What is a Supply Bond?
Supply bonds are a subset of the broader category of contract bonds that must be filed with the company receiving materials from the supplier. Supply bonds provide the receiving company an additional security that, in the event the supplier fails to deliver materials as agreed upon, the receiving company will be compensated for damages resulting from the default.
Supply bonds must be issued by insurance carriers admitted in the state where the goods are to be supplied. The insurance carrier issuing any surety bond, such as a supply bond, will also be referred to as the “surety company” or the “bond company”.
Why is a Supply Bond Required?
Supply bonds protect a receiving company by transferring to a surety bond company the cost of ensuring they are compensated for damages resulting from the supplier’s failure to provide materials as specified in the supply agreement. The surety company provides the receiving company a guarantee (the surety bond) that they will receive payment for financial damages due to a violation of rights pertaining to the supply agreement up to a limit specified in the bond (“penal sum” or “bond amount”). Ultimately, suppliers are responsible for their actions and required by law to reimburse the surety company for any payments made under the bond. Supply bonds refer to the supplier as the Principal, the surety bond company as the Obligor and the receiving company as the Obligee.
How much does a Supply Bond Cost?
Supply bonds cost between 1% and 3% of the contract amount. Supply bond rates are determined by the size of the bond and the financial stability, experience and reputation of the supplier. For suppliers that qualify for bond amounts up to $500,000, supply bonds cost 3% of the bond amount. For suppliers needing larger bonds, the rates will be tiered based on the size of the bond. The tiered rate is essentially a volume discount for larger bond amounts. The most typical tiered rate is known as a 25/15/10 rate; translated to mean 2.5% of the first $100,000 of the bond amount, 1.5% for the next $400,000, and 1.0% for the rest.
Example: $2,000,000 Supply Bond Cost Calculation
| Bond Amount | Premium Rate | Bond Cost |
|---|---|---|
| First $100,000 | 2.5% | $2,500 |
| Next $400,000 | 1.5% | $6,000 |
| Next $1,500,000 | 1.0% | $15,000 |
How does the wording in the bond form and contract impact the cost of a supply bond?
The bond form is a tri-party agreement which defines the rights and obligations of the requiring entity (obligee), surety company (obligor) and supplier (principal). While many bond forms use similar language, each bond form and contract can be customized by the project owner requiring the specific bond and may contain provisions that increase potential costs for the surety company, which will ultimately be passed on to the supplier via higher bond premiums, stricter underwriting or collateral. The primary text to consider in a supply bond surrounds cancellation provisions and forfeiture clauses
Cancellation Provisions
Most bonds contain a provision allowing for the surety company to cancel the bond (“Cancellation Provision”) by providing a notice to the supllier and project owner 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 supplier failing to pay premiums due, claim payouts, or material changes in the supplier’s
credit score. Supply bonds are non-cancellable and must be released by the requiring entity when the supply agreement has be completed.
Forfeiture Clause
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”). Supply bonds with forfeiture clauses will be more expensive than a bond with similar coverage that does not contain the clause.