What Is a Surety Bond?
This article is part of a larger series on General Liability Insurance.
A surety bond is a type of financial coverage that is designed to guarantee the performance of contractual obligations by the contractor who purchases it. A bond is generally required by the owners of the project for the primary contractors to purchase but can also be required by general contractors for subcontractors to purchase. Surety bonds can serve many purposes, but the ones available are dependent on the project and specific industry.
How Surety Bonds Work
What makes bonds a bit different from standard liability insurance policies is that there are three parties involved in a bond as opposed to just two.
The way it works is that a project owner or general (prime) contractor (GC), known as the obligee, can require a business or individual that they hire to purchase a bond in the event that some type of obligation is failed to be met.
That business or individual, which can act as a general contractor to the project owner or a subcontractor to the GC, is known as the principal. The principal would purchase this bond from a bond issuing company known as the surety.
The bond surety company would pay the bond amount―on behalf of the principal―to the obligee in the event that a claim is filed against the principal for not fulfilling particular contractual requirements that were covered by the bond. After damages are paid, the principal usually has to pay back the surety for the covered damages.
Parties Involved in a Surety Bond
Below are the role and descriptions of the three main parties involved in a surety bond: the obligee, principal, and surety.
The obligee is the organization or individual that is asking the business or individual to purchase a bond. Depending on the contractual hierarchy and project scope, the obligee can be a government entity, project owner, or general contractor, if work is being subcontracted. The obligee is the one that would determine the bond type, set the amount, determine the term, and be the one who files the claim if obligations are not met.
Let’s say a private school is doing a renovation, and they hire a general contractor to do the work. The school requires that the contractor purchase a performance bond. The school is considered the obligee as they are the project owners.
The principal is the entity or individual that has been hired to do work and is required by the obligee to purchase the bond. The principal can be a general contractor or subcontractor, depending on the order of the hierarchy. Often, after a claim is filed by the obligee and paid by the surety, the principal will have to pay back the damages amount to the surety.
In the same example about the private school hiring the general contractor to do renovations, the general contractor is the one that is hired and asked to purchase the bond. Therefore, the general contractor is considered the principal.
The surety is the bond issuing company that underwrites, finances, and pays the bond in the event of a claim. A surety can be a bank but is most commonly a specific department or division of an insurance company that handles surety bonds. The surety will review the credit history and financial statements of the principal as well as be the one responsible for collecting collateral before issuing the bond. The surety will seek out damages from the principal after a bond is paid.
If the general contractor doing work for the private school went to a bond provider called Surety Now to purchase the bond, Surety Now would be the surety as it is the one underwriting and financing the bond. Surety Now would also be the one to pay the private school if performance obligations are not met by the general contractor.
Sureties can sell bonds in-house but, generally, will use authorized independent insurance agencies to sell bonds.
Types of Surety Bonds
Surety bonds can take the form of literally thousands of different subdivided types, all of which fall into four main bond categories: contract surety bond, commercial surety bond, fidelity bond, and court surety bond.
Contract Surety Bond
A contract surety bond is a financial guarantee