Performance Bonds

What a performance bond is

A performance bond is a three-party surety agreement in which a surety company guarantees to the project owner that a contractor will fulfill the terms of a written contract. In the construction context—the setting in which performance bonds most commonly arise—the guaranteed obligation is the completion of the work described in the contract documents, in accordance with the specifications, on time, and free of unpaid mechanic's liens.

The instrument itself is short. A one-page bond form, executed by the contractor as principal and the surety, and delivered to the project owner as obligee, is the standard. The AIA A312 Performance Bond—now in its 2010 revision—is the most widely used form in private construction. Federal work is bonded on Standard Form 25. State and local projects generally require the form specified by the applicable procurement statute or the specific request-for-proposal.

The bond's terms are simple in principle and complex in execution. In substance, the surety agrees that if the principal fails to perform, the surety will—at its option—arrange for the completion of the work, tender a completion contractor to the obligee, or pay the obligee the reasonable cost of completion, up to the penal sum. The surety's obligations are triggered by a declaration of default by the obligee and are subject to the conditions precedent stated in the bond form.

The three parties

The principal is the contractor whose performance is guaranteed. The principal is typically the general contractor on the project, though performance bonds are also issued to subcontractors when the general requires downstream bonding, and to prime contractors on non-construction service and supply contracts.

The obligee is the party to whom the guarantee runs. On construction projects the obligee is the project owner—federal agency, state agency, municipality, developer, homeowners' association, institutional owner. On subcontract bonds the obligee is the general contractor. On service contract bonds it is the ultimate purchaser of the service.

The surety is the corporate surety company issuing the bond. The surety must be authorized to write surety business in the state where the project is located. On federal work, the surety must appear on the U.S. Treasury's Circular 570 (the T-List). On state work, the surety must generally hold a certificate of authority from the state's insurance department. The surety on our bonds writes under the Janus Assurance Re umbrella.

Penal sum and coverage

The penal sum is the maximum amount the surety may be required to pay under the bond. On federal work, both the performance bond and the payment bond are almost always required at 100% of the contract price. On state work, penal sums vary by statute; 100% is the most common but some jurisdictions permit lesser amounts. On private work, the owner may negotiate any penal sum, though below 50% of the contract price the bond loses much of its practical value.

The penal sum is a ceiling, not a scheduled payment. The surety's obligation is measured by the actual reasonable cost of completing the contract, capped at the penal sum. If completion costs less, the surety pays less. If completion costs more, the surety's exposure is capped at the penal sum and the owner bears the excess.

The penal sum generally follows the contract price. If the contract is increased by change order, the surety expects to be notified and may issue a bond rider increasing the penal sum. Undisclosed contract increases can, in extreme cases, provide grounds for the surety to argue material alteration and reduced exposure.

The one-year maintenance provision

A performance bond customarily includes a one-year maintenance provision, sometimes called a warranty period. During this period—generally running twelve months from the date of substantial completion or of the certificate of occupancy—the surety's obligation extends to warranty repair work required by the terms of the underlying contract. Maintenance obligations are ordinarily limited to defects in workmanship and materials, not to consequential damages or to items that would properly be covered by an owner's insurance policy.

Where warranty periods longer than one year are required by contract, they can be bonded separately with a dedicated maintenance bond. Two-year, three-year, and even five-year maintenance obligations arise regularly on infrastructure work; five-year roof warranties and ten-year weatherproofing warranties, however, are almost universally uninsurable through the standard surety market and require alternate arrangements.

Federal Miller Act requirements

The Miller Act, codified at 40 U.S.C. §§ 3131–3134 and implemented through the Federal Acquisition Regulations at 48 CFR Subpart 28.1, is the federal statute requiring surety bonds on federal construction projects. The statute obligates the general contractor on a federal job to file a performance bond and a payment bond when the project exceeds one hundred fifty thousand dollars for the construction, alteration, or repair of any building or public work of the United States.

Under the Miller Act:

• The performance bond must be executed in an amount that the contracting officer deems adequate to protect the federal government. The Federal Acquisition Regulations suggest that 100% of the contract price should be the requirement.
• The payment bond is required to ensure that suppliers of labor and materials will be paid. The amount must equal the total amount payable under the contract.
• The payment bond penalty may not be less than the amount of the performance bond.
• Payment bonds are required on contracts exceeding thirty thousand dollars.
• Bonds must be issued by a surety company appearing on the U.S. Treasury's Circular 570 ("T-List").

For a detailed treatment, see our complete Miller Act guide.

State and municipal requirements

Every U.S. state has enacted a "Little Miller Act" modeled on the federal statute for state-owned construction projects. Thresholds vary; forms vary; wording varies; the underlying architecture is broadly similar. A performance bond and a payment bond, generally at 100% of the contract price, are required on state work above the statutory threshold. The specific bond forms are usually prescribed by the applicable state department (transportation, general services, university system).

Municipal work operates under two overlapping regimes. Municipal purchasing policies generally require bonding on public-works contracts above a threshold set by ordinance—often lower than state thresholds. Separately, municipal building departments and licensing boards require standing license and permit bonds as a condition of contractor licensure and of specific permit issuance. These license and permit bonds are not performance bonds; they are contractor-conduct bonds addressed on our sister site.

How much a performance bond costs

Performance bond premium in the standard contract surety market ranges from approximately one percent to over four percent of the contract amount, charged once at bond issuance. The applicable rate is a function of the contractor's financial strength, character, prior experience, and the risk characteristics of the specific project.

