As spring approaches, many contractors are undoubtedly looking either to get first-time licenses or renew current licenses to prepare for the rush of summer projects.
On paper, the process seems pretty straightforward—complete required training, pay applicable fees, get bonded and insured. Unfortunately, the bonding requirement for contractor licensing can present challenges that turn the licensing process from an annual inconvenience into a costly, confusing mess. Avoid the headaches associated with contractor bonds by knowing what goes into the cost.
Understanding the cost of bonding allows contractors to ensure they are taking steps to receive the lowest available rate when applying for their surety bonds, but there are a few important things to know before applying for a bond, including how surety bonds differ from traditional insurance, why they’re required and how underwriting works.
Bonded & Insured
Almost all licensing entities, or obligees, have two requirements: The contractor must purchase both an insurance policy and a surety bond. Considering that bonding and insurance requirements are often listed together in application materials, it is easy to mistake them as being one in the same.
Unlike insurance policies, contractor license bonds do not protect contractors. In fact, a bond provides protection from the contractor if loss occurs as a result of his/her failure to comply with all terms established by rules and regulations set forth by state and local lawmakers.
For example, if a contractor obtains a $10,000 surety bond and then causes financial harm to others, a claim may be made against the bond to collect up to the full bond amount for reparations.
Also, unlike an insurance claim where the premium paid by the contractor guarantees the insurer will pay to cover a claim, the premium paid to the surety guarantees it will put up the bond amount, so contractors do not have to use their own money up front. Although the surety makes the money available to settle a claim, the contractor must then reimburse the surety for every dollar. An insurance claim may lead to higher premiums, but a claim against a surety bond can have financially devastating consequences because the contractor is responsible for repaying the surety in full.
Some contractors are financially unable to cover the cost of a claim and may be forced to declare bankruptcy, meaning the surety company backing the bond has no means to collect the money paid out in a claim. In order to minimize the risk of financial loss, surety companies are reliant upon underwriters when determining an initial or renewal premium to be paid by a contractor.
When the risk is minimal, meaning a claim against the bond is unlikely and the amount of the bond is such that the surety can easily take the loss, contractor license bonds may be approved instantly at a set rate for which all applicants qualify. However, these are an exception to the norm. Most contractor license bonds require underwriting because they are seen as being higher risk.
Reasons a surety company may require underwriter review prior to granting approval range from a large bond amount to specific issues such as the language on the form. For example, a bond form that does not explicitly state claims may only be made up to the full amount of the bond may be seen as risky due to an aggregate concern.
Although it may seem like an overly complicated process to determine something as simple as a quote, underwriting is actually pretty straightforward. When an application for a contractor license bond is submitted, the underwriter is essentially looking at an applicant’s qualifications, which can be broken down into three categories—character, capital and capacity:
- Character refers to the applicant’s reliability to financial obligations and is determined by a soft credit check.
- Capital is an asset an applicant possesses that may be used to repay the surety for claims if the contractor does not have the cash to cover the cost.
- Capacity is the contractor’s ability to repay the surety for claims against his or her surety bond.
When an underwriter has reviewed the contractor’s application and determined they are highly qualified, they will typically provide a quote between 1 and 3 percent of the total bond amount, meaning a contractor could pay as little as $100 for their $10,000 surety bond. Applicants who are less qualified may receive a higher quote ranging from 4 to 10 percent of the bond amount. In some cases, the underwriter may decide the applicant is too risky to quote. Major issues that will almost always result in a high quote or outright rejection include claims against a previous surety bond and subsequent failure to repay the surety or any public record such as bankruptcies or tax liens, even if they have been satisfied.
Keeping Costs Reasonable
By the time a contractor has paid all necessary fees, their insurance premium and their surety bond premium, getting or renewing a contractor license can be a costly endeavor. However, there are a few things that can keep the cost of a surety bond reasonable.
First, working with the right surety provider can make a world of difference. For example, online specialty brokers will often have access to a variety of surety companies, meaning the applicant can get a better quote than what a local insurance agency may provide. Contractors should also be wary of agents trying to “sell” to them. After all, the bond is required for licensing, so finding an agent who approaches the interaction as more of a partnership rather than a sale will often result in being approved at the lowest rate for which the contractor qualifies, because the agent will compare quotes until they believe they have the lowest one available. Finally, it is advisable to find an agent with whom you are comfortable asking questions. It helps to prevent surprises such as additional fees when it’s time to pay and can also help you to understand why a high quote was given and steps to remedy that