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Service Contracts and Performance Bonds

November 20, 2021

Service contracts often require performance bonds, payment bonds and bid bonds but service contractors may be unfamiliar with bonding. Below is an explanation of service contracts and what contractors need to know about bonding these contracts.

 

What Are Service Contracts?

 

The term contractors often refers to construction companies. However many contractors perform services such as mowing, security, transportation, food services, and many more. 

 

These contractors are referred to as Service Contractors in surety bonding. These service contracts can require bid bonds, performance bonds and payment bonds just like construction contracts.

 

Service Contracts are Unique

 

Although Performance bonds, bid bonds, and payment bonds may be required, service contracts are quite different than Construction Bonds. Because of these unique differences, they are usually handled by a Surety bond company's commercial underwriting staff instead of the contract bond underwriters.

 

What Does The Service Bond Guarantee?

 

The first thing to understand is what is being guaranteed by the contract. A service contract could be quite simple. For example, a contract between a city and a printer to print a certain number of bus passes is a pretty simple obligation. The risk is easily calculated by Surety bond underwriter and if the printer cannot perform, the Surety could likely find another printer to fulfill the obligation at a similar price.

 

Alternatively, a multi year contract between a city and a school bus contractor could be viewed as very risky. The contractor will likely need a lot of capital to acquire and or maintain a fleet of buses. Additionally, they may not be able to get enough drivers or wages may significantly increase. Finally, if the bus contractor cannot complete the obligation, it may be very costly to find a replacement contractor.

 

Each service contract is different and it is important for both the contractor and the Surety to understand the obligation.

 

Fixed Cost or Unit Cost Service Contract

 

Although these contracts are usually not referred to as fixed cost or Unit cost, it is an important underwriting consideration. 

 

For example, suppose a snow removal contractor signs a contract with a property owner to remove snow from the properties all year. They could agree to one fixed price for the year or they could agree on a price for each removal. 

 

A fixed price contract would provide more risk and reward for the contractor. If it's a mild winter, the contractor could make extra profit. However, if it's a very snowy winter, the contractor could lose money and could even risk a claim on the bond.

 

Surety bond companies prefer pricing based on unit pricing. In our example above, there would be a set price every time the contractor removes snow. If the contractor has estimated correctly, the contract should be profitable.

 

Length of The Service Contract

 

Contract length is an important consideration in all Surety bond underwriting but it is often an even bigger concern in service contracts. Many of these contracts tend to last longer than one year. 

 

Longer contracts present more risk for both contractors and bond companies. Labor, material, fuel and other costs become harder to predict over longer time frames. Longer contracts increase the chances that the contractor will incorrectly estimate these costs and be unable to complete the contract profitably.

 

Longer contracts also increase the risk that the contractor may run into financial challenges unrelated to the bonded project. A contractor may lose money on other projects or operations in general that may prevent them from fulfilling the bonded obligation. 

 

Therefore Surety bond underwriters prefer service contracts with shorter timelines. A common middle ground is to provide a bond with language that renews annually by mutual agreement. This language has become common in service contracts but it may not be accepted by all obligees.

 

Underwriting Service Contractors

 

Service Contracts require the contractor to qualify from an experience standpoint as well as financially.

 

Financial Underwriting 

 

Surety bond underwriters will want to make sure that the contractor has enough capital and liquidity to complete the contract. Of particular importance to bond underwriters on Service Contracts is working capital

 

Working capital is a contractor's current assets minus their current liabilities. It's a good measure of the service Contractor's ability to meet their cash obligations over the near term. 

 

A Surety will also look for a history of profitability for the contractor.

 

Experience 

 

Experience is also important to Surety Bond underwriters. Does the contractor have experience completing similar contracts? Underwriters typically do not want to write bonds that are more than double a contractor's previously largest completed project.

 

Project Uniqueness

 

As discussed above, Service Contracts are often very unique. There are often a limited number of contractors who may be able to perform the work. The more unique the obligation, the more the Surety Bond company wants to make sure the contractor has the staff, equipment and financial means to complete the contract because finding a replacement contractor may be very expensive or even impossible to step in.

 

Alternatives to Performance Bonds

 

Often a contract may allow a contractor to post an Irrevocable Letter of Credit instead of a Performance or Payment Bond. This is usually a mistake. Contractors usually have no defense or protection from a claim made against an ILOC. Alternatively, a performance Bond requires the Surety to investigate a claim to make sure it is valid before paying the Obligee. Service Contractors can read about other differences between performance bonds and ILOCs here.

 

Service Contracts Require Indemnity

 

Like all Surety bonds, bonds written for service contracts require indemnity. That means that if the Surety Bond company suffers a loss, they expect to be reimbursed by the company and other indemnitors. This is a major difference between Surety bonds and insurance. Service contractors can read more about indemnity here.

 

Service contracts do not have to be difficult to bond. Access Surety has many bond companies who write performance and payment bonds for service contracts and we can get these approved quickly and easily. Contact us anytime.

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