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Surety Bond Meaning

Surety bonds are widely used and widely misunderstood. Anyone who plans to enter into a bond agreement needs to know exactly what they're getting into. This glossary entry provides a complete rundown of an important subject – surety bonds.

What Does Surety Bond Mean?

What is a surety bond? A surety bond is essentially just a financial tool to guarantee that one party can seek compensation if wronged by another party. This type of bond is used to ensure the lawful behavior of commercial businesses, to make contractual agreements more trustworthy, and to mandate that performance benchmarks are met. Hundreds of different options exist, each with different surety bond meanings and requirements, but all of them are agreements between three equal parties:

  • The obligee is an entity, often a government agency, that requires specific parties to obtain a bond. Any claims filed against the bond are also paid to the obligee.
  • The principal is responsible for obtaining and renewing the bond, often as a condition for professional licensure. Payments made to settle claims are ultimately paid by the principal.
  • The surety company issues bonds to the principal that meet the mandates of the obligee. Surety companies guarantee that claims are paid, up to the bond total, before recouping their losses from the principal.

What are Surety Bonds Used For?

Everyone wants to trust that the people they do business with are honest and ethical. Just consider a recent survey about consumer preferences showing that trust matters "a great deal" or "a lot" to 65% of the respondents. Unfortunately, not everyone is honest.

There are many instances when consumers or contractual partners are wronged by the people they form business relationships with. Surety bonds exist to hold unscrupulous businesses accountable and to provide restitution for their victims. Since surety bonds guarantee payment for valid claims, the obligee is confident they can be justly compensated after being wronged.

This protection is considered so important that many agencies require businesses to obtain surety bonds before they're granted licenses, essentially saying it's illegal to do business without a bond. They provide an essential mechanism for building consumer trust in businesses specifically and markets generally. Everyone, principals and obligees alike, benefit from the accountability that bonds ensure.

Example of a Surety Bond in Action

It can be difficult to understand the surety bond definition in the abstract. So consider an example of a common type of surety bond in action. Most contractors need a license to legally work on residential and commercial projects, and most need a surety bond as part of the licensure requirements. Details vary across states, but in almost all cases, the surety bond holds the contractor liable for any misconduct that violates state law and results in damages for the project owner (eg. the person that hired the contractor).

In our hypothetical, let's say a contractor required 50% of the project costs upfront but then failed to start the project – a clear violation of state law. In that case, whoever hired the contractor could file a claim against the surety bond for compensation equal to the stolen money.

Upon receiving the claim, the surety would launch an impartial investigation. The goal is to prove or disprove whether the contractor did in fact accept payment and then fail to start work. Invalid claims won't receive a settlement. However, all valid claims receive an immediate settlement from the surety.

Even though the obligee (the project owner) has been compensated at this point, the claims process has not reached its conclusion. Since the contractor (the principal) accepts financial liability for claims when signing the surety bond agreement, he must repay the surety the same amount as the settlement. He must also pay interest that grows larger the longer the debt remains unpaid as well as fees to cover costs that the surety incurs settling the claim.

How Much Do Surety Bonds Cost?

In surety bond terminology, it's important to distinguish totals from premiums. The bond total is the maximum amount the bond will pay to settle claims. The bond premium is the actual cost of the bond, usually around 1-5% of the total.

The exact amount of the premium is based on the credit risk of the bond applicant – essentially how likely they are to pay the surety back for any claims settled. Poor credit is not necessarily a disqualifying factor, but it will mean slightly higher premiums. To improve your chances of getting approved for a bond at a fair rate regardless of credit, take advantage of Viking Bond Service's special bad credit surety bond program.

Bond premiums are paid initially to activate the bond, then again to renew the bond, typically on a 12-month schedule (in surety bond terminology, this is known as the "bond term"). As long as the principal avoids claims filed against the bond, the premium is the only cost.

How Do You Obtain Surety Bonds?

To obtain a surety bond, your best strategy is to work with a reputable surety company. Understanding surety bond meanings, definitions, and details can be tricky, so it helps to have a guide through the process. You will need to fill out an application with basic information about yourself, your business, and any equity partners involved. Underwriters will evaluate that information and calculate a bond quote. Once the principal pays the premium, they typically need to submit formal documentation to the obligee. At that point, the surety bond requirement is satisfied for as long as the bond is active.

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