What is a payment bond and how does it benefit subcontractors and suppliers?

Jason Dettbarn, Vice President - Contract Underwriting, Merchants Bonding Company

Public construction work in the United States is generally awarded to the lowest bidder through the open competitive sealed bid system. Surety bonds play a critical role in making the system work, not the least of which is the payment bond.

The payment bond protects laborers, materials suppliers and subcontractors against nonpayment. Because mechanic’s liens cannot be placed against public property, the payment bond may be the only protection these claimants have if they are not paid for the goods and services they provide to the project.

More than 100 years ago (because government property is not subject to mechanic’s liens), laborers, materials suppliers and subcontractors had nowhere to turn if they were not paid for their services.

The federal government authorized the use of corporate surety bonds to secure construction projects, which is still covered under the Miller Act today.
The use of payment bonds is one important way surety bonding protects taxpayer money.

What are the most common mistakes you see with respect to insurance coverage?

Colleen Telling, Manager & Counsel, Contract Documents & Risk Management, AIA Contract Documents

Often, contractors carry the same types and limits of insurance coverage on every project. However, no two projects are the same. Therefore, contractors should examine each project’s unique characteristics and enhance or add coverages as necessary.

AIA’s Insurance and Bonds Exhibit allows owners and contractors to discuss specific types of coverage and limits applicable to a project. For example, if a contractor must perform delegated design, it should purchase professional liability insurance. AIA’s Insurance and Bonds Exhibit provides spaces for the policy limits per claim and in the aggregate.

Another coverage is railroad protective liability insurance, which is necessary when a contractor performs work within 50 feet of a railroad. AIA’s Insurance Exhibit anticipates this type of coverage by listing it as an option.

For both of these insurance options, contractors are cautioned to confirm whether their agreement with an owner requires this insurance for a period after completion of the work.

What value do insurers bring as a partner to project teams?

Ryan Hucker, Vice President, U.S. Construction Practice Leader, Aspen Insurance

Insurers not only bring meaningful capacity and financial protection against unforeseen loss, but also can act as counsel to advise on what steps can be taken to mitigate the likelihood of a claim. 

When projects span considerable time frames, the ability to have an honest and open dialogue among stakeholders, as well as constructively review processes, increases the probability that projects will be delivered on time, on budget and to the expected standard.

Additionally, it is imperative to review and monitor the progress throughout the project life cycle. Failure to do so may result in significant cost overruns, project delays and the associated financial implications, as well as reputational damage that can affect current and future projects.

As a partner, insurers offer security and peace of mind so projects can continue with protection in place if problems occur. Continually monitoring and assessing where potential problems are is not just good practice, it is essential—and failure to do can have serious implications.

What are the main reasons for contractor default? How does a surety bond help?

Henry W. Nozko, Jr., President, ACSTAR Insurance Company

Because construction is usually priced before the product is made, project failures and defaults are not uncommon. Three common causes for blow-ups and defaults are mistakes, overloading and lack of cash.

Mistakes include missing a major cost item in a project estimate, underestimating the cost of installation or a bid that’s simply too low.

Overloading the backlog with too many projects might cause management to lose control of cost and the ability to efficiently close projects.

Project schedules might not be maintained due to a stretched field force, resulting in delay claims or, worse, termination.

Working capital could lose pace with a fusillade of payment obligations, leading to a domino-type breakdown.

To an extent, on a bonded project, the losses suffered by the obligee are recompensed under the surety bond—making the nominal cost of a surety bond a huge bargain.

Carl G. Castellano
Chief Risk Officer and Vice President of Contract Surety
Philadelphia Insurance Companies

Contractors default (or fail) when they inadequately prepare or execute on their business plan. Remember the “Ps” applicable to any business: proper prior planning prevents poor performance.

Three of the more common and costly characteristics of defaults are when contractors significantly increase volume, increase individual project size or change their type of work (e.g., moving from public to private construction).

Most contractors successfully avoid defaults even with these characteristics by properly planning for the stress placed on their financial and operational resources, including working capital, human resources, equipment and management.

Defaults are costly. Projects may not be completed on time, sometimes resulting in lost revenue for the owner, and vendors and subcontractors may be unpaid.

Surety provides significant benefits to owners. Initially, the surety prequalification process should result in fewer defaults. In the case of a default, the surety will respond in accordance with the terms and conditions of its bond, typically that owners receive their completed project lien-free.

What can a contractor do to qualify for larger contract bonds?

Mike Sanders
Senior Vice President, Underwriting
Old Republic Surety Company

As the economy expands, many contractors will find growth opportunities involving larger construction projects, most of which will require bonding. There are steps a contractor can take to help qualify for larger bonds.

Sharing your goals and business plans with your agent and your surety underwriter is essential. They will coach you on the necessary steps to take that could maximize your bond capacity. Share with them the specific reasons why a larger project is a good fit and a smart strategic move for your company.

A stronger balance sheet always helps when qualifying for larger bonds. Retain as much profit as possible in your business. Resist the temptation to take large bonuses or distributions from the company.

Provide high-quality and timely financial information in response to the needs of the underwriter. Engagement of a CPA who is highly experienced in construction accounting can help tremendously.

Maximize your business and personal credit ratings, as well as your reputation in the industry.