How are construction bond premiums calculated?

When a contractor obtains a bond, it demonstrates financial stability to their employers, especially during challenging economic conditions. Now more than ever, the need for financial stability and security is paramount and the demand for bonds has increased. A surety broker will offer advice and guidance on bond wordings to ensure your needs and best interests are met. The surety broker will then approach the market for terms and placement, ensuring you get the best rate available. Kerry London’s Bonds team explains the factors that influence premiums.

What bond might I be asked for?

The UK surety market supports clients with a variety of bonds, including performance bonds, advance payment bonds and retention bonds. These are available for both the main contractor and for sub-contractors. Surety or performance bonds are amongst the most commonly bonds used in construction.

How much does a bond cost?

Premiums are assessed on several criteria, including company financial ratings, the type of bond required, and the contract wording. Companies with favourable credit ratings are likely to attract the most competitive premiums. Bonds underwriters conduct a thorough risk assessment of all aspects of the project, using the contractor’s financials and a detailed risk assessment of the project to provide an indicative premium and terms.

Hannah Sewell-Moore, Surety Manager, Surety and Bonds, Kerry London said, “There is a misleading assumption that tough economic conditions and insolvencies have driven construction bond rates up, but rate increases have been minimal. Unlike many other insurances, performance bond premiums are largely based on a company’s financial performance. Contractors can save themselves valuable time shopping around by choosing one construction bonds specialist safe in the knowledge that premiums will be broadly similar.”

Underwriters need reassurance regarding their client’s current and future financial performance to ensure they can continue as a business while meeting their contractual obligations. This reassurance applies throughout the entire construction supply chain, including the sub-contractors. Bonds companies may require some or all the following to provide cover:

Company accounts – Healthy cash flow is important to bond underwriters because if a claim is triggered to complete a contract, they will recoup those losses from the solvent contractor.

Cash collateral – Bond companies may request a cash collateral payment when a contractor is new to the surety company or has a lower financial rating. Collateral up to 50% of the bond amount (100% if the company has a poor credit rating) is commonplace. Contractors familiar with this process sometimes factor this additional cost into their bids or absorb the risk in the knowledge that the remuneration will far outweigh the initial outlay.

Director’s guarantee – Alternatively, smaller businesses or companies with poor cash flow may need to provide a director’s guarantee to the bonds company.

Performance milestone reductions – Brokers can help contractors soften the blow of upfront cash collateral payments by arranging performance milestones. The cost of the bond is reduced at practical completion, usually refunding half of the financial collateral.

Some employers require contractors to have a post-completion bond to ensure they rectify defects for several years. Most sureties are 12 months, but they can be longer.

Contractors new to surety companies are generally considered an unknown risk and will undergo a thorough risk assessment process, including annual or bi-annual face-to-face meetings.

What do bonds cover?

Performance bonds usually cover 10% of the contract value. Retention bonds are generally between 2.5 and 5% of the contract value, and advance payment bonds are a fixed sum depending on the advance payment value. Once a practical completion certificate is issued, the bond amount generally decreases by 50%. Bonds are either calculated on a per annum or a flat rate, depending on the contractor’s financial strength.

How long does a bond last?

The bond duration is agreed upon between all parties before the bond is issued. The length of a bond varies:

• A performance bond will typically be in place for between 1 and 3 years
• A retention bond between 1 and 2 years
• Advance payment bond typically ranges between 6 months to 2 years
• A section bond will generally be in place for two years

Bonds will typically expire on practical completion or 12 months afterwards. Sometimes, extensions are given to enable contractors to rectify defects. The specific expiry provision will always be agreed upon and included within the bond wording.

Can a Performance Bond be cancelled?

The premium for the bond will always need to be paid for in full before the bond is issued. Unlike a general insurance product, a bond is a legal obligation that cannot be cancelled for any reason other than expiry. Once a construction project is complete and the bond has reached its expiry event, the issuing surety will confirm it has been released.