What Is A Surety Bond?
What is a surety bond?
Surety Bonds Explained 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 how surety bonds work and what risks they bring to your company and your personal assets.
Insurance For Them, Paid By You
A surety bond is an insurance policy for the party requiring the bond, called the obligee. In most instances, the obligee is a government department and the bond is in place to protect the public. The obligee requires the principal (you) to obtain and pay for the surety bond (performance bond costs are reimbursed when included in the bid).
Your Personal Assets & Company At Risk
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 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.
The bonding company is only saying "you're good for it" if any claims arise. If they are wrong and they 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.
How Surety Bonds 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 when 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 - 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 companies' 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.
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 their sale. Obviously costs are an important part of making your decision on where to purchase 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 throughout the country.
Short of becoming a bond expert, there is no way for you to determine with certainty what your bond is guaranteeing. Your bond agent should be able to explain specifically what your bond is guaranteeing. It isn't reasonable to expect them to have all of the thousands of bond requirements throughout the country memorized, but at minimum, they should be willing to take the time to research it and get back to you.
What surety bond do I need?
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 for a specific contract, then you need a contract bond.
If your bond is not for a specific contract, it will fall under one of the following categories:
- Court Bonds - When required by a court.
- License & Permit / Misc. Bonds - When required of you, but not for a specific contract. Also known as non-contract.
- Fidelity Bonds - Bond insurance for your company, not required by anyone
If you are still unsure about which bond type you need, you can contact us for help.
Summary & A Definition Everyone Can Understand
If you read this article in full, you should have a good handle on how surety bonds work and the risk they pose to you. If you didn't have the time or passion for suretyship to read it in full, here is a definition in terms that should make sense, even without a law degree.
Definition: A surety bond is a guarantee made by an insurance carrier (bonding company backing the bond) utilizing 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.
If you are scratching your head thinking, "What is the point of the bond if I have to pay for claims?", then you need to read (or re-read) the article in full. Alternatively, you can contact us to get further clarity. We're happy to help!
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