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Setting up construction bonds

Tuesday 31st January
Setting up construction bonds

There’s no doubt that the economic uncertainty of the last few years has driven the demand for construction bonds to support commercial contracts and regulatory obligations. A surety bond guarantees that one party will fulfil its obligation to another party, providing the additional security that a project will be completed.

How does a construction bond work?

Employers request bonds to protect against a situation such as a contractor failing to fulfil their contractual requirements. If a contractor cannot deliver the contract, this can cause major project disruption and financial problems for the employer. Demand for bonds increases during periods of economic uncertainty, when employers are more likely to ask contractors to provide a contractual guarantee in the form of a surety bond. In the event of a contractual default (such as insolvency), by the contractor the bond can be called upon to help cover the cost of finishing the project.

The need for a bond is set out by the employer prior to the signing of the construction contract. The contractor is then responsible for obtaining the bond from a surety with the employer as the beneficiary.

Surety bonds vs bank bonds

The biggest benefit to choosing a surety bond over a bank bond is that it diversifies a company’s credit options and reduces the usage of existing bank credit lines (as well as potential cost savings in an era of rising interest rates). Additionally, a surety bond can often provide a good risk management perspective on projects or any other risks which might occur in the underlying contract or obligation.

What types of bonds are available?

There is a range of different types of bond available, including:

  • Performance bonds
  • Advance payment bonds
  • Retention bonds
  • Section bonds – also known as Highways or Sewer bonds
  • Bid bonds
  • NHBC bonds
  • Warranty bonds

How are Bonds calculated?

Performance bonds are usually 10% of the contract value. Retention bonds are generally between 2.5 to 5% of the contract value, and advance payment bonds are a fixed sum depending on the advance payment value. The bond wording can stipulate that the amount reduces when certain milestones are achieved. For example, once the practical completion certificate is issued, the bond amount could decrease by 50%. Bonds are either calculated on a per annum or a flat rate depending on the contractor’s financial strength.

Getting a quote

Surety brokers have experience of the market and will have access to a range of Sureties. They will ask for the latest company accounts, up-to-date management accounts, current forecasts for the financial year, current workload, a questionnaire completed by a bank. If a specific bond wording is required, this should also be provided for review as amendments may be needed to prove acceptable to the sureties.

How much does a Bond cost?

The cost of a bond depends on the company’s financial strength, the type of bond needed, and the conditionality of the wording required. Generally, the higher the credit score, the lower the premium rate (subject to conditionality of the wording). The surety will analyse the financial and project information and, subject to this information meeting the sureties’ underwriter criteria, will provide an indicative price and terms.

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 either Practical Completion of the project, 12 months after Practical completion, Making good Defects, or a fixed Expiry Date. 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.

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Kerry London is authorised and regulated by the Financial Conduct Authority. The company is a leading UK independent and Lloyd’s accredited broker, which means that we work with a wide range of niche and major insurers.

This note is not intended to give legal or financial advice, and, accordingly, it should not be relied upon for such or regarded as a comprehensive statement of the law and/or market practice in this area. In preparing this note, we have relied on information sourced from third parties, and we make no claims as to the completeness or accuracy of the information contained herein. You should not act upon information in this bulletin nor determine not to act without first seeking specific legal and/or specialist advice. We and our officers, employees or agents shall not be responsible for any loss whatsoever arising from the recipient’s reliance upon any information we provide herein and exclude liability for the content to the fullest extent permitted by law.

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