What a performance bond actually pays out

A performance bond is a promise by a third party, usually a bank or an insurer, to pay the employer a sum of money if the contractor fails to perform. It is typically ten per cent of the contract sum, and it costs the contractor a fee that ends up in the tender.

Two kinds, and the difference is everything

An on-demand bond pays on written demand. The surety does not investigate whether the contractor was actually in default. These are common internationally and rare in UK construction, because a contractor that offers one is handing the employer the ability to call the money for any reason at all.

A conditional bond, sometimes called a default bond, pays only on proof of breach and proof of loss. Almost every UK construction bond is this kind, and the practical consequence is that calling it is not a form filled in. It is a claim to be established.

The cap is not the loss

Ten per cent of the contract sum sounds substantial until a contractor fails at seventy per cent completion. The cost of bringing in a replacement to finish a part-built job of unknown quality routinely exceeds ten per cent of the original sum, because the replacement prices continuity risk it did not create.

The bond caps the surety’s exposure, not the employer’s loss. Anything above the cap is a claim against a company that has just demonstrated it cannot pay.

Expiry is where they are lost

Bonds expire. The date is set at contract stage, when the programme looks like the programme. On a job that runs a year late, the bond can lapse while the contractor is still on site and still capable of failing.

Extending a bond needs a request, an underwriting decision and an execution. It does not happen in a fortnight, and a surety asked to extend cover on a visibly troubled contract may decline. The time to deal with it is when the delay becomes apparent, not when the bond has three weeks left.

What to check while it still matters

• Is it on demand or conditional, and does the wording match what was agreed at tender?
• What is the expiry date, and does it sit beyond the realistic completion date rather than the contractual one?
• Is the surety rated, and is it the entity you expected?
• Does it cover the whole contract sum including instructed variations, or the original sum only?

That last one catches people. On a job where variations have added twenty per cent, a bond fixed to the original contract sum covers proportionately less than it did on day one.

The realistic view

A performance bond is a partial recovery mechanism with a cap, a deadline and an evidential burden. It is worth having. It is not worth relying on as the answer to contractor failure, and a project whose only risk mitigation is a bond has not really mitigated anything.