What is a surety bond?
Surety bonds can be an overwhelming topic for businesses, particularly if they are new to the process. In basic terms, a surety bond is an agreement between three distinct parties: an obligee, a principal and a surety. Each party plays a key role in the agreement as follows:
- Obligee — An obligee is a party that receives a remedy (from the surety) in the event of a default, which can occur, for example, after an unfinished project, breach in contract or failure to comply with specific laws or ordinances. Obligees can be a government entity, private entity or individual that requires a principal, such as a contractor, to be bonded. When an obligee requires a surety bond, they are, in turn, helping regulate industries, protecting tax dollars and safeguarding consumers from financial loss as a result of poor business practices.
- Principal — The principal is the party, generally a professional or business, required to purchase a bond. By purchasing a bond, these individuals or entities are guaranteeing compliance as it pertains to certain laws and regulations. They are also guaranteeing that any work they’ve agreed to complete will be done on time and to a standard outlined in a contract with an obligee.
- Surety — A surety is a party that provides a guarantee to an obligee. If the principal cannot fulfil their obligations, the surety will step in and remedy the default by arranging for performance or payment. Before becoming bonded, the principal will often be required to sign an indemnity agreement with the surety company. This agreement states that the principal will pay the surety back if a loss occurs.
Put simply, surety bonds can be thought of as a written agreement to guarantee compliance, payment or performance of an act.
It is important to note that surety bonds are not insurance, but rather assurance. Unlike insurance, a surety bond is a three-party agreement that guarantees performance. While insurance policies provide a payout to the insured following a loss, surety bonds are more similar to financial instruments, essentially acting as credit that functions on the premise that no losses will occur. If a surety does not believe a principal can perform their tasked duties, the surety will not issue a bond. In some cases, both bonds and insurance may be required for a given project.
There are thousands of different types of surety bonds. Some surety bonds provide coverage for — or ensure compliance with — local, state or federal licensing and permit requirements. Other surety bonds guarantee payment of tax or other financial obligations. For the purposes of this article, we will examine the three main types of surety bonds: contract, commercial and fidelity surety bonds.
3 main types of surety bonds
During construction projects, project owners want to trust that the contractors they’ve hired will complete work on time and as agreed upon. While traditional contracts are often used to lay out specific requirements for both contractors and subcontractors, the terms and conditions of these contracts can be broken. When this happens, project owners may be left with unfinished work. That’s where a contract surety bond can help.
As they relate to construction projects, contract surety bonds ensure that obligees will be made whole following uncompleted projects. This can involve financial compensation or a promise that any incomplete work on a project will be completed.
Contract surety is common, and it is used to protect an obligee if a contractor fails to fulfill the duties outlined in a contract. There are several widely used contract surety products, which are generally utilized before a project bid, during a bid or during the project itself:
- Bid bonds — A bid bond is requested by a project owner during the contract tendering process. A bid bond gives project owners reassurance that contractors bidding on a project will enter into a contract and provide the required performance and payment bonds if awarded the contract. This is accomplished via backing from a surety during the initial proposal from a contractor. Basically, this type of bond guarantees that a bid has been submitted in good faith.
- Performance bonds — A performance bond protects project owners from financial losses if a contractor does not fulfil the terms and conditions detailed in a contract. Performance bonds have the following benefits:
- The surety will either arrange for performance to complete the work or provide payment to the obligee to fulfill the obligation
- Performance bonds start working as soon as a project owner experiences their first dollar of loss
- Payment bonds — These bonds guarantee that a contractor will pay all subcontractors, trade workers and other claimants involved in a project for goods provided or duties performed. Payment bonds work in tandem with performance bonds and help to ease the administrative burden of the project owner. They also help:
- Ensure all subcontractors, trade workers and suppliers are paid
- Garner more competitive prices for an owner, as more subcontractors, trade workers and suppliers are likely to bid on a project if they know their credit is secured
- Reinforce project continuity, as payment bonds give subcontractors, trade workers and suppliers an incentive to stay on a project even if a contractor defaults
Contract bonds may also be required to support principals and contracts not related to the construction industry.
Commercial bonds are often required by governmental bodies or industry legislation. They are also frequently purchased by companies or professionals in compliance with state licensing and permit regulations, guarantying some aspect of a principal’s occupation. The type of commercial bond purchased will depend on the work the principal will be performing.
License and permit bonds are the most common. They are required by state, municipal, or federal ordinances and regulations. Specifically, these bonds may be required in certain industries or occupations before an individual or entity is granted a professional license (e.g., contractor license bonds, electrician bonds, HVAC commercial bonds, nonresident license bonds and plumber bonds). Above all, commercial bonds are meant to protect the consumer, ensuring that any work a contractor does is up to code.
Another common subcategory of commercial bonds includes court and judicial bonds. These bonds can be required of plaintiffs or defendants in judicial proceedings and are used to preserve the rights of the opposing litigant or other interested parties. For example, imagine a party was sued and had a judgment placed against them. To go through the appeals process, the party would have to put up an appeal bond for the amount of the judgment. Effectively, the bond is used as a stopgap measure and guarantees that, if the appeal is denied, the party that wins the judgment gets their funds immediately.
Other common types of commercial surety bonds include sales tax bonds and auto dealer bonds.
Unlike contract and commercial bonds, fidelity bonds effectively are forms of insurance. Specifically, fidelity bonds protect employers against losses caused by the fraudulent or dishonest acts of their employees. Typically, if an employer trusts one or more employees to handle cash or other valuable assets, they should consider a fidelity bond. There are several different types of fidelity bonds, including business services bonds, standard employee dishonesty bonds and Employee Retirement Income Security Act of 1974 (ERISA) bonds.
- Business services bonds — Should an employee’s dishonest or fraudulent acts while on a customer’s premises lead to the loss of a customer’s money, equipment, supplies or personal belongings, business services bonds can provide protection. This type of bond is particularly beneficial for businesses with core operations that require them to perform work at a customer’s home or office (e.g., janitorial services, contractors, dog sitters and house sitters).
- Standard employee dishonesty bonds — This type of bond protects employers from financial losses caused by the fraudulent activities — such as money, securities or property theft — of an employee or group of employees. This bond is often purchased by nonprofits, accountants and businesses that offer medical services.
- ERISA bonds — ERISA requires trustees of pension plans to have fidelity bond coverage that’s equal to at least 10% of the total plan’s assets. ERISA bonds protect participants and beneficiaries from the dishonest acts of a fiduciary who handles employee benefit or pension plans, including 401(k)s.
For businesses new to the process, becoming educated on and purchasing surety bonds can be overwhelming. That’s why it’s so important to partner with organizations that have proven surety bond experience and expertise. Established, highly rated partners can not only help issue small bonds quickly (sometimes in minutes), but they can also think outside of the box to provide customized surety solutions and programs.