, who needs the bond), an obligee (the project owner, who requires the bond), and an obligor (the surety provider or guarantor, that sells the bond). Construction surety bonds are based on this contractual triangular relationship, in which the obligator uses its good name to vouch to third parties for the contractor’s obligation.” 

“The main purpose of a construction bond is to provide the security, or guarantee, to the owner that the project he instructs the contractor to build will be completed in the case of failure or bankruptcy of the contractor’s company,” says Robbert.

The owner transfers the risk of an expected loss due to the delay or incompletion of the works to the bond provider – a bank or an insurance company. “The better the creditworthiness of the guarantor, the better the guarantor,” Robbert continues. “And the more solid the construction surety bond.”

A contractor is required to have construction bonds for nearly all government and public works projects and infrastructure developments such as ports, bridges, hydroelectric plants, grids, pipelines, and tunnels. All entail substantial completion and performance risks, and construction contractors are often required to provide construction surety bonds to be considered for a contract.

“Although the protection or benefit with the issuance of a construction bond is with the owner, the need to have a bond facility in place lies with the construction companies,” explains Robbert. “The owner stipulates in the tendering process that the construction company needs to present a bond from a guarantor as a condition to be chosen to build the project.”

In other words, the protected party – the owner – is not the one who needs to buy a bond. It’s the contractor who must purchase the construction bond.

“We do not have any contractual relationship with the beneficiary (the owner) – only a contingent liability, on behalf of our client (the contractor),” adds Robbert.

Before choosing the right contractor, the project owner requests that a set of specific surety bonds be issued. Choosing the right contractor and the contractors’ surety goes hand in hand.

The surety provider evaluates the contractor. The risk evaluation process typically involves the assessment of the contractor’s financial strength, their ability to perform the contract and their character – that is, the integrity, reliability, and commitment to meet obligations.

After this process, both parties agree on the final surety bond facility structure. Then, this is how a construction bond works:

• If the contractor fulfils its obligations, no action is necessary and the bond will eventually expire.
• If the contractor is unable to perform their duties as agreed and fails to complete the project, the surety company will pay the full penalty amount and other damages incurred.

Construction bonds tend to be relatively long-term: two years on average; four to six years for larger infrastructure projects. 

“What is covered under the bond depends on the wording, which is based upon the owner’s need for protection,” says Robbert. “The bond to be issued normally follows the milestones of the project in order to cover the specific risks in each phase.”

Here are several examples of construction bonds:  

• A bid bond protects the owner against the losses he occurs if the construction company withdraws after being greenlighted to build the project, leaving the owner to restart the whole process of choosing a new construction company. The construction bond covers the cost of the delay as well as any new costs to be made.
• A performance construction bond protects the owner against any loss occurring due to late or incomplete delivery of the project, or against the failure of the other party to meet obligations specified in the contract.
• A maintenance bond protects the owner against failure of the project after completion, which can lead to losses due to repair costs. Sometimes referred to as a construction retention bond, it provides a guarantee that the contractor will fix any issues after the job has been completed, including after full payment has been made.

Performance construction bonds and construction retention bonds cover most eventualities, but they do not cover the losses that are not stipulated in the bond wording. “Certain parts of a project cannot be secured via a construction bond, says Robbert. “For example, financing a loan guarantee by a bank to the construction company, with the obligation to repay that loan, is something we can’t secure with a bond.”

One of the biggest changes in coverage stems from the global Covid-19 pandemic, which is affecting the exposure that contractors face and will continue to face for years to come. Threatened supply chains, worker safety, and  ESG concerns, may not be covered by the general force majeure clause that appears in most contracts and are already influencing construction surety bond underwriting.

The most obvious benefit for the owner of a construction bond, whether bid bond, performance completion bond or construction retention bond, is the assurance of project completion as the owner is protected in the event the contractor defaults on the contract.

In addition, consider these benefits of construction bonds:

• They reassure owners they’re working with capable and qualified contractors who have gone through a meticulous qualification process to determine their ability to handle a contract and avoid default.
• They enable companies to tender for a contract knowing that credit lines with their bank won’t be affected and offer financial security as the additional financial resources provided by construction bonds protect cash flow.
• They provide technical, managerial or financial assistance as needed. They reduce risk of liens filed by subcontractors, labourers and suppliers.

The cost of a construction surety bond normally is calculated with the formula: x% (tariff) * bond amount = premium amount.

For example: 1% (tariff) * EUR.100,000 (bond amount) = EUR.1,000 (premium amount). 

With a Standard & Poor’s global rating of AA, Allianz Trade  is accepted by corporations and banks around the world, a guarantor with one of the best ratings worldwide and a reliable reference for your beneficiaries.

More than 40% of our surety clients operate in the construction segment. Every year, we provide bonding facilities worth around € 50 billion to approximately 14,800 clients. We evaluate each client on an individual basis and tailor solutions to unique needs.

We have global insights and surety teams around the world and can support companies in their global activities and international bond requirements, by providing centrally managed surety programs to companies operating in several countries.

“We have a strong local presence, with a mighty international network of teams in all regions, in 24 countries,” explains Robbert. “So, we have the ability to follow our clients all over the globe. We have expert teams that understand the local markets, the distribution partners and agents.”

To see how construction bonds and other surety products  can support your business,  visit our local websites and contact our local teams.