Surety bonds work as a type of insurance policy for the party requiring the bond, also known as the obligee (in most instances the obligee is a government agency), and are in place to protect the government and its citizens from certain losses.
If you don't have the time to read about surety bonds below, watch our quick 90-second video which covers how surety bonds work.
Surety Bond Definition
A surety bond is a binding contract between three different parties, which include the principal (the one who needs the bond), the surety (the company who writes the bond), and the obligee (the department requiring the bond).
The surety bond provides a guarantee to the obligee that the principal will conduct themselves per the terms outlined in the surety bond.
How Does a Surety Bond Work?
Surety bonds are legally binding contracts that ensure obligations will be met between three parties:
- The principal: whoever needs the bond
- The obligee: the one requiring the bond
- The surety: the insurance company guaranteeing the principal can fulfill the obligation
Surety bonds work as a form of insurance. If the bond’s requirements are not met, such as not performing contracted work or failing to pay suppliers or vendors, a claim may be filed against the bond. Think of a surety bond as a form of credit to the principal. Whether claims or made by the public or the obligee, they must be repaid by the principal to the surety.
Although the surety backs the bond, you are required to sign an indemnity agreement. This is also known as a general agreement of indemnity, and it includes your business and all owners.
Indemnity agreements pledge your corporate and personal assets to reimburse the surety for any claim(s) and legal costs that may arise. Read our guide to learn more about how indemnity agreements work.
Ready to Get Started?
Get a real-time quote today.
Do I Need a Surety Bond?
You only need a surety bond if you're being required to obtain one, which you will be notified of depending on the circumstance. There are hundreds of surety bond requirements across the country for varying reasons and occupations. Some of the more common bond types are required to get a business license, such as auto dealer bonds, contractor license bonds, mortgage broker bond, and freight broker bonds.
What Does a Surety Bond Cover?
When you are required to get a surety bond, you are expected to abide by the terms of the bond. If you fail to do so, a bond claim is made. This can be a costly endeavor for a few reasons. When it comes to surety bond claims, you are expected to pay every expense of the claim, including legal costs.
The surety providing your bond is saying you are in a strong enough financial position to cover any claims that may arise. If the surety is wrong and payment cannot be collected from you directly or through the courts, they are ultimately responsible for the costs. For this reason, bonds are underwritten based on the potential of a principal causing a claim, as well as the ability of the principal to repay a claim in the future.
Now that you know how surety bonds work in general, you may be asking yourself “what is a surety company?”; read our article to learn the definition of sureties, how they work, and how to choose the right one for you. You can also take a look at our most frequently asked surety bond questions.
The Consumer’s Guide to Surety Bonds E-Book
If you want the most thorough answers available to all of the fundamental questions related to securing a surety bond, you can download our free "Consumer's Guide to Surety Bonds" e-book. The topics covered in the e-book include:
- How surety bonds work
- How indemnity agreements affect you
- The various surety bond types required
- Surety bond pricing
- How to get bonded
- How claims affect you
This e-book was designed to educate consumers, specifically with first-time applicants in mind. It is an excellent resource if you are unfamiliar with how surety bonds work, the pricing of surety bonds, or how bonds affect you or your business.
Which Surety Bond Do You Need?
Every business is different, and so it makes sense that not everyone requires the exact same type of bond. In general, three categories of surety bonds exist that may be required as part of doing business. These broad surety bond types include:
- License and permit bonds - these types of bonds are required for various professionals so that they can operate legally. Auto dealers, licensed contractors, and freight brokers are some examples of professionals required to secure a license or permit bond.
- Contractor bonds - individuals or businesses working on public construction projects are likely required to obtain a contractor bond.
- Court bonds - these bonds are required by certain courts for a variety of purposes, such as probate or judicial bonds.
It can be challenging to know which type of bond you need. However, you can utilize our find your bond tool to quickly find out.
How to Get a Surety Bond
After determining the type of bond you are required to have, you need to then understand what the requirements are in your specific area. Throughout the country, states, counties, and cities may have different surety bond requirements based on your profession or business. If you purchase the incorrect bond because you do not take a close look at these specific requirements, the obligee will not accept the bond.