Typical premium ranges by contractor profile:

Contractor profile	Approximate rate
Very large contractors, strong balance sheet, seasoned, routine work	1.0% – 2.0% of contract
Solid mid-market general contractor	1.5% – 2.5% of contract
Smaller or newer contractor, standard risk	3.0% – 3.5% of contract
Non-standard, distressed, environmental perils	4.0%+ of contract, often with collateral

Rate is only part of the picture. The larger question for most contractors is capacity—how much bonded work the surety will support at any given time. Rate reduction is generally available only after a track record has been established with the surety; capacity growth over time is where the material economic benefit of a strong surety relationship shows up.

Bid bonds carry no premium of their own on most accounts. The premium charged at final bond issuance is the compensation for the bid bond exposure as well.

The underwriting process

New-account underwriting for a contract surety bond program generally proceeds as follows:

1. Submission. Contractor delivers a complete file—business financial statement, personal financial statement of principal owners, work-in-progress schedule, general liability certificate, résumés of key personnel, banking and subcontractor references, and a completed contractor questionnaire.
2. Review. Underwriter analyzes working capital, net worth, prior largest completed project, gross-profit trend, and personal credit. First-round questions to the contractor commonly follow.
3. Structure. Underwriter proposes a program—single-project limit, aggregate limit, rate, required indemnity, any special conditions (collateral, funds control, project-specific consent).
4. Acceptance. Contractor accepts the program terms and executes the general indemnity agreement.
5. Bonding. Bonds are issued on individual project requests within the approved program limits, subject to the underwriter's review of each specific contract.

For established accounts requesting bonds within existing program limits, the process is compressed to hours. Submit the contract; the underwriter reviews the specific obligee, wording, and scope; the bond issues. For unusual projects—foreign obligee, unfamiliar work type, penal sum approaching single-project limit—an additional review is warranted.

What happens if the contractor defaults

Performance bond claims are relatively rare, but they are not unknown. The typical claim sequence:

1. Notice of potential default. Owner sends written notice to the surety identifying a problem—missed schedule, quality issues, non-payment of subcontractors, abandonment.
2. Cure period. Under most bond forms, the surety has an opportunity to arrange the contractor's cure. This often means bringing supplemental resources to the job or negotiating a workout.
3. Declaration of default. If cure is not achieved, the owner formally declares the contractor in default and demands surety performance.
4. Surety election. Under the AIA A312, the surety may (a) arrange for the principal to complete the work, (b) undertake to perform through its own contractors, (c) tender a completion contractor selected by the surety with owner approval, (d) waive its right to complete and pay the owner the reasonable cost of completion, or (e) deny liability.
5. Recovery. The surety pursues its indemnity rights against the principal and personal indemnitors for all losses, expenses, and attorneys' fees.

The dynamic under a performance bond is fundamentally different from that under an insurance policy. The surety's claims strategy is oriented toward completing the project promptly at the lowest cost, then recovering from the principal. The principal's cooperation—or lack of it—is central to the outcome. This is why the general indemnity agreement is signed at the outset of the relationship: it is the legal machinery that converts a surety loss into a claim against the contractor and its personal indemnitors.

Alternatives to bonds—LOCs, SDIs, escrows

Contractors sometimes ask about alternatives to surety bonds. The most common alternatives are irrevocable letters of credit, subcontractor default insurance (SDI), and cash escrow. Each has meaningful drawbacks compared to a performance bond.

Letters of credit are the most common substitute. An LOC is a bank's undertaking to pay the beneficiary on demand, subject to presentation of specified documents. Owners like LOCs for the speed of payment. Contractors dislike them because the bank counts the LOC face amount against the contractor's borrowing capacity dollar-for-dollar, and because LOCs require ongoing collateral maintenance. A ten-million-dollar performance bond does not tie up ten million dollars of the contractor's balance sheet; a ten-million-dollar LOC effectively does.

Subcontractor default insurance (SDI) is a distinct product carried by the general contractor rather than obtained by each sub. SDI is real insurance—the GC pays a premium, the carrier assumes risk of subcontractor default. SDI supplements but does not fully replace subcontract performance bonds for larger projects; the two are commonly used in combination on the largest work.

Cash escrow is straightforward but capital-inefficient. The contractor's own cash secures the obligation. It is used most often for very small obligations or in situations where surety is unavailable.

For nearly all contract surety uses, a performance bond from a T-listed carrier is the cheapest and least capital-intensive option available.

How to apply

PerformanceBond.com underwrites contract surety accounts in all fifty-three U.S. states and territories, with a two-hundred-fifty-million-dollar maximum single-program capacity and one-hour response time on inbound submissions. Every account is handled by a senior underwriter—no coordinators, no callback queues.

To apply, submit the standard contractor questionnaire along with the additional documents listed above, or call us to discuss the account first. Most established accounts are approved on the strength of a phone call and the underwriter's review of the financial statement and work-in-progress schedule.

For the specific procedures and pre-award instruments, see also:

• Statement of Bondability — prequalification letter used at the bid stage
• Bid Bonds — guaranteeing that the bidder will enter the contract
• Payment Bonds — protecting subcontractors and material suppliers
• The Miller Act — federal statutory requirements
• Site-work & encroachment bonds — the incidental surety GCs need at permit pickup