Performance bonds: Don’t bank on it

The provision of a performance or contract guarantee bond has long been an established practice when appointing a contractor to undertake major works.

The reason for these types of bonds is to protect the employer from the original appointed contractor failing to carry out their contracted duties in terms of performance and delivery, amongst other things. Bonds therefore act as a really important safety net to enable a principal to finish the project.

Although banks have traditionally supplied bonds those involved in the construction industry are increasingly turning to the insurance industry as a source of bonds.

Importantly, there can be major differences between the wordings of bonds provided by banks and insurance companies. Ultimately this means the liabilities that sit with the surety provider in the event the bond is called into action will not be the same.

The most common difference is whether the wording makes a bond “on demand” or not.

The difference between the two can generally be described as:

• An on demand bond does not require the employer to sue the contractor and prove breach of contract
• A non on-demand bond requires the employer to establish the contractor’s breach of the building contract.

Generally speaking banks will not supply on demand bonds, but might make exceptions for major contractors.

Insurance bonds are more flexible in wording, and cost as bank charge you for a bond while eroding the contractors credit line.

Other types of bonds

Those involved in construction projects should be aware that there are three main other types of bonds:

• Advance payment bonds cover the advanced payment made by an employer to the contractor. This type of bond is widely used when there is costly M&E equipment that needs to be pre-ordered.
• Retention bonds are taken out by the contractor and subcontractors in lieu of providing a monetary retention to the employer/main contractor respectively. This type of bond helps to improve cash flow. The use of a retention bond can be agreed at the start of a contract or upon practical completion where the contractor wishes to release the retention monies.
• Sewer/drainage bond are guarantees obtained by a property developer that they will complete the roads and sewers to the required standard and within a defined time frame to enable them to be adopted by the appropriate authority under the relevant acts.

Arranging a bond through a broker

To a contractor the main benefit of using an insurance company to provide surety, as opposed to their own bank, is that it frees up capital and credit lines that would normally be held to the value of the bond being provided. Therefore the use of bonds can greatly help with cash flow, provide security to both the employer and the contractor. Retention bonds free up capital that can be withheld by a third party for the retention period.

To arrange a bond through an insurance broker three initial pieces of information are required:

• A completed Bond Application Form
• Latest audited and/or latest management accounts
• A copy of the proposed wording.

For those companies that regularly require bonds, pre-agreed levels of bonding can be established and the rate charged (% of bond value agreed) from the outset.

This enables a business to budget accordingly for the cost of bonds. Surety providers will reserve the right to increase the rate charged for more onerous and/or on demand bond wordings.

Potential advantages of using a broker

• When using a specialist broker rather than a bank, ask them how they can provide the following services:
• Providing support and guidance through the application process
• Providing help with your contract bid
• Easing cash flow
• Freeing you from cash restrictions that affect a contractors ability to bid for multiple contracts
• Protecting your site from potential financial loss
• Help you to arrange a pre-costed facility.

Peter Morse is an executive director of the Clear Insurance Group