Hiring a subcontractor is a regular necessity in the construction industry, and it often raises the question of whether a prime or general contractor should require their subcontractors to provide performance and payment bonds to them. Subcontractors aren’t typically required by the owner of the project to provide bonds to the prime or general contractor. However, a prime or general contractor may request their subs to give them bonds to reduce their own risk from the subcontractor defaulting or not paying laborers and suppliers. In other circumstances, the prime contractor’s surety company may impose the sub-bonding requirement as a condition of approving the prime contractor’s bonds.
This leaves many prime and general contractors wondering whether requiring bonds from subcontractors frees up their bonding capacity, which we will explore in this article.
How Do Sureties Determine Bonding Capacity?
One way surety companies determine bonding capacity is to essentially evaluate the amount of risk there is in a contractor’s work. Generally speaking, projects that have more subcontracted work are considered lower risk, because the subs take over responsibility for meeting production and performing the actual work. The risk for prime or general contractors is even further lowered when subcontractors provide surety bonds to them because they have a guarantee from a surety company that the work will be completed.
There are of course many other financial aspects to determining bonding capacity, and as a contractor, it’s important to understand how bonding capacity is calculated and know what is counted by a surety against it or not. To learn more about how your capacity is determined, we strongly encourage you to read here: Aggregate Bonding Capacity: What is it and How is it Calculated? – CSBA
Impact on a Contractor When a Surety Bond is Required for a Subcontractor
When subcontractors are required to be bonded, there is a financial impact on the contractor as the cost of the subcontractor’s premium falls to the contractor. This can make a bid less competitive because the contractor’s bid amount will increase. With that in mind, we at CSBA tell our clients to ask a few prequalifying questions to ensure you require subcontractors to provide bonds in those situations that pose the most risk to you:
- Do you have bids that are in line with the subcontractor’s bid? If not, consider not using them, or requiring performance and payment bonds.
- Has the subcontractor completed a job of similar scope and size? If not, consider not using them, or requiring performance and payment bonds.
- Is the subcontractor a specialty trade that would be difficult to replace? If yes, consider requiring performance and payment bonds.
- Does the subcontractor represent a large portion of the project or are they a critical path that could delay completion? If yes, consider requiring performance and payment bonds.
- Require the subcontractor to provide a letter from their surety company stating they have the bonding capacity for a project of the size you are considering them for. If their surety won’t provide a bond for a project that size, you may want to use a different subcontractor.
The goal of these questions is to limit the number of bonds required for the project, limiting the bonds to subcontractors that pose the most risk to a project. This, in turn, keeps the premium low and protects the contractor in the riskiest areas.
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What Types of Bonds Are Usually Required of a Subcontractor for a Construction Project?
A contractor can require several bonds from a subcontractor, namely:
For Bid Bonds, it provides protection from the subcontractor backing out of the bid and not entering into the contract if it’s awarded to the subcontractor. It’s a useful tool for a contractor to use when there is a unique trade that can’t be easily substituted at a similar price and quality. An alternative to this is to have the subcontractors provide letters from their surety company verifying their bonding capacity. If the letter comes directly from the surety and not an agent, it will give some assurance that the subcontractor is able to provide performance and payment bonds if needed.
For performance and payment bonds, it gives the contractor a guarantee that the subcontractors will finish the work according to the contract terms and pay all of their laborers and suppliers. If the subcontractor defaults on their subcontract, the surety will complete the work under the performance bond. It’s similar with the payment bond, in that the surety will handle the payments if the subcontractor doesn’t pay as they are supposed to. This includes unpaid wages to their employees which helps you to avoid penalties and interests added by the Department of Industrial Relations.
For the supply bond, this guarantees that the product or material will be delivered in the quality and timeframe specified in the purchase order.
To understand more on how subcontractor surety bonds can make a difference for your project, we recommend reading this article: Subcontractor surety bonds can make a BIG difference on your next project
Bonding Subcontractors and Freeing Up Your Capacity for Bonds
Requiring subcontractors to get a bond doesn’t, in and of itself, free up the equivalent amount of your bonding capacity. Instead, it allows the surety to stretch the contractor’s bonding capacity because the surety will view them as less risky. As mentioned earlier, surety companies evaluate risk, and bonding subcontractors is one way to lower that risk. It’s better to think of bonding capacity, relating to subcontractors, as it is being stretched rather than freed up. For example, if a contractor’s typical bonding capacity for single projects is $5 million, and the contractor wants to bid on an $8 million project of which 50% will be subbed out, the surety is likely to consider the larger job, because it won’t necessarily demand more resources from the contractor since half of the work is being subcontracted out and bonded back.
As you can see, while your bonding capacity won’t be freed up by requiring a subcontractor to get bonds, it does help in many other ways. These finer points of bonding can be intricate, which is where CSBA can help. We at CSBA are well versed in guiding both newer and seasoned contractors to grow their bonding capacity and gaining the surety bonds they need for the jobs they want. With over 225 years of experience, we have the key relationships that can make all the difference in bonding.
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We want to know more about how we can help your construction company get the right contractor bond for your next project.