What Is the Definition of a Performance Bond?

This article outlines the definition of a performance bond and how it works.

What Is a Performance Bond?

Look at the skyline of any major city and you are bound to spot the state bird--the crane. When eying new construction that scatters over America's downtowns, suburbs, and rural landscapes, did you ever stop to think who is financially backing these projects? Probably not, but if you have ever heard the term performance bond, after reading the following paragraphs, you may never look at construction or those annoying highway repair projects the same way again.

What Is a Performance Bond? (continued)

According to the International Risk Management Institute, Inc., "A performance bond guarantees that [a] contractor will perform [said] work in accordance with the construction contract and related documents, thus protecting the owner from financial loss up to the bond limit (called the penal sum) in the event the contractor fails to fulfill its contractual obligations." A performance bond involves three contractually obligated parties: the principal, the obligee and the surety. The principal is the person or group performing the work, by contract, for the benefit of the obligee. One example of a principal may be a construction company hired to build a new office building. The obligee is the person or group paying a premium to be protected against a loss. A commercial real estate company would be an example of an obligee, if keeping with the above example. Lastly, there is the surety, which is the company financially backing the bond for the penal sum. This should not be confused with insurance, in which one party (the insurance company) protects the assets of another (the insured) in the event of a loss. The bond relationship is more like one of a bank extending a line of credit to another for the purpose of a business transaction. If the principal fails to perform its duty to the obligee, the surety steps in to pay for the loss, up to the penal sum. Although the surety has paid for the loss, the principal is responsible for making the surety whole again due to an indemnity agreement within the bond contract language. Also like a bank, the surety does its due diligence in determining if a principal is risk-worthy. Because of its strict underwriting standards, a surety enters into this contract expecting no losses.

Underwriting

Character, capacity, and capital are the so-called "three C's" in determining the affordability of the risk. Character refers to the principal's reputation of business uprightness and integrity. Capacity, when used in the vernacular of sureties, refers to the professional and technical capability of the principal to fulfill the tasks for which the bond was acquired. Lastly, the principal's capital evidences its financial solvency and credit-worthiness to complete the job. To further solidify this, a surety may occasionally require collateral equal to the penal sum from the principal. This helps reduce the risks to the surety.

How It Works

Most surety bonds are non-cancelable and terminate only when the principal has fulfilled its obligation to the obligee. However, what happens if the principal fails to do so? Despite stringent underwriting practices by sureties, the fulfillment of a contract may be affected by several factors outside of the principal's financial viability. These factors may include a delay in receiving equipment and/or materials for the project; a delay in shipping of equipment and/or materials due to inclement weather; and exceeding the estimated budget for the project.

How It Works (continued)

Once the obligee reports the breach or default to the surety, there are several action steps it may take:
· The obligee may find another contractor to complete the work left by the original contractor. The surety pays the obligee the difference between the prices charged by the two contractors and the balance. For example, if Contractor A left $150,000 of the project unfinished and Contractor B will charge $200,000 to complete it, the surety would provide the obligee with the $50,000 difference and the $150,000 remaining in the contract.
· The surety may take control of the project and have it completed. Provisions within the agreement may allow the surety to use the principal's available plant, equipment and materials. In addition, it may also use its existing subcontractors and suppliers.
· If the principal is not at fault in the breach or default of the contract, the surety may not get financially involved. In this situation, the owner would go forward with completion of the project with no financial assistance from the surety.

How It Works (continued)

An indemnity agreement is usually included in the bond agreement. This calls for the principal to protect the surety against any financial loss. The surety may recoup its financial losses from the principal by:
· Subrogating against the principal (including liquidation of collateral, if applicable by contract);
· Having the principal's subcontractors and suppliers contracts assigned to the surety so that they receive the monetary benefit.

Conclusion

Please note that there are many types of surety bonds and this brief article is a simplification of the terms and processes used in completing the transactions. Like many financial relationships, there are exceptions to the above scenarios and legal statutes for which this article is not the proper forum for explanation. What you can take away from this overview is that performance bonds provide financial backing to a contractor performing a specific job as well as a payment guaranty. There is a price to pay for such a guarantee--premiums for these bonds can cost as much as one percent of the work contract, adding to the cost of the overall project. Contractors may have trouble obtaining a performance bond if it is at "capacity" due the number of jobs it has scheduled. This inability to obtain a bond can slow down or halt completion of a project. So the next time you wonder why that new wing of the mall or your state road intersection is STILL not completed, you know of one possible reason for the delay. Now you know how performance bonds help protect the property owner from financial loss and ensure that a project is completed per the plans and specifications defined in a contract.

References

• International Risk Management Institute, Inc
• Contractual Risk Transfer: Strategies for Contract Indemnity and Insurance Provisions Volume II, Pgs. XVII.L.4 -- XLVII.L.6, March 2005, Patrick J. Wielinski, J.D., W. Jeffrey Woodward, CPCU, Jack P. Gibson, CPCU, CLU, ARM, International Risk Management Institute, Inc. Dallas, Texas.
• "How Surety Bonds Work", Dan Donohue and George Thomas, Assistant Vice-President, Contract Surety Claims, Fireman's Fund Insurance Company, 1996 Kilcullen, Wilson & Kilcullen 1800 K Street, N.W., Suite 300 Washington, D.C. 20006-2202