Contractor license bonds are a subset of the broader license bond category that must be filed with the government agency (city, county, or state) responsible for regulating construction activity in the contractor’s jurisdiction as a condition of licensure for most contractors. Many states handle contractor licensing directly, while others allow local municipalities to regulate and license contractors.
Contractor license bonds must be issued by insurance carriers admitted in the state where the government agency requiring the bond resides. The insurance carrier issuing any surety bond, such as a contractor license bond, will also be referred to as the “surety company” or the “bond company”. Contractor license bonds refer to the contractor as the Principal, the surety bond company as the Obligor and the government agency as the Obligee.
Why is a contractor’s license bond required?
Contractors are required to purchase license bonds by state and local statutes to protect a government agency by transferring to a surety bond company the cost of ensuring the public is compensated for damages resulting from a contractor breaking contractor license law. The surety company provides the government a guarantee (the surety bond) that the customers, vendors, suppliers and employees of a licensed contractor will receive payment for financial damages due to a violation of the statutes and regulations pertaining to the contractor license up to a limit specified in the bond (“penal sum” or “bond amount”). The bond company also directly receives claims from the public and determines the validity of claims. Ultimately, contractors are responsible for their actions and required by law to reimburse the surety company for any payments made under the bond or face indefinite license suspension.
Contractor license bond violations triggering a bond payout may include a contractor failing to pay employees, abandoning an uncompleted job or failure to repair faulty workmanship.
How does the wording in the bond form impact the cost of a contractor license bond?
The bond form is a legal document, a tri-party agreement which defines the rights and obligations of the government agency (obligee), surety company (obligor) and contractor (principal). While many bond forms use similar language, each bond form can be customized by the government agency requiring the specific bond and may contain provisions that increase potential costs for the surety company, which will ultimately be passed on to the contractor via higher bond premiums, stricter underwriting or collateral. The primary text to consider in a contractor license bond surrounds (1) aggregate limits, (2) cancellation provisions and (3) forfeiture clauses.
Bond forms always specify the penal sum defined as the maximum amount of financial damages any single party can recover from the bond related to a single claim occurrence. Most bond forms also contain a clause which limits the amount of financial damages from all parties and all claims to a specific amount (“aggregate limit”), usually the same amount as the penal sum. For example, a $15,000 contractor bond with an aggregate limit of $15,000 will pay out no more than $15,000, regardless of the number of damaged parties or claim occurrences. Contractor bonds without an aggregate limit will be more expensive than a bond with similar coverage containing an aggregate limit.
Most bonds contain a provision allowing for the surety company to cancel the bond (“Cancellation Provision”) by providing a notice to the contractor and government agency requiring the bond with the cancellation taking effect within a set period of time, usually 30 days (“Cancellation Period”). Cancellation provisions allow the surety company to cancel the bond for any reason, but most often due to the contractor failing to pay premiums due, claim payouts, or material changes in the contractor’s credit score. Contractor bonds with no cancellation provision or cancellation periods greater than 30 days will be more expensive than a bond with similar coverage containing a standard cancellation provision.
Surety bond claims are paid by surety companies to damaged parties to reimburse that party for the financial loss incurred up to the bond penalty amount. Certain bonds contain a clause which requires the surety company to pay the full bond penalty to the damaged party, regardless of the actual damages incurred (“Forfeiture Clause”). Contractor bonds with forfeiture clauses will be more expensive than a bond with similar coverage that does not contain the clause.