You can take these steps to ensure you’re getting the right bond:
- Contact your state or local licensing authority or the obligee requesting the bond to ask which category of bond you need, and in what amount
- Use our bond analysis tool for free to determine which bond you need
- Contact us directly for assistance with figuring out your specific bond needs
How Surety Bonds Benefit You
There are several inherent benefits to obtaining a surety bond. Above and beyond meeting the legal requirements set forth by the obligee, securing a bond means you as a professional or business owner are extended a form of credit, as described above. As the principal of the bond, this credit from the surety is often a more cost-effective way of meeting obligee requirements compared to the alternatives.
Some obligees allow you to post cash instead of a bond, often in the form of a single lump-sum payment to a custodian or trustee that is on hold to cover claims. In other cases, a letter of credit may be posted instead of a surety bond. These options can be significant financial burdens both upfront and in the future, and they come with a slew of downsides.
The disadvantages of using an alternative to a bond include:
"What's a Surety Bond?" Infographic
- 100% Collateral - Your assets are used to make the guarantee instead of allowing the surety to provide the guarantee for you.
- Higher Costs - Although you save the expense of the bond premium when you use an alternative, you face other challenges. For instance, you could lose investment earnings, even from a relatively conservative portfolio, by posting cash as your bond.This, in most cases, is a bigger financial burden compared to paying the cost of a surety bond.
- Decreased Capital - Posting your own assets, including cash, in lieu of purchasing a bond decreases your liquidity. This can make it more difficult to get financing or cover major expenses in the future. Also, lower capital reserves could lead to your company defaulting on a contract or going bankrupt.
- False Claims - A surety works through an investigation process when a claim against a bond is made. This is not often the case when you post assets or cash to cover an obligee’s requirement. You could inadvertently pay for claims that are not valid when using an alternative to a bond because you do not have claims advocates on your side.
Although these options provide a way to meet obligee requirements without posting a surety bond, the downsides are substantial. With a bond, the biggest benefit you receive is the bonding company is making a guarantee on your behalf but only for a small percentage of the bond amount. For many, this is a much better option than parting with your liquid cash or using other assets as collateral.
It is important to understand that the indemnity agreement that requires you to back your promise with corporate or personal assets also may make more sense. The surety is extending surety credit with only a signature as collateral.
Compared to other extensions of credit that require physical collateral, such a mortgage on your home, a bond is less risky. If you have a claim to pay and you used a mortgage to pay the up-front cost, the financial institution uses your home as collateral if you cannot pay through other means.
How to Protect Your Personal & Corporate Assets
The bond is a legal document signed by you and the surety, backed with your assets. The best way to protect your assets from bond claims is to avoid claim activity in the first place. This means you meet the requirements the obligee sets out for bondholders each and every time. To avoid bond claims, and ultimately protect your personal and business assets, it is imperative that you know what the bond is guaranteeing you will or will not do.
Unfortunately, bond form language contains legalese that may be difficult to understand if you aren’t in the legal profession. It is also common for bond forms to reference state statutes, making it more challenging to fully grasp your responsibilities as the principal.
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. Be sure to work with a surety that provides this education on your specific bond so you can avoid claims whenever possible.
What Do Surety Bonds Guarantee?
As mentioned above, each bond differs based on the type of bond it is and the requirements the obligee puts in place for that specific bond. Therefore, what your bond guarantees varies based on these details, along with the specific language of your bond form.
It is extremely important to understand what your bond is guaranteeing, but with thousands of different bond forms for a variety of bond types required throughout the country, there is no general answer to this question. What may be beneficial is reviewing common bond types and what they guarantee, such as bonds required in California, Florida and Texas. You can see all surety bond requirements by state here.
It is also helpful to understand the various bond categories, as we laid out above. Some common surety bonds that are required for licensing include auto dealer bonds, contractor license bonds and freight broker bonds. You can take a look at the full list of license and permit bonds here for more specific information.
Short of becoming a bond expert, there is no way for you to determine with certainty what your bond is guaranteeing, even if we provide a surety bond example form for you to review. However, the good news is your bond agent should be able to explain the specifics of your bond in easy-to-understand terms.