What is a Surety Bond?
A bond guarantees the fulfillment of a legal obligation. It’s a three-party agreement where the third party (surety company) guarantees to a second party (obligee or owner) the successful performance of the first party (principal). One of the primary uses of bonds today is to protect public and private funds from financial loss.
A surety bond is NOT an insurance policy. An insurance policy assumes that there will be a loss, so the premium for an insurance policy is calculated to cover losses that will occur. A bond, on the other hand, is an extension of credit with the assumption that the legal obligation will be fulfilled, and consequently, there will be no loss. The bond premium paid to the surety covers only the underwriting expenses of the surety company. When losses occur, they have a significant impact on the surety company’s financial results.
Benefits of Surety Bonds
Surety bonds are a risk transfer mechanism. The risk of doing business with the principal is shifted from the obligee to the surety company. Federal, state and local governments often require surety bonds to guarantee that business owners and individuals will comply with various laws protecting public funds. For example, license bonds protect the public from business misconduct. Contract bonds protect taxpayers by guaranteeing that projects are completed properly, on time and without liens. Court, public official, government and miscellaneous bonds protect and secure public funds and private interests.
What is Indemnity?
To indemnify means to make whole. Under common law, the surety company has the right to be indemnified by the principal in the event of a loss. The General Indemnity Agreement (GIA) enforces that right by stipulating that if the surety suffers a loss while providing a bond to the principal, the principal is obligated to make the surety “whole” by reimbursing any losses and expenses. If the principal is a closely held corporation or partnership, the individual owners and their spouses will be required to personally indemnify the bond. Personal indemnification demonstrates the principal’s personal commitment to the business entity and to the surety company.
Types of Surety Bonds
Different surety needs are met by different classes of surety bonds:
- A Contract Bond guarantees that an entity awarded a contract will meet its obligations under that contract. Included in this group are bid bonds, performance bonds, payment bonds, maintenance bonds and supply bonds.
- Subdivision Bonds guarantee that developers will make certain “off site” or “public” land improvements in accordance with state, county or municipal specifications.
- A Commercial Surety Bond can guarantee a variety of business obligations which require surety bonds. Commercial Surety Bonds include all non-contract surety bonds, including numerous types of license and permit, miscellaneous and court bonds.
- License & Permit Bonds guarantee that individuals granted a license or permit to operate a business or to exercise a privilege will meet the obligations under that license or permit.
- Miscellaneous Bonds guarantee a variety of non-classifiable obligations. These include utility, lost securities, workers compensation premium payments, and sales tax payments.
- A Court Bond guarantees that an individual will comply with the terms of the court. This includes probate and fiduciary bonds, as well as bail and immigration bonds.
The Underwriting Process
A surety company must determine the probability of a loss should the principal be unable to complete their obligations under the bond. Since a bond is an extension of credit, the surety company must analyze the principal’s financial standing and business aptitude to determine if the principal has the financial strength and business knowledge to support the bonded obligation. This is called the underwriting process. Surety company underwriters evaluate risks in ways similar to banks evaluating loan applications. Underwriters consider business and personal financial statements, credit reports, credit references and other factors.
A surety company may occasionally request collateral to reduce the risk of the bond. Collateral is sometimes required for high risk principals or unusual obligations. There are many forms in which collateral may be provided, including cashiers checks, certificates of deposit or irrevocable letters of credit. In addition, collateral reduces the risk a surety company assumes when issuing a bond. After all obligations of the bond have been met, the obligee releases the surety company from their obligation under the bond and the collateral is returned to the principal.
Claims on Bonds
If the principal does not fulfill the obligation under the bond, the obligee can make a claim against the bond. The surety company will step in to make the obligee whole. The surety company will then look to the principal for reimbursement of the loss and expenses incurred. It is important that the principal respond to the surety company’s request for information in a timely manner in order to minimize the cost to all involved.