This guide explains how a surety bond works.
In the modern, globalized world, we’ve collectively adopted the tentative business ritual, the “just in time” mentality. Goods and services are delivered the moment they’re needed. And so is payment. The problem with this mantra is that when problems occur, they can hit businesses hard. Non-compliance with contractual obligations by a third party can harm reputation, revenue, and future growth opportunities and create sobering financial realities.
That’s where the surety bond steps in. But what is a surety bond – and what’s the difference between a surety and an insurance policy? Keep reading to find out.
What Is a Surety Bond?
A Surety Bond is a contractual agreement between three parties. It’s one of many written agreements available to guarantee debts owed by one party to another.
In conjunction with a surety bond provider, the agreement consists of three parties:
- The obligee
- The principal
- The surety
The obligee is the beneficiary of the bond. In other words, the person (or entity) to whom service or duty is owed. The principal is the person or entity who owes the debt and must post the bond.
The surety is the third-party company that provides the bond. If the principal fails to fulfill their contractual obligations, the surety steps in to cover the cost of any losses or damages sustained by the obligee.
Put, a surety bond is like a security deposit.
Types of Surety Bonds
There are many types of surety bonds. Each covers a specific kind of contract between the three parties. These include:
- Performance bonds
- Contract surety bonds
- Commercial surety bonds
- Supply bonds
- Maintenance bonds
- License and permit bonds
Performance bonds are one of the most common types of surety bonds. Typically, they’re employed in construction and service contracts, guaranteeing that the principal (contractor) will complete all tasks outlined in a contract.
Bid bonds guarantee that a contractor will honor a submitted bid, while payment bonds ensure that suppliers or subcontractors receive payment. Supply bonds guarantee that materials and equipment are delivered on time.
Maintenance bonds ensure the carrying out of repairs and upgrades as stipulated by a contract. Finally, license and permit bonds guarantee that a contractor complies with local licensing and permit regulations.
What a Surety Bond Is Not
Despite appearances, surety bonds are not insurance policies! Insurance covers specific losses that an obligee does not have to pay for. With a surety bond, the principal is still liable for outstanding debt, which must be paid to the surety. When put in place, the bond exists to lessen the risk for an obligee and ensure their time, resources, and finances aren’t wasted.
When Do Surety Bonds Make Sense?
Surety bonds are most common in contracts where one party isn’t sure whether the other can fulfill their contractual requirements. Generally speaking, surety bonds aren’t about distrust. Instead, they’re common when two parties haven’t worked together before. They are most valuable when a contract requires a third party to guarantee that a principal will fulfill their obligations. While bad credit may be a factor, it’s equally common for startups and newly formed companies to seek out surety bonds to compensate for the lack of contract history.
How Much Do Surety Bonds Cost?
Surety companies charge a nominal fee to issue each bond. Usually, this amounts to between 1% and 5% of the bond amount. In most cases, the principal is responsible for paying this fee – though it’s not unheard of to share the cost between parties.
How Surety Bonds Protect Both Parties
Surety bonds aren’t only intended to protect the obligee in a contract. They protect the principal by providing financial security. The principal can secure work and land new contracts even with limited credit history and bad credit. From the obligee’s side of the fence, a surety bond protects against potential losses. If the principal fails to fulfill their obligations, the surety covers damages. This makes surety bonds particularly useful (and expected) for large contracts, where unfulfilled obligations can have severe ramifications for an obligee.
How Surety Bond Claims Work
When the principal fails to fulfill obligations in the surety contract, the company is responsible for paying claims to obligees. In most cases, the obligee must demonstrate how and why the principal didn’t measure up.
Such evidence may include the following:
- Failure to complete work on time
- Undelivered goods and materials
- Signed contractual agreements
- Losses on the part of the obligee owing to any of the above
Once a surety company is satisfied and determines that the principal is liable for unfulfilled obligations, it will pay the claim. The company may reduce the amount paid out if obligations were fulfilled in part. Then, the surety company turns to the principal to recuperate the debt plus outstanding fees associated with the claim, such as interest. Additional costs incurred by the surety company – legal, investigation, and processing fees – will also be passed on to the principal. As you might expect, failure to comply with the surety fees will result in legal action against the principal.
Lower Your Financial Risk
So, what is a surety bond in a nutshell?
A surety bond is a layer of security for both parties in meeting their obligations to each other. They ensure goods and services are either delivered or reimbursed if they aren’t, and they help startups to secure work even if they’re newcomers to an industry. Whether for auto dealers, collection agencies, contractors, or alcohol and tobacco, if you need the peace of mind that a surety bond brings, Surety Bonds Co can help.
Click here to learn more about our surety bond consultation services.