A performance bond is a specific type of surety bond that contractors obtain for the potential liabilities they may incur for not completing a contract to proper specifications. Surety companies that bond contractors can include an indemnity clause within the bond agreement, which requires the contractor or other third party to reimburse the surety company in the event it must make payment on the bond.
Surety Bond Basics
There are three parties who have an interest in the performance bond: the contractor, who is the person or entity obtaining the performance bond, the surety company that issues the bond and the contractor’s customer, who can potentially collect on the bond in the event of a contract default. Generally, surety companies will charge the contractor a fee that ranges from 1 to 5 percent of the bond’s maximum value. However, unlike insurance, most surety companies will not issue a performance bond unless the contractor or other third parties indemnify the surety for any future payments on the bond.
Indemnification of Bonds
The main difference between obtaining insurance and a performance bond is that with insurance, your maximum monetary risk is the premiums you pay to the insurance company. In contrast, the surety company provides assurance to the contractor’s customer that it will cover any damages that result from a contract breach. However, the contractor remains liable by indemnifying the surety company, which requires the contractor and other third parties to provide sufficient collateral to cover the surety’s monetary risk.
Traditional Performance Bond
A common type of surety bond is the traditional performance bond. The terms of the bond provide that the surety and the contractor are fully liable to the customer for all liabilities that arise from the contractor’s breach. Provided the customer isn’t also in default or breach of the contract terms, provides a reasonable amount of notice to the surety company and contractor, and properly terminates the contractor’s ability to continue the contract, the surety must pay damages to the customer. A defining characteristic of the traditional performance bond is that the surety company has exactly the same responsibility as the contractor to complete the contract.
Performance Indemnity Bond
Although not the same as the indemnity provisions of most surety performance bonds, which require the contractor to reimburse the surety company for any resulting costs, there is a specific type of performance bond that many refer to as an indemnity bond. The provisions of this bond arrangement require the surety company to reimburse the contractor’s customer for the cost of using a substitute contractor to complete the project. However, the risk to the surety company increases because it is no longer in control of the substitute contractor and the resulting costs. Moreover, some indemnity bonds require the payment of consequential damages such as for costly delays in contract completion and loss of profits by the customer.
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