When doing business with others, it can often be beneficial to have additional assurances that the commitments made to you in an agreement will be honored—which is often what a surety bond can provide. In general, a surety bond is a guarantee or promise to be liable for another party’s contractual obligations to another. Surety bonds are used to either help ensure that obligations under a contract are met or help ensure that recompense will be paid to cover failed obligations of another.
But how do surety bonds work? Let’s get into it.
What Is a Surety Bond?
A surety bond is a three-party agreement whereby a surety company agrees to secure the obligation of a party if it fails to meet its obligations (usually contractual in nature) to the other party under the agreement. This arrangement adds a third party to the typical two-party agreement. Those three parties are:
- The principal: The party that must satisfy an obligation. This person or organization purchases a surety bond and agrees to act or pay as promised.
- The obligee: The party that requires a guarantee from the principal that it will fulfill its obligations under an agreement. This person or organization is usually the party that receives the benefit of the surety bond; obligees are often a local, state, or federal government organization requiring the bond.
- The surety: The party that issues the surety bond, typically an insurance company. Should the principal fail to meet its obligations under the underlying agreement, the surety is responsible for assuring those losses.
If the principal defaults, the obligee can make a claim against the surety bond. The surety (usually an insurance company) will then determine if the claim is valid and, if it is, will reimburse the obligee (the amount cannot exceed the bond amount).
Types of Surety Bonds
Not all surety bonds are the same, nor do they all serve the same purpose; therefore, surety bond requirements will vary by the type of bond. Some surety bonds focus on ensuring compliance with local, state, or federal licensing requirements while others are more focused on tax obligations or other financial agreements. Below is a breakdown of some of the common types of surety bonds.
Common Characteristics of the Different Types of Surety Bonds
When first exploring surety bonds, the following elements are important to consider:
- Bonding capacity: The maximum amount of surety credit that a surety will extend (this can be estimated using a contractor’s working capital, cash flow, or another basis).
- Bond premium: The fee charged by the surety that is usually paid by the principal upfront (typically 1%-15% of the bonded amount).
- Working capital: Working capital includes current assets less current liabilities. Sureties typically require principals to have between 5% and 10% of the bonded amount in working capital to be considered for a bond.
- Bond term: The period for which a surety bond is valid, which usually ranges from 1 to 4 years. Bonds can usually be reviewed after the term is up.
Contract Surety Bonds
Contract surety bonds are one of the most common types and are used to guarantee the performance of a contractor (who is typically the principal in these situations). If the contractor doesn’t fulfill its obligations under an agreement, the surety company must either secure another contractor for the obligee or reimburse the obligee for the financial loss resulting from the principal’s default.
Types of contract surety bonds include:
- Maintenance bonds: Sometimes called warranty bonds, these bonds protect the obligee from losses due to faulty materials or workmanship.
- Payment bonds: These bonds guarantee that the contractor will pay its subcontractors, laborers, and suppliers, among others.
- Bid bonds: These bonds ensure that contractors can meet specifications according to the bids they submit and won’t back out once they’ve been awarded the contract.
- Performance bonds: Performance bonds protect an obligee if a contractor fails to complete a project according to certain standards.
Commercial Surety Bonds
Commercial surety bonds are another common type of surety bond and may be required by governmental entities to protect public interests. They are usually used by licensed businesses to ensure that regulations and codes are followed. Common types include:
- Mortgage broker bonds: These bonds help protect borrowers against losses from improprieties by mortgage brokers and help ensure that state regulations are being followed.
- License and permit bonds: These bonds are typically required by government entities when professionals apply for a license, such as electricians or building contractors.
Fidelity Surety Bonds
An organization or company can obtain a fidelity surety bond for instances of employee dishonesty or theft. For companies that operate using expensive items or large amounts of cash, fidelity bonds can be especially useful. The three main types of fidelity surety bonds include:
- Employee dishonesty bonds: Common in nonprofit organizations, these bonds help protect against losses due to employee dishonest behavior.
- ERISA bonds: These bonds are typically required by institutional investors and pension plans to help protect parties from losses due to the negligence of employees who work with retirement plans.
- Business services bonds: These bonds can help protect against losses incurred if an employee steals or damages the assets of a client or customer.
Court Surety Bonds
Court bonds are used to help protect against losses in court proceedings and can be obtained by plaintiffs, defendants, and estate administrators. Some typical court surety bonds include:
- Guardianship bonds: These bonds are designed to help protect incapacitated persons or minors by guaranteeing their guardians will act in their best interest and execute on the court’s orders.
- Attachment bonds: Also called “writ of attachment bonds,” these bonds are used in proceedings where a creditor is seeking to attach property of another.
- Cost bonds: These bonds are used in litigation to ensure that plaintiffs will pay for court costs and expenses (typically used when a case is filed out of state).
- Administrator bonds: These bonds are used to guarantee that the administrator of an estate will perform their duties in accordance with the provisions of a will, the legal requirements of the particular state and/or any court-appointed mandates and will cover any losses incurred by the estate due to improper acts of the administrator.
How Much Does a Surety Bond Cost?
With so many types of surety bonds and unique circumstances, there’s no one cost for a surety bond. As a general rule, the amount of premium that a business pays for a surety bond is typically a percentage of the bond’s covered amount. Several factors will affect the cost of a surety bond, including:
- Type of surety bond
- The coverage amount required
- Applicant’s credit score
- Applicant’s financial history
- Location
Find the Right Surety Bond Help with Acrisure
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