How the Cost of a Contract Bond Is Determined

This post is part of a series sponsored by Old Republic Surety.

The business of surety and fidelity bonding represents a growing segment of the insurance industry. Surety companies are eager to partner with independent insurance agents in the vital three-way relationship between the surety client (known as the obligee}, the independent agent and the surety itself. Old Republic Surety continues its educational series for independent agents who are building a book of surety business.

What goes into determining the cost of a contract bond? Here is a basic introduction for insurance agents who have limited experience in contract surety bonds.

These are some of the most common contract bonds:

• Bid bond, for which there typically is no cost.
• Performance bond.
• Payment bond, which usually is included with the performance bond and has no cost.
• Maintenance bond, which has no cost for one year because it is included with the performance bond. If the maintenance bond is for more than a year, there is a premium cost.
• Site or completion bond, which usually has a higher tier rate with higher financial risk.
• “Fast” or “quick” bond is for a small contract bond request with lower underwriting requirements.

Note that some common bonds have no cost attached to them or are included with another bond.

Common contract surety rating factors

Some contract surety 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 or the rate tier for a contractor:

• Number of years in business.
• Ratio of adjusted working capital collars to adjusted net worth.
• Is the total of adjusted working capital and adjusted net worth greater than the percentage of bond liability?
• Debt to equity ratio.
• 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.
• Project experience, as well as quality of management, accounting systems, 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 subtrades such as concrete; excavation; underground; plumbing; electrical; and heating, ventilation and air conditioning.
• Class A is less risky work than Class B. Examples include grading (non-excavation), 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:

• Bond penalty, which is usually 100% of the contract price for both performance and payment bonds.
• Time surcharge, applied when 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.
• Tiered rate. When premium is based on tiered rates, the cost will decrease incrementally based on the size of the contract.
• $/M equals the rate per thousand of the contract price (M = $1,000).
• Change order (CO). An addition or deduction.
• Additional premium (AP) or return premium (RP).
• Overrun (AP). Add CO’s increase to contract price.
• Underrun (RP). Deduct CO’s decrease from 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.

Example 1: “Fast” flat rate bond premium. This calculation is straightforward. The premium rate is a set dollar amount per $1,000 of the contract price. In this example, the premium is $30 per thousand, on a $1 million contract amount, or $30,0000.

$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 bond. 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.