What is a Surety Bond?Harry Shoemaker
Surety Bond Overview – Bond Republic
Welcome to our bond education center. Here, we’ll cover some surety bond basics.
What is a Surety Bond?
A surety bond is a contract between three parties – the principal, the obligee and the surety – whereby the surety and the principal promise to the obligee that the principal will fulfill some sort of obligation. If the obligation is not met, the obligee has the right to recover a stated penalty amount from the surety which, in turn, has the right to collect what they have paid on the bond from the principal. Basically, surety bonds serve as a guarantee that an obligation will be satisfied and, if not, assurance of immediate financial restitution. In the end, surety bonds provide businesses, governments and other entities the guarantee that requirements will be upheld in deed or in monetary compensation and by doing so promote activity in the marketplace.
Example: Joshua’s construction company, the principal, needs to submit a $50,000 bond in order to be awarded the contract to build an office building for Jericho Data, the obligee. This performance bond requires that the building be constructed to the specifications of the contract. Joshua finds a bond with Mercantile Company, the surety, who guarantees to pay Jericho Data up to $50,000 if Joshua fails to abide by the contract to which he agreed. Most of the time, obligations are satisfied and the penalty is never distributed, however, if Mercantile pays Jericho due to Joshua’s failure to abide by the contract, it then has the right to recover that amount from Joshua.
One of the most common types of obligees is a state government. Examples of surety (or bonding) companies include Merchants Bonding and CNA Surety.
Types of Bonds
Contract Bonds Ensure that contracts are honored
- Bid – Contractor must enter contract if awarded the bid
- Performance – Contractor must perform work as specified in contract
- Payment – Contractor must pay for services (labor, materials)
- Maintenance – Contractor must warranty their work for the maintenance period
Commercial Bonds Ensure that other general obligations are fulfilled
- License and Permit – Required by governments before receiving certain licenses
- Court – Prescribed by statue and related to court proceedings
- Public Official – Guarantees honest and faithful performance of duties in public trust
- Miscellaneous – Don’t fit into other classifications, often for specialized business needs
The Employee Retirement Income Security Act of 1974 (ERISA) established minimum standards for the treatment of employee benefit plans in private industry. One focus area of ERISA relates to the performance of pension plan fiduciaries – those people tasked with the management of employee retirement plans – and one way to help safeguard pension plan assets is to require that those fiduciaries be bonded. An ERISA bond guarantees the performance of fiduciaries.
Underwriting guidelines are used by the surety to determine whether they want to bind themselves to the surety contract. The guidelines serve to evaluate the risk associated with standing behind the principal. There are a number of elements to consider when evaluating the risk:
- Penalty amount
- Duration or term of the obligation
- Likelihood of a claim on the bond
- Credit-worthiness of the principal
Bonds that are considered very low risk are often freely written, meaning you can easily purchase them without an application process. Applicants for riskier bonds are evaluated by examining their credit and other factors. To some extent, the applicant who applies for a bond is very similar to the applicant who applies for a credit card. In the case of a bond, the surety is concerned with the likelihood of having to pay a claim, along with the chance of recovering the money from the principal. Similarly, a bank issuing a credit card is concerned with whether the cardholder will use the card responsibly and pay their credit card bill. In both cases, credit history is a fairly reliable indicator of the applicant’s character with respect to individual responsibility and repayment risk.