Performance bonds—insurance-like arrangements in which a surety (the bonding company) contractually agrees to pay for the performance of a principal (the contractor) to an obligee (the owner) in case the principal fails to perform the obligations of its contract—should be used more often in construction agreements to provide owners with a source of funds to cover defective work in a project.
Currently, owners typically require contractors to obtain insurance policies with the hope that such policies cover defects in the work they perform for the owner. Though owners are willing to spend a lot of money, time, and effort in obtaining these policies, insurers continue to make revisions to their policies to limit, and sometimes prevent, coverage for these defects.
Performance bonds may provide better protection to an owner. Typically, the bond provides funds to pay for repair of defective work that may not be covered by insurance as part of the bond’s guarantee of the faithful performance of the contract by the contractor.
Unlike insurance policies, performance bonds provide coverage only for the owner’s project—if an owner discovers a defect in the contractor’s work, the owner will not have to worry whether another owner’s claim against the contractor for another defective project will reduce the coverage available under the contractor’s bond. The performance bond’s recovery pool belongs to the owner for the specific project it is drafted to cover.
These bonds also provide funds for recovery where insurance policies may not, with the ability to provide coverage for design-build projects, such as green building projects, that are otherwise difficult to insure. More owners are incorporating green elements into their buildings, but insurers are either wary of writing policies to cover green elements, or are not sure how to write those policies.
(More generally, and for similar reasons, design defects are becoming harder to insure. A bond allows an owner to come closer to guaranteeing the owner’s design objectives than insurance policies do. Owners should consider obtaining performance bonds to guarantee design contracts as well.)
There are disadvantages to performance bonds. Bonds are only good for the period that the owner requires and pays for. A CGL insurance policy may provide coverage for damage that occurs during the policy’s period, regardless of when the insured makes a claim for coverage. On the other hand, if a performance bond expired last year but the owner discovers a defect today that was caused during the term of the bond, the bond will not provide coverage.
Still, owners should consider requiring performance bonds to provide extra protection to their projects. They usually cost the owner between .5 and 2.0 percent of the contract price for each year that the bond is effective. The term of the bond typically ends either upon completion of construction or, more commonly, at the end of the contract warranty period (one or two years after completion), though owners should extend the bond for additional years if they want bond protection for latent construction defects.