What is a Surety Bond?

by Rosie Esplana

June 24, 2023

Surety bonds ensure that suppliers will be able to pay their financial obligations if contract performance targets are not met. Without them, many significant projects would be impossible to complete.

application for surety bond — *freepik.com by yanalya*

Surety Bond Meaning

A surety bond is a contract between three or more parties: a supplier, their client, and an insurance company (surety bonds are also offered through banks, although banks’ terms are less flexible, and the bond appears on your balance sheet, but the insurance company’s surety does not).

The principal is the one who is responsible for fulfilling an obligation.
The obligee is the person who needs assurance that the principal will fulfill his or her obligations.
The surety is the company that issues the surety bond and guarantees that the principal will fulfill his or her obligations.

Contractors deserve credit

Large and sophisticated commercial construction projects (such as those for which the government serves as the customer) frequently require a safety net – someone who can assure the client that the contractor will fulfill their contractual responsibilities. Contract certainty comes into play here.

Whenever businesses (the principle) are unable to meet the terms and conditions of your contract, a surety provider can ensure that your customer is not left in the dark; the project’s remaining and subsequent costs will be paid on your behalf, preventing your client from incurring financial damage.

In the event of insolvency, the surety comes to your rescue with two types of bonds: first, they use a Performance Bond to finish the work you started, and then they use a Labour and Material Payment Bond to pay the subcontractors you hired.

Although these bonds cover your charges, you’re not out of the woods yet; unlike insurance, you’ll have to pay the surety provider the full sum of the bond at some point.

Security for your client

It’s crucial to realize that a surety bond isn’t the same as – or a substitute for – commercial insurance. Instead, surety operates as a form of client insurance. When the government is the customer in a surety agreement, surety can also be thought of as insurance for the general public.

Regardless or whether you require a surety bond, you will require insurance, and it is worthwhile to investigate your policy alternatives. Regardless of your surety needs, you’ll want to make sure you have adequate coverage for contractors to safeguard your firm from typical claims and losses.

What is the Purpose of a Surety Bond?

A surety bond, at its most basic level, obligates the surety to pay a specified sum of money to the obligee if the principal fails to fulfill a contractual duty. Surety bonds are widely used by government entities, but they can also be used by commercial and professional parties. Surety bonds assist principals, who are often small contractors, in competing for contracts by ensuring that customers will receive the goods or service promised.

The principal pays a premium to the surety, which is usually an insurance company, in order to secure a surety bond. The principal must sign an indemnification agreement pledging company and personal assets to reimburse the surety in the event of a claim. If these assets are insufficient or uncollectible, the surety must pay the claim with its own money.

Types of surety bonds

The term “surety bond” refers to a variety of distinct forms of surety bonds that are used in various contexts. Most of them have a few characteristics:

A principal’s bonding capacity is the greatest amount of money he or she can borrow. The contractor’s working capital, cash flow, and managerial experience all play a role.
Sureties typically require principals to have a certain amount of working capital, which is defined as current assets minus current liabilities. The requirement varies depending on the size of the principle, but it is usually between 5% and 10% of the entire bonded amount.
Premium on bonds: The surety charges a fee ranging from 1% to 15% of the bonded amount, which is usually paid up advance by the principal for the full term.
A bond term typically lasts one to four years and can be renewed if necessary.

Contract surety bond

A contract surety bond is often used to ensure a contractor’s (in this example, the principal’s) performance on a construction contract. If the contractor fails to complete the project, the surety firm must find a new contractor or reimburse the project owner for any financial losses. Some forms of contract surety bonds can be guaranteed by the SBA.

A contract bond’s cost is usually determined by the contract amount, and it normally ranges from 0.5 percent to 3% of the contract price. During the underwriting process, surety underwriters will assess the contractor’s character, cash flow, credit score, and work history.

Bid bonds ensure that a contractor will be able to meet the specifications in the bids they submit and will not back out of a bid that they have won.
A performance bond protects an obligee in the event that a contractor fails to execute a job on time. These bonds are frequently linked to bid bonds.
Payment bonds ensure that the contractor pays its subcontractors, employees, and material suppliers according to the contract’s terms. Most significant government and commercial building projects require this form of bond.
Maintenance bonds, also known as warranty bonds, protect the project owner against losses caused by faulty products or poor workmanship on the construction site. A usual term lasts between one and two years.

Commercial surety bond

Government institutions require a commercial surety bond to defend the public interest. Licensed firms often use these bonds to ensure that they follow all regulations and codes that pertain to the general public’s safety. Licensed contractors, automotive dealers, lottery ticket sellers, liquor stores, notaries, and licensed professions are examples of typical principals.

Commercial surety bonds come in a variety of forms, including:

Government entities require licensing and permit bonds when professionals seek a license. Pipe layers, electricians, and contractors are examples of typical principals.
Mortgage broker bond: This sort of bond protects borrowers from mortgage brokers who commit fraud and ensures that they follow state requirements.
Other types include: Liquor stores, utilities, warehouses, auctioneers, lottery ticket vendors, auto dealers, fuel sellers, travel agents, and agricultural businesses all require specialized commercial surety bonds.

No construction project owner, public or private, can afford to take a chance on a contractor whose liability is unknown or who may go bankrupt halfway through the project. And how can a government body that uses a low-bid system to award public works projects know that the lowest bidder is trustworthy?

Surety bonds provide the necessary assurance. If the contractor defaults or fails to execute the task according to the contract, taxpayers are protected from financial damage. Payment bonds ensure that the contractor pays for the labor, materials, and subcontractors involved in the project.