What is a surety bond?
A surety bond is a three-party agreement between a surety company, an obligee and a principal. The third party (surety company) guarantees to the second party (obligee) the successful performance of the first party (principal). The surety company guarantees that the obligations of the principal to the obligee will be performed in accordance with a contract, statute or regulations. Bonds are used to protect public and private funds from financial loss.
How is a surety bond different than an insurance policy?
A surety bond and an insurance policy are not the same. The cost of assumed losses are calculated into the price of an insurance policy premium. A bond, on the other hand, is an extension of credit with the expectation that the legal obligation will be fulfilled, and subsequently, there will be no loss. Losses are not included in the cost of bond premiums, only underwriting expenses are factored into the rates. A surety company’s fiscal results are severely impacted when losses on bonds do occur.
What are the benefits of surety bonds?
Surety bonds are a mechanism for transferring risk. The surety company assumes the risk of the principal doing business from the obligee. Federal, state and local governments generally require surety bonds to give certainty that business owners and individuals will adhere with various laws safeguarding public funds. For example, license bonds protect the public from business impropriety. Contract bonds protect taxpayers by pledging that projects are finished appropriately, on time and without liens. Court, public official, government and miscellaneous bonds protect and secure public funds and private interests.
Why do surety bonds need to be underwritten?
A surety company must determine the risk of a loss occurring if the principal is unable to satisfy the obligation under the bond. Since a bond is an extension of credit, the surety company must review the principal’s financial information and business experience to determine if certain requirements are met to support the bonded obligation. This procedure is known as the underwriting process. Just as a bank evaluates loan applications, surety company underwriters evaluate risks in a similar way by considering business and personal financial statements, credit reports, credit references and other factors.
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) carries out that right by stating 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. The individual owners and their spouses may be asked to personally indemnify the bond if the principal is a closely held corporation or partnership. Personal indemnification establishes the principal’s private commitment to the business entity and to the surety company.
Why do I need to produce collateral to obtain a surety bond?
A surety company has a right to request collateral to reduce the risk of the bond. Collateral is occasionally required for high-risk principal’s or abnormal obligations. Collateral reduces the risk a surety company assumes when issuing a bond. Collateral can be provided in many forms, including cashiers checks, certificates of deposit or irrevocable letters of credit. Collateral is returned to the principal only after all bond obligations have been met and the obligee releases the surety company from their obligation.
What does a surety bond cost?
Surety bond premiums are determined on the size, type, and duration of the contract. They also can vary from surety company to surety company but generally range from one-half of one percent to two percent of the bond amount. In many cases, performance bonds incorporate payment bonds and maintenance bonds. When bonds are specified in the contract documents, it is the contractor’s responsibility to obtain the bonds. A contractor will generally factor in the bond premium into the amount of a particular bid. The premium is normally payable upon execution of the bond. If the contract amount changes, the premium will be adjusted for the change in contract price. Payment and performance bonds are not typically priced on the size of the bond, but rather based on the value of the contract being bonded.
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