What is a Surety Bond?
What is a surety bond?
Surety Bonds Definition in 90 Seconds
Surety bonds are often misunderstood, as their purpose is different depending on which perspective you are coming from. They are part insurance, part credit and very confusing for most.
If you read this article in full, you'll have an understanding of what bonding is and what risks they bring to your company and your personal assets.
What Does “Surety Bond” Mean? A Surety Definition Everyone Can Understand
The simplest way to define surety bond is insurance for them, paid and backed by you. Surety bonds are an insurance policy for the party requiring the bonds, called the obligee. In most instances, the obligee is a government agency and the bond is in place to protect the government and its citizens. The obligee requires the principal (you) to obtain and pay for the surety bond (performance bond costs are reimbursed when included in the bid). People will sometimes incorrectly refer to surety bonds as an “indemnity bond” (a specific type of bond related to loans) or a “security bond” (a mispronunciation of surety bond and not an actual bond type).
If you don’t have the time or passion for surety and its meaning to read the entire article, here is the definition of surety bond in terms that should make sense, even without a law degree.
Surety Bond Definition: A guarantee made by an insurance carrier (bonding company backing the bond) that is a hybrid of insurance and credit. It is a form of insurance to the obligee (party requiring the bond protection), as they are the beneficiary that can file a claim if the bond's promise is not met. It is a form of credit to the principal (bonded party), as claims must be re-paid by the principal to the bonding company.
How Does a Surety Bond Work?
Now that we’ve answered “what are surety bonds?” let’s go over how they work. When you’re required to get a surety bond you are expected to abide by the terms of the bond (if you don’t, claims occur). When it comes to surety bond claims, you are expected to pay every penny, plus legal costs. The bond is backed by the bonding company, but the bonding company will require an indemnity agreement (also known as a general agreement of indemnity) to be signed by your company and all owners personally. Indemnity agreements pledge your corporate and personal assets to reimburse the bonding company for any claim(s) and legal costs associated with them. Read our guide to learn more about how indemnity agreements work.
The bonding company is only saying "you're good for it" if any claims arise. If they are wrong and cannot collect payment from you directly or through the courts, they are ultimately responsible. That is why they need to underwrite the likelihood of you causing a claim and your ability to re-pay them.
Now that you know how surety bonds work, you may be asking yourself “what is a surety company?”; you can read our article to learn the definition of sureties, how they work and how to choose the right one for you.
What is Surety Insurance?
“Surety insurance” is an inaccurate phrase generally used by people who want bonds that will protect their business, which means there is no legitimate surety insurance definition. As mentioned above, surety bonds are insurance for the obligee, not you. If you’re looking for insurance to protect yourself or your customers from employee dishonesty such as theft, you’ll want to obtain fidelity bonds. Take a look at our guide to learn how to get bonded and insured.
Obtaining a Surety Bond
First you need to determine which bond you need, and there are thousands of different bond requirements throughout the U.S. If you purchase the wrong one, it will be rejected by the obligee.
If your bond is not for a specific contract, it will fall under one of the following categories:
- License Bonds / Misc. Bonds - When required of you, but not for a specific contract (often needed to get a license or permit, and also known as non-contract).
- Court Bonds - When required by a court.
- Fidelity Bonds - Bond insurance for your company, not required by anyone.
“How Do Surety Bonds Work?” Continued: They Benefit You
At this point, you are likely asking, "What's the point of the bond if I have to pay for claims?" As previously mentioned, surety bonds provide insurance to the obligee. For you, they provide surety credit. This can be better understood by reviewing the alternatives to posting a surety bond below.
Surety Bond Alternatives
Posting cash directly with the obligee or with a trustee is an alternative on occasion. Some obligees will also accept an Irrevocable Letter of Credit in lieu of a surety bond.
Unfortunately, all of these alternatives have several downsides in common:
- 100% Collateral - These options require 100% collateral. In other words, you are providing them your assets to make the guarantee.
- Higher Costs - You won't have to pay for a bond premium, but the lost investment income (even in conservative investments) from posting 100% collateral is more than the surety bond costs for most.
- Decreased Capital - Posting your own assets in lieu of a bond decreases your liquidity.
- False Claims - False claims may be paid without adequate investigation on your behalf. Giving your money directly to the obligee to decide when they want to use it for an insurance claim is risky business. An insurance company would never allow you to make decisions as to when you may collect on insurance claims and neither should you.
- Increased Default \ Bankruptcy - Lessening your working capital increases the likelihood of your company defaulting on a contract or going bankrupt.
How Surety Bonds Benefit You Continued
After reviewing the alternatives, most begin to realize that the bonding company making a guarantee on your behalf for a small percentage of the bond amount is a much better option than parting with your liquid cash.
This is usually the "Eureka moment" for most in understanding how a surety bond is a form of credit to you (the principal). The indemnity agreement that requires you to back the bonding company with your corporate and personal assets also begins to make more sense. The bonding company is extending you surety credit with only a signature as collateral. When a bank extends you credit on a mortgage, they have your home as collateral.
Lastly, bonding company claims professionals provide a defense against false claims and can assist in providing a resolution in legitimate ones. In theory, they are your partner and representation when claims occur. By law, they do have a responsibility to act accordingly on behalf of the obligee (party requiring bond) as well as to ensure legitimate claims are paid or resolved. With your signing of the indemnity agreement, the bonding company’s claims people are ultimately making decisions on when to pay, knowing you are legally responsible to reimburse them. Therefore, it's always recommended to work with a professional bond agent that will be a good claims advocate.
How To Protect Your Personal & Corporate Assets
The best way to protect your assets from bond claims is to avoid claim activity in the first place. The bond is a legal document signed by you and the bonding company, backed with your assets. Therefore, it is imperative that you know what the bond is guaranteeing you will or will not do.
Unfortunately, bond form language is written in legal language that is difficult to understand without a law degree. Many bond forms make reference to state statutes as well, requiring further research. If bond claims do happen, learn how we can save you money on them.
Your surety bond agent should be able to explain specifically what your bond guarantees. If they can’t, they likely won’t be a very good claims advocate for you after the bond purchase is complete. Obviously costs are an important part of making your decision on where to buy your bond, but there are other factors to consider as well.
What is my bond guaranteeing?
What your bond guarantees is dependent on the bond type and the bond form’s language. While it is extremely important to understand what your bond is guaranteeing, it is beyond the scope of this article. There are thousands of different bond forms for a variety of bond types required throughout the country.
Short of becoming a bond expert, there is no way for you to determine with certainty what your bond is guaranteeing. The good news is your bond agent should be able to explain the specifics in easy to understand terms. However, it isn’t reasonable to expect them to have all of the thousands of bond requirements throughout the country memorized, but at a minimum, they should be willing to take the time to research it and get back to you.
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