Surety bonds are a form of protection that dates back to
Babylonian times. Such bonds are a key piece of many public
and private sector transactions. U.S. Customs, for example,
requires importers to carry bonds to ensure compliance with rules
and regulations. Courts require bail bonds to release criminal
case defendants. Property or project owners require contractors
to carry performance bonds. The Airline Reporting Corporation
requires travel agents to meet certain requirements when carrying
airline ticket stock, and an ARC Bond meets those requirements.
In the U.S., suretyship is considered a form of insurance
and is regulated accordingly. This is something of a misnomer
since insurance is typically a two party transaction, while surety
bonds are a three party transaction. The three parties to a surety
contract are:
- The Principal: The party that takes out the bond as a
guarantee against a stated obligation.
- The Obligee: The party to whom the guarantee is
made by the surety on behalf of the principal. In the above
examples, a property owner, U.S. Customs, and the Airline
Reporting Corporation are potential obligees.
- The Surety: The entity that steps in and pays the
obligee in the event of a specifc failure to perform or meet an
obligation on the part of the principal.
There are two primary categories of surety bonds. Contract
Surety Bonds and Commercial Surety Bonds. Contract Surety
Bonds provide financial security and construction assurance on
building and construction projects by assuring the project owner
(obligee) that the contractor (principal) will perform the work
and pay subcontractors, laborers, and material suppliers.
Contract surety bonds include:
- Bid bonds - Financial assurance that the bid has been submitted
in good faith.
- Performance bonds - protection for the owner from financial
loss should the contractor fail to perform the contract in accord
with its terms and conditions.
- Payment bonds - guarantee that the contractor will pay certain
subcontractors, laborers, and material suppliers associated with
the project.
- Maintenance bonds - guarantee against defective workmanship
or materials for a specified period.
- Subdivision bonds - guarantee to a city, county, or state that
the principal will finance and construct certain property and
infrastructure improvements.
Commercial Surety Bonds guarantee performance by the
principal of the obligation or undertaking described in the
bond.
Commercial surety includes:
- License and permit bonds - required by state law or local
regulations to get a license or permit to engage in a particular
business.
- Judicial and probate bonds, also known as fiduciary bonds
- secure the performance on fiduciaries' duties and compliance
with court order.
- Public official bonds - guarantee the performance of duty by a
public official.
- Federal (non-contract) bonds - those required by the federal
government, e.g. Medicare and Medicaid providers, customs,
immigrants, excise, and alcoholic beverage.
- Miscellaneous bonds, e.g. to guarantee employer contributions
for Union benefits, and workers compensation for self-
insurers.
One of the main differences between an insurance and
surety contract is that an insurance premium is usually based
on a certain expectation of losses. Surety contracts are
designed to prevent loss, according to the Surety Information
Organization (
www.sio.org). In this model the underwriting
process involves pre-qualification and the bond is underwritten
with little expectation of loss. The premium is mainly a fee for
pre-qualification services. In some cases a surety company will
require indemnity of the owners of a closely held corporation.
The two main reasons for this requirement are that the surety
company requires all personal/business assets to back the
guarantee and that there is less chance a principal will avoid
stated responsibilities if personal/business assets are at stake. If
an underwriter is unable to approve a bond request based on the
qualifications given by the principal, the company may suggest
depositing some form of collateral as an inducement to write
the bond. In practice, many bonds are written on this basis,
particularly ones that are considered financial guarantees.
Obtaining a surety bond is like opening a line of credit.
And similar to a banking experience, developing a long-term
relationship with a surety company can be an important step for
you or your business. Call us for further details on surety bonds
and how they apply to your business.
