Surety bonds for construction projects

Valuable tool to mitigate, manage risk
Monday, May 31, 2010
By Rob Burns

The construction industry is a risky business. Governments and owners of construction projects need financial security in place and the assurance their projects will be successfully completed.

Surety bonds are a valuable tool in mitigating and managing the risk inherent in construction projects. They play a vital role in the success of a construction project by providing valuable prequalification of the contractors, along with financial security and construction assurance to owners of construction projects.

In effect, the burden of the construction risk is shifted from the owner to the surety company. When 50 per cent performance and 50 per cent payment bonds are required on a project, the bonds ensure the contractor will complete the project and pay the subcontractors and suppliers. Surety bonds guarantee the owner that the contractor will successfully perform the contract. The surety company is willing to accept this risk based on the results of a professional and rigorous prequalification of the contractor.

The prequalification process is one of the most valuable benefits of a surety bond. Contractors that do not meet the high qualifying standards of competence are disqualified from the process.

A surety will often request more capital be allocated or retained in the construction company, especially if the contractor is looking at a larger or longer duration contract. In addition, the surety will evaluate the team and key personnel, prior experience in this type of work, quality of trades and the total work program the contractor currently has in place.

Since the surety takes indemnities as security from the contractor, these indemnities also serve as an incentive for the contractor to complete the contract, thereby providing a further mitigation of risk for project owners. If the contractor defaults and is unable to complete the work, then the surety steps in and uses its resources and expertise to arrange for completion of the project.

Subtrades are also often severely affected by the default of a general contractor. An often underestimated value of surety is the labour and material payment bond. In the event a general contractor defaults and there are unpaid trades, the labour and material payment bonds provide protection to the local trades by ensuring they will be paid for the work they have performed. This prevents subtrades from defaulting or abandoning the project and, instead, allows the subtrades to continue to perform the work to project completion.

Rob Burns is senior vice-president of underwriting at Travelers Guarantee Company of Canada.

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