In the construction industry, a performance bond is usually required by the client who wants the intended work to be covered by an insurance policy. When a contract is awarded to a particular contractor, the owner may require the winning contractor to post a specific bond to ensure performance or completion of the project, and that the owner will be properly reimbursed for any losses that may be incurred in relation to the project.
In case the contractor defaults, the owner may file a claim to recover the damages amounting to the total cost of the job. A performance bond is a common fixture for public works contracts.
Before a bond is acquired, both parties must first be amenable to the terms of the bond. The full scope of the required work, the time frame for completion, and the estimated value of the work must first be determined before the bond is issued. The issuer usually defines the terms of the performance bond, including the claims and payment.
The cost for this type of bond is paid for by the contractor; and this is typically included in the cost of their bid for the particular project. The cost of the bond depends on various factors, and these include the type of construction being done, and the full cost of the required work. It ranges from 1 to 5% of the total estimated construction cost. If the issuer finds the contractor to be a risky investment, higher upfront bonding costs, including interest, may be imposed.
This type of insurance or bond is basically a policy for the owner. A contractor must first be qualified in order to be bonded, so its ability to acquire a bond is in itself an assurance to the owner that the said contractor is likely to complete the job, and that it is financially stable.
A performance bond likewise gives the assurance that in case the contractor defaults on its obligations to deliver or takes a longer time to comply than what is agreed upon, the owner will be compensated for the losses accordingly. In any case, the owner is shielded from any possible financial damage or loss arising from the project.
The required bond to ensure performance places smaller general contractors at a distinct disadvantage in securing projects as they may not be able to at least qualify or afford to be bonded. There are also some contractors who may not be willing to spend upfront for bonding requirements or undertake the additional work required just to secure a performance bond, and this could result to fewer bidders.
Less competition provides a good opportunity for the remaining bidders (usually larger contractors) to place higher bids. In any case, the bid costs may be higher because contractors will definitely include the bond cost in their project cost estimates that will ultimately be passed on to the owner.