What are performance bonds?

One insurance product that is commonplace on construction projects is the performance bond. But what are performance bonds and why do many project leaders insist on them?

Put simply, a performance bond provides security - it is a guarantee of the satisfactory completion of a project by a contractor. And in today’s vulnerable business climate, it is clear why more and more clients require that assurance as part of the conditions of awarding a contract.

Also known as contract bonds, or performance guarantees, a performance bond is usually around two years in duration, though may be longer depending on the scope of the project. It ensures the proper performance of a contractual obligation – or financial recompense if that is not possible.

A performance bond provides a written guarantee to your client that if you breach your contract or become insolvent, a surety bond company (such as Allianz Trade) will compensate them.

If a performance bond is a requirement of your contract, then the first step will be to arrange a bond facility with a surety bond company.

The bond facility provides the framework of your relationship with the surety bond company and will include an estimate of the maximum aggregated amount the insurer is willing to guarantee your company across multiple bonds and projects.

You will need to apply for each bond separately and a risk evaluation and due diligence will be carried out to assess the financial strength of your business, along with your ability to complete the contract and commitment to meet obligations.

In the event that you cannot adequately fulfil the contract, compensation can help your client overcome difficulties that your removal may cause, such as finding new contractors to complete the work.

A performance bond is mutually beneficial. It protects and reassures the project owner, while helping contractors meet their contractual obligations and win more work.

Performance bonds provide vital protection for the project owners that construction companies and contractors want to work with. While there’s no legal requirement to purchase a performance bond, many potential customers make it a contractual requirement. By providing those potential customers with the reassurance of a bond, and by proving you’re willing to meet their contractual obligations, investing in performance bonds makes it more likely that you’re able to win new projects.

While your business, as the contractor, pays for the performance bond, it is your client who would financially benefit from it, if it is called upon.

There may be instances where the performance bond can be charged back to the project. There is no standard approach, but adding the cost to the margin/project cost, may be part of negotiations in the original contract with your client.

In the case of a sub-contract, the sub-contractor pays for the performance bond and if you are the principal contractor, you will be the beneficiary.

Performance bonds are not a one-size-fits-all product. While they guard against most eventualities, coverage is based upon the client’s specific protection needs.

The cost of your bond will depend on a number of factors, including the overall financial strength of your business, the complexity of the project, and market conditions. This cost will also provide an effective guide to your client on your credit worthiness and your reputation in the bond market.

In the UK market, the amount guaranteed through a performance bond is not the full amount of the contract. The standard surety bond product in the UK is the ABI conditional bond wording, although typically offered in a bespoke form by the beneficiary.

Traditionally, the amount guaranteed is 10% of the contract – providing adequate recompense for your client to pay for damages, acquire new contractors, remedy bad works, or deal with increased costs etc, if you are unable to fulfil the contract.

All performance bonds are actually guarantees, and the right to claim under a guarantee is linked to the non-performance of the contract.

Using a surety bond company that is not a bank can allow businesses to free up liquidity, and tender for contracts knowing that credit lines with their bank won’t be affected.

Performance bonds are very common in construction contracts, but can also be used in other industries. There are different types of construction bond, and they can also be either 'on demand' or 'conditional'.

On demand performance bonds are an amount of money set out in the bond that is payable on demand, without needing to satisfy any preconditions.

Conditional performance bonds require the client to provide evidence that the contractor has not performed their obligations under the contract, leading to them suffering a loss.

• A retention bond: Can be used to release locked up cash that a client holds to cover any faults in your work. The retention bond provider acts as the guarantor instead, agreeing to pay up to the amount that would have been retained if you, the contractor, fail to carry out the work satisfactorily, or resolve defects
• Advance payment bond: Acts as security that specialist equipment that may need to be paid for up front, will be used to carry out the work contracted
• Section bond: Covers public body works where construction impacts on existing public infrastructure (roads, sewers etc).

Part of the global Allianz insurance group, Allianz Trade is trusted by over 62,000 clients around the world.

We have an unparalleled understanding of credit risk, with 83 million businesses monitored across all sectors in over 160 countries.

We are a UK leader in surety bonds, with an industry-respected AA Standard & Poor rating that characterises our financial strength and security.

We understand what companies want from a surety bond and evaluate each client on an individual basis, tailoring solutions to their unique needs and circumstances.

Thanks to our global insights and surety teams, we can provide centrally-managed surety programs to companies operating in multiple countries.
Visit our surety bond page to find out how we can help and request a quote online.