What Is A Surety Bond?
Additional Lessons
- Lesson 1: What Are Surety Bonds?
- Lesson 2: Surety Bond Categories
- Lesson 3: The Contract Bond Process
- Lesson 4: The Commercial Bond Process
- Lesson 5: SBA Bond Program
Lesson 1 Class Notes: What Are Surety Bonds?
Welcome to Surety Bonds 101! Today we are covering Lesson 1, "What are surety bonds?". I am your instructor, Professor Bond. Let's get started.
Surety Bond Definition
Surety bonds are often mistaken for insurance. However, surety bonds are different from insurance, from the way they work to how they are underwritten.
So what are surety bonds? In simplest terms, a surety bond is a guarantee. What the bond is specifically guaranteeing is determined by the bond language. It is important to know that surety bonding differs from insurance in that there are three parties involved.
The first party, referred to as the principal is the party that needs to be "bonded". The second party, called the obligee is the party requiring the bond of the principal to guarantee something. Usually, the obligee is a department within the government. The third party is the bonding company, also known as the surety or carrier. The surety is the party providing the financial backing to make good on any claims that might arise.
How Surety Bonds Work
So let's take a look at all parties involved using an example. A license & permit bond is a common bond type, which will serve as a good generic example. For this scenario, we will assume the state of Florida is requiring a bond of an auto dealer in order to become licensed to operate within the state. The Florida Department of Motor Vehicles is the obligee and the auto dealer is the principal. The auto dealer must obtain the surety bond from an acceptable bonding company. In this case, the bonding company is making a written guarantee to the state that the auto dealer will operate per the terms of the license. Should the auto dealer breach the states regulations, the Florida DMV can place a claim against the bond.
In the event a claim is paid out by the surety, they will pursue the auto dealer for repayment of all costs associated with the claim, including...legal fees! This may come as a surprise, but remember, bonds are not insurance. Suretyship is more a form of credit than insurance. Prior to issuing the bond, the surety will require the principal to sign an agreement for corporate, personal, and spousal indemnification. This indemnity agreement states that the surety shall be held harmless and the principal is fully responsible in the event of a claim.
At this point you may be asking yourself, if the principal ultimately is going to pay for claims, what is the point of the bond? The answer becomes clearer when you look at the most commonly accepted alternative to surety bonds, the irrevocable letter of credit or ILOC. Surety bonds approved in standard markets are typically about 1-3% of the bond amount annually. A letter of credit typically requires a 1% fee. However, surety bonds usually require no collateral whereas a letter of credit almost always requires a full 100% collateral. This difference can greatly change the amount of working capital the principal has available.
Comparing Surety Bond Alternatives
At first glance, it seems surety bonds are more expensive. However, one could invest the liquid cash that would otherwise be frozen by the bank. Doing so easily covers the bond premium, making it less expensive than the letter of credit.
If a claim does arise, bonding companies have claim professionals that will properly investigate claims to ensure they are valid prior to paying the obligee. On the other hand, a bank is not staffed to handle claim situations and will be quicker to pay any claims using the principals' frozen assets.
Obviously, surety bonds are the preferred choice hands down. Suretyship is a form of credit, but does not affect your credit rating whatsoever. An ILOC equates to the principal paying a fee to the bank to guarantee the freezing of their own assets.
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So let's review!
- A surety bond is a guarantee of something
- There are three parties involved: principal, obligee, & surety
- A surety bond is not insurance, but a form of credit
- Surety bonds are the best choice
That will be all for Lesson 1. Please visit me in the Surety Bond Forums if you have any questions!
