Q. What is the normal relationship between the contract and bond amounts?
A. Performance and Payment Bonds are normally issued for 100% of the initial contract amount.
Q. What do you call a bond that’s for less than the full contract amount?
A. Underwriters call these “percentage bonds,” such as a 50% Performance and Payment bond. Some obligees stipulate these in order to make the bond cheaper (doesn’t work), to help the contractor preserve their bond capacity (doesn’t), or to make the bond easier to obtain (nope). What it does do is deprive the obligee of part of the protection they are buying.
Q. What happens with the original 100% bond amount if there is a subsequent amendment increasing the contract price?
A. The bond is often required to automatically follow an increase in the contract amount, without “notice to or consent of” the surety.
Q. Is there a limit to how much the bond can be automatically increased?
A. A limitation may be stipulated in the bond to protect the surety from huge unanticipated increases, such as no more than a 10% increase without the written agreement of the surety.
Q. What is the basis of the calculation for the bond cost?
A. The cost of the bond is normally based on the amount of the contract being guaranteed, not the bond. If the bond is for 75% of the contract amount, the bond cost would be unchanged. Why does this make sense?
- The surety’s decision making process is still based on the entire scope of the contract including all technical aspects and the difficulty of performance. The underwriting expenses are unchanged.
- Which 75% of the contract does the bond cover? It covers the entire contract, but subject to a lesser maximum bond penalty. You could say it covers the bad 75% where the claim lies. Full penalty bond losses are extremely rare, so the reduction to 75% has little benefit for the surety.
Q. What is the cost difference for Performance only, no Payment bond?
A. Since the underwriting is unchanged, there is no cost reduction.
The Maximum Rule:
Does your brain hurt yet? It will after this.
The purpose of the Maximum Rule is to limit how much is charged (the maximum) for a “percentage” bond. Suppose you have a 10% P&P bond on a $1 million contract with a straight rate of $25 / thousand. Based on the contract amount, the bond fee would be $25,000. Will the obligee pay $25,000 for a $100,000 bond? Even though the bond will cover the entire $1 million of work, it’s a hard sell. This is where the Maximum Rule comes in.
The price calculation under the Maximum rule is different. Here is a typical example:
If the rate used in the Maximum Rule is $50 / thousand for the aggregate of the Performance ($100,000) plus Payment bond ($100,000) amounts, it will equal $50 x 200 or $10,000. So in this example the maximum applicable charge would be $10,000 for the $100,000 bond, in recognition of the greatly reduced bond penalty.
With the Maximum Rule, you charge the normal price or use the Max Rule price – whichever is less. As the percentage of the bond amount increases, the advantage of using the Maximum Rule disappears. In this example the tipping point is 25%. The Performance and Payment bond amount must be less than 25% of the contract amount for the Max Rule to result in a reduced charge.
Here’s the good news. The vast majority of contracts stipulate a P&P bond equal to 100% of the contract amount; this is the typical statutory requirement on public work. The same routine is normally followed on private contracts as well because it is the best way to protect the obligee’s interests.
A special note from the author: Steve Golia
I am an Independent Broker and Surety Bond Specialist. If you wish to co-broker bond business, together we will deliver the best in bonding expertise for your clients. I have a broad range of markets available and often can solve problems even when others have failed.
Call me now (856-304-7348) or email: Steven.Golia@gmail.com