How the Cost of a Contract Bond Is DeterminedPosted by Todd Taylor, AFSB, CPCU
What goes into determining the cost of a contract bond? Here is a basic introduction.
Common Contract Bonds
These are some of the most common contract bonds:
- Bid bond—surety consents to provide performance and payment bonds, if the contract is awarded
- Performance bond—guarantees performance according to contract, bond terms
- Payment bond—guarantees payment according to contract, bond terms
- Maintenance bond—guarantees against defects in materials or workmanship for a stated period after completion
- Site or completion bond—guarantees of completion involving contractor financing
Contract Surety Bond Rating Factors
Some contract surety bond costs are related to a contractor’s qualifications, while others are based on the scope of work or the classification of construction work that is being completed. The contract price is also a factor.
These qualifying factors may affect the rate of the rate tier for a contractor:
- The number of years in business.
- Business credit score and personal (owner and spouse) credit score.
- Full company and personal (owner and spouse) indemnity.
- Total of analyzed working capital and analyzed net worth ratios to total bonded exposure.
- Debt to analyze net worth ratio.
- Bank line of credit established and available?
- Quality of contractor’s financial presentation, including internal preparation and the compilation, review, and audit by the contractor’s CPA.
- Past performance, such as prior claims, job references, and job profit percentage.
- Scope of work to be performed.
- Project experience and the quality of management, accounting systems, and perpetuation plans.
Rates will vary based on the class of work, for which difficulty and risk are assessed:
- Class B work involves more difficult work and more risk. Examples include general construction, building construction, and related substrates such as concrete; excavation; underground; plumbing; electrical; and heating, ventilation, and air conditioning.
- Class A is less risky work than Class B. Examples of glazing (window installation) and roofing.
- Class A-1 is lower risk than Class A. Examples include contracts for furnishing and installation, or installation of equipment such as ornamental iron, signs, or alarm systems.
- Supply-only work involves no labor and is considered the lowest risk level. This can refer to supplying material or equipment.
Costs are also affected by such things as:
- The bond penalty is usually 100% of the contract price for both performance and payment bonds.
- Time surcharge is applied when the contract duration is expected to exceed one or two years, depending on rate filing. Some rate filings do not charge for the second year of exposure.
Surety premium terms and definitions
These basic factors are used in the calculation of premiums:
- Flat rate. With a flat-rate premium, there is no change in rate based on the contact size.
- $/M equals the rate per thousand of the contract price (M = $1,000).
- Tiered rate. When the premium is based on tiered rates, the cost per/M within the tiers will decrease incrementally based on the size of the contract.
- Change order (CO). An addition or deduction to the construction contract changes the contract price after the execution of the bond.
- Additional premium (AP) or return premium (RP)
- Overrun (AP). Add CO’s increase to the contract price.
- Underrun (RP). Deduct CO’s decrease from the contract price.
Sample premium calculations
The following examples show premium calculations for common contract bond types. They do not cover all rating situations but are basic examples for insurance agents who are new to surety bonds. Contact your surety underwriter to get rate information for your account.
Related: "The ABCs of Surety Bonds: What’s the difference between surety bonds and insurance?"
Example 1: “Flat rate bond premium. This calculation is straightforward. The premium rate is a set dollar amount per $1,000 contract price. In this example, the premium is $30 per thousand, on a $1 million contract amount, or $30,000.
$1 million contract amount
100% performance and payment bonds
$1 million performance and payment bond penalties
Flat rate per thousand of $30/M
Total premium = $30,000
Percentage of the contract cost = 3% ($30,000/$1 million)
Example 2: Contract bond with a tiered or graduated rate. This example is based on the following factors:
- Class B electrical subcontract with a project duration of one year.
- Contract amount of $1 million for 100% performance and payment bonds
- $1 million performance and payment bond penalties
Graduated rate tier calculation:
First $100M of contract price x $25/M = $2,500
Next $400M of contract price x $15/M = $6,000
Next $500M of contract price x $10/M = $5,000
Total premium = $13,500.
Percentage of the contract cost is 1.35% ($13,500/$1 million)
Example 3: Maintenance bonds. This example is based on a two-year 100% maintenance bond required upon project completion and acceptance, and 100% of contract and bond amounts. For the first year, there is no charge as it is included with the performance bond charge. Second-year is charged using a maintenance rate tier, as follows:
First $100M of contract price x $2.50/M = $250
Next $400M of contract price x $2.25/M = $900
Next $500M of contract price x $2.00/M = $1,000
Total premium = $2,150
Example 4: Overrun (AP) premium. This is based on a final status inquiry and/or final pay application showing change orders (CO), adding another $150,000 increase in the contract price.
Original Contract Price: $1 million
Revised Final Contract Price with COs: $1.15 million
COs of $150M contract price x $10/M = $1,500. AP
Note: The rate tier applied is the last rate tier of $10/M to these COs. An underrun (RP) premium would use a similar calculation by deducting the COs from the original contract price to figure the RP.
Consult your underwriter for the surety’s specific rate and premium approval before quoting rates or premiums to the contractor. Your underwriter is your partner and will be happy to help you understand the cost calculations and answer your questions.
If you have any questions about anything regarding surety, contact an appointed agent, or reach out to an Old Republic Surety branch nearest you.
Related: "Abbreviation for Million and Thousand: K & MM Meaning"
Todd Taylor is a contract surety bond manager with our Orlando Old Republic Surety branch office. He’s worked in the surety industry in the Midwest and Florida over 25 years. He has a bachelor's degree in business finance and CPCU, AFSB designations. He enjoys travel and photography.