A surety bond is a type of risk management tool; it's an agreement where the surety (often a large insurance company) provides their financial backing of the principal (the party responsible for fulfilling an obligation) for the benefit of the obligee (the party to whom the principal owes the obligation). There are many specific types of surety bonds but they all have the same basic structure. A surety bond is an agreement between three parties:
A surety bond is similar to an insurance policy in some ways but has key differences. A claim can be made on a surety bond to address a failure by the principal to fulfill a covered obligation. This is similar to claiming on an insurance policy to help remedy a covered negative event. A distinction however is that the surety, while verifying the validity of the claim, may seek to remedy the situation by means other than a payout. Another distinction is that the surety expects repayment of funds expended satisfying surety bond claims. The surety will seek to collect the expended funds from the principal, in contrast to an insurance policy where the insured is not held responsible for funds paid out on claims. In short, with a surety bond, the principal is ultimately responsible to the surety for any funds paid out to satisfy claims.
There are two main categories of surety bonds:
Contract Surety Bonds – These are surety bonds that are directly tied to a specific contractual obligation. Contract surety bonds are often used in the construction industry. These surety bonds come in several common forms such as:
Surety bonds are used to help manage risk. An entity such as a state licensing board may require a surety bond be required for a company to be licensed to conduct business in a specific field. A state treasury may require a retailer to maintain a surety bond to help ensure the required sales tax payments are remitted as expected. A government agency may require the contractor contracted to complete a construction product be bonded to help ensure the project reaches completion within the desired timeframe and quality guidelines. The common consideration with regard to adding the surety bond requirement is a perceived risk to the obligee. A determination has been made that there is a risk, financial and/or otherwise to the principal not fulfilling their obligation.
Surety bonds help mitigate the risk to the obligee by transferring some of the risk to the surety. When sureties issue surety bonds, they put themselves in a financially responsible position with regard to some covered actions of the principal. In instances where the principal fails to fulfill their obligations, the potential for a claim on the surety bond arises. The obligee can go directly to the surety, in the form of a claim, to seek recourse. When the surety determines a claim is valid, the surety will seek to satisfy the claim which typically amounts to the surety paying on the claim up to the bond amount. With many bond types bond claims can lead to the surety cancelling the bond, if permitted to do so in the surety bond language. A canceled surety bond can jeopardize the principal's relationship with the obligee or the licensing/permitting agency. Typically if a surety bond is required as a licensing or permitting requirement, the requirement is continuous for as long as the license or permit is active. For that reason, among others, it is beneficial for the principal to avoid claims.
Surety bonds are similar to insurance products in the form of the claims process, but are very different with regard to the expectation of losses due to claims. Unlike that of an insurance product, the funds expended to settle a surety bond claim are expected to be recuperated. A surety will seek to collect funds expended on claims from the principal. The principal is ultimately responsible for funds the surety spent to settle claims on the bond.
One way a surety bond helps to mitigate the risk is the underwriting process. Although many surety bonds are very easy to apply for, the underwriting process still provides additional scrutinization of the principal via credit checks and in some cases financial analysis. When a surety executes the surety bond, they are providing a financial backing of the principal to the obligee. For sureties to be comfortable in this arrangement, they underwrite the principal's request via an application, credit check, at times financial statement and other information pertinent to the specific bond request. Through the underwriting process, the surety assesses the risk of bonding the principal. If the perceived risk to the surety is deemed tolerable, the surety issues the surety bond. This is beneficial to an obligee because it shows that the surety views the principal as an acceptable risk and is willing to back that view by issuing the surety bond.
An additional way surety bonds are beneficial to the obligee is the claims process itself. If the principal fails to fulfill the covered obligation, a claim can be made on the bond. The surety is the immediate path of recourse. Going to the surety directly can at times be more expedient than attempting to remedy the situation with the principal directly.
Surety bonds provide a clear benefit to the principal over other forms of security. In most cases, a surety can be obtained by paying a premium for the bond. In some cases, collateral may be required to secure the bond but in most cases, it is not. Other forms of security require the principal to put up assets that can be directly accessed to cover situations that would amount to a claim on a surety bond. The assets used to secure these are frozen until the security instrument is no longer needed. Obtaining a surety bond rather than a bank instrument for security can leave these assets free to be used for other things.
An additional benefit to the principal is the claims process. When a claim is made on a surety bond, the surety will validate the legitimacy of the claim. In some cases, the surety may even seek to remedy the situation that lead to the claim without paying out on the claim. In contrast to using a bank instrument for security where the funds can be accessed without additional review, funds are only paid out on a surety bond once the claim has been validated and a payout is deemed the most prudent way to satisfy the claim.
A surety bond can be obtained to fulfill a requirement. Surety bonds can be required for licensing or permitting. They are sometimes required in court proceedings to allow for certain actions to be taken. Surety bonds are also common in government contract work where the bond is a requirement of the contract. Surety bonds are used in many other sectors of commercial industry as well such as transport, real estate and taxation. The common theme however is that a surety bond has to be required by some entity. A principal can't get a surety bond just to have one; someone has to require the principal to be bonded. Typically when a surety bond is required, there will be documentation stating the requirement and the amount needed.
Applying for a surety bond begins with an application. Most commercial surety bonds require similar sets of information. These bonds can be applied for using a standard surety bond application. There may be additional small amounts of information required for some specific bond types. Surety bonds required to fulfill a requirement in a judicial proceeding typically require the court order for the surety bond and information about the proceedings. Some transportation related bonds may require the principal's unique transportation identifier code. Commercial real estate lease surety bonds require a copy of the lease agreement. If any additional information outside of the surety bond application is needed, it is made know very quickly by the surety bond agent.
Contract bonds also require an application but the process is more in depth. The application process for contract bonds, among other considerations, looks at the principal's ability to complete the contracted obligation. To perform this type of review, the process includes additional information requests such as work history and active projects. Since each contract can differ, the requirements to complete a contract surety bond application can vary. Additionally, the size of the contract can affect the level of information needed to complete the application process. This may sound slightly complicated but it's not and a contract surety bond agent can provide the specific application and requirements for each individual contract bond request.
One additional consideration when applying for a surety bond is the bond form. The bond form provides specific language describing the surety’s responsibility to the bond. There typically isn’t a generic bond form that covers several different bond types; there’s usually a specific bond form for each bond type. With regard to commercial surety bonds, such as license bonds, in most cases, we will already have the required bond form. For contract surety bonds however, such as a performance bond for a construction contract, the bond language is specific to the contract so we won’t have a copy in this case and one would need to be provided when applying for the bond.
Our surety bond agents take pride in providing excellent customer service. Regardless of the type of surety bond you need, our agents will make sure you know exactly what is needed to obtain the bond and will seek to get you the best quotes and terms for your specific bond request as quickly as they can.
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