A key element of effective public agency risk management is contractual risk transfer. Using indemnification language and insurance requirements, public agencies can effectively transfer risk (responsibility for liability claims) to contractors, vendors, permittees, and other third parties. Since these parties have control over the work being performed, they are best positioned to manage associated risk and should accept responsibility for losses arising out of their work.
However, contracting for services creates other exposures for public agencies that cannot be managed through contractual risk transfer. This is where surety bonds come in.
Surety bonds are not insurance. They are, instead, financial instruments that protect public agencies by guaranteeing performance on the part of contractors or other service providers. Unlike an insurance policy, which is an agreement between two parties (the “insurer” and the “insured”), surety bonds involve three parties. In a typical arrangement, a public agency (known as the “obligee”) will require a construction contractor (the “principal”) to obtain a bond from a third-party financial institution (the “surety”) guaranteeing the contractor’s performance related to an agreement with the public agency. If the contractor fails to perform as required, the surety steps in to perform the contractor’s various obligations.
There are two common types of surety bonds often required by public agencies. These are most commonly required in construction contracts.
- Performance Bond – provides funds or arranges for a substitute, such as an alternative contractor, if the principal defaults on its performance obligations (i.e. fails to complete the contracted construction project).
- Payment Bond – provides funds to pay subcontractors if the principal fails to do so. This is important for the public agency since, absent a payment bond, the agency could become liable for monies owed to subcontractors.
Surety bonds are expressly required by California law in some cases. For example, CA Civil Code Section 9550¹ requires payment bonds for public works contracts in excess of $25,000.
In certain circumstances, such as large construction projects with the potential to affect land or waterways under the jurisdiction of the Federal government, local public agencies themselves may be required to obtain surety bonds and function as the principal. While the Authority does not provide surety bond services itself, resources are available to assist members in this area.
The Authority’s Contractual Risk Transfer Manual has a section addressing surety bonds (pages 70-71), including sample contract specifications.
If you have any questions or need assistance related to surety bonds, please contact your assigned regional Risk Manager.