Trippe Hawthorne, a partner, and construction lawyer at Kean Miller, was a featured author for the American College of Real Estate Lawyers (ACREL), where he wrote on the subject of contractors and what it means to be licensed, insured, and bonded. Many property owners see this nomenclature in marketing and promotional materials for General Contractors, but may be unclear as to what it all means.

With the aftermath of Hurricane Ida, being educated on the nuances of these designations are of critical importance to both the property owner and the contractors.

Following is the full-text of the article, originally published in the August 2021 issue of the ACREL News and Notes monthly newsletter.

Every property owner who has endeavored to undertake a construction, renovation, or repair project has heard or seen the phrase “licensed, bonded, and insured”. But what does this mean, and does it really matter? Like all good questions, the best answer is, “it depends”.

Licensing: Many but not all states require contractors to be licensed. If the project is in a state where a contractor’s license is required, the importance of observing the licensing laws is critical. Violations of state licensing law can have catastrophic consequences to the unlicensed contractor and to the project. While owners do not typically have direct liability for a contractor’s violation of state licensing law, a project employing unlicensed contractors is subject to being shut down by licensing board investigators and authorities, which will undoubtedly cost the owner significant time and money. Also, it is generally the case that where a license is required for a particular type of work, a contract for such work with an unlicensed person may be subject to nullification.

The licensing process varies from state to state, but it is generally structured to require proof that a contractor has basic financial, business, and technical competency to perform the work for which the license in a particular classification has been issued in a responsible way. Technical competency is typically addressed through testing and/or required levels of experience in the specific area for which the license is sought. Many states have a tiered or subdivided contractor license system under which the state’s requirements for licensing are differentiated based on the monetary value of the contractor’s contracts and/or the type of services the contractor offers. Contractors that are licensed for large commercial construction contracts may hold a different type of license than subcontractors who are not dealing directly with owners, or contractors that only perform residential construction or home remodeling. Contractors and subcontractors performing inherently dangerous work which can threaten life, health, and safety (such as plumbing or electrical work) might need still other types of licenses.

Financial and business competency and viability is typically addressed through minimum asset requirements, examination of basic financial records, and background checks. The background checks may be for the licensed contractor and its key employees and agents, and will include review for things like bankruptcies or unsatisfied judgments.

The structure and purpose of most state contractor licensing systems is to ensure basic competency and basic levels of financial stability. State licensing requirements help create, identify, and illuminate the channels available to customers, creditors, and the government to hold a contractor accountable, particularly where there is a public threat to life, health, or safety. Nevertheless, a contractor’s ability to obtain a license should not be overvalued, particularly with regard to competency, and state licensing law is generally of little help to owners in the event of a contractual dispute with a licensed contractor. A license (where required) is the bare minimum that any responsible contractor needs before they begin to accept contracts.

Bonded: While, as discussed below, traditional insurance is not intended to guarantee a contractor’s performance under a construction contract, certain types of surety bonds are. “Bonded” means that a surety will stand behind the contractor for some obligation owed by the contractor. The surety guarantees some aspect of the contractor’s performance to someone. The key questions then are “what performance has been guaranteed” and “to whom”?

Generally, when the words “licensed, bonded, and insured” are used in an advertisement for a contractor, the word “bond” generally refers to a license and/or permit bond. This license and/or permit bond guarantees that the contractor will abide by the terms of the license issued and/or the permit they have pulled, protecting some or all of the licensing board, the public works department, the owner, or the general public. The existence of and requirements for obtaining a license and permit bond vary greatly by state, county, or municipality. In the event of a troubled contractor, though, the proceeds of these bonds are likely to be claimed by a number of different people, and the amount of the bond may not be likely to be sufficient to cover the contractor’s liabilities. In other words, while it could be nice that a bond of general applicability exists, owners should not place any reliance on such a bond in their decision-making process.

For a significant project, the owner will want to dictate the terms and conditions of the bond and have it dedicated to the project and that particular owner. Typically, this is done through a “payment and performance bond” issued for a specific project. The payment bond guarantees payment to subcontractors, material suppliers, laborers, and others that have worked on the project, and who may have lien rights against the owner. The performance bond generally serves as a guarantee by the surety to the owner that the contractor will perform the work pursuant to the terms and conditions of the contract. The performance bond does not entitle the owner to anything more than is owed under the construction contract, but does provide security that the project will be completed for the contract sum, even if not by the contractor.

Insurance: Whether a contractor is “insured” may be the most important or least important part of the trio, depending on the risk at issue. Insurance is the most valuable tool in protecting against the risks to third parties created by a construction project, but is not particularly useful in protecting the owner for its own damages caused by the contractor’s breach or bad work.

The most common risks addressed by a contractor’s liability insurance include property damage, injuries, and workers’ compensation claims. Many states’ contractor licensing laws require a minimum amount of general liability and workers’ compensation insurance in order to obtain and maintain a license. Liability and worker’s compensation insurance is important to protect owners from claims by third persons arising out of or related to their project, and insurance for these claims is of critical importance if they arise. While an owner can ascertain and determine a contractor’s available insurance through review of an insurance certificate supplied by the contractor’s insurance agent, for more significant projects, the owner will want to be added as an “additional named insured” to the contractor’s liability insurance policies and ensure that the available insurance has appropriate coverage and limits for the work at issue, and will defend the owner and contractor in the event of a claim.

While a contractor’s liability insurance may protect the contractor and even the property owner from claims for damages to third parties arising out of the project, it is not intended to protect the owner against breach of contract by the contractor or bad workmanship. In other words, “insured” means that a contractor has insurance to protect against risks to people other than the owner, and it is not likely to protect the owner from the owner’s own damages that may arise out of or relate to the project.

Construction projects also typically involve different types of property insurance, ranging from the owner’s property insurance policy or program to a builder’s risk policy, which protects the project and the materials and component parts thereof while the work is incomplete.

It’s important to understand the difference between being bonded and insured. For a contractor, one of the biggest differences between insurance and bonding is which entity takes on the risk; an insurance policy transfers the risk to the insurer, while a bond ultimately keeps the risk with the bonded contractor. For an owner, the main difference is in which types of circumstances are covered by bonds versus which are covered by insurance. Bonds should generally be associated with the Contractor’s performance of its obligations under the contract, whether to perform the work, or to pay subcontractors and material suppliers. Insurance should be associated with personal injury or property damage, typically to third parties.

The cost of licensing and insurance for a contractor is typically a general cost of doing business, while the cost of a project specific bond is… project specific. So, for projects where cost is a key factor (are there any where it is not?) many times, eliminating bonding requirements is a way to reduce project costs.

Surety bonds protect the interests of the project owner and ensure that the projects are completed correctly, securing the completion of the job and the security of the owner’s investment. Many surety bond companies won’t issue a bond without having sufficient security from the contractor and unless the contractor is sufficiently insured. If an incident occurred, causing property damage or personal injury, the surety would want to be confident that the contractor’s insurance would protect the continued viability of the contractor and its ability to complete the project, which the surety has guaranteed.

From a planning perspective, knowing that a contractor is “licensed, bonded, and insured” is certainly better than hiring a contractor that is not licensed, is not insured, and can’t get a bond, but prudence will always suggest consideration of the requirements and ramifications of the particular project, and at least some analysis of whether the protections offered by this contractor for a particular project are appropriate and sufficient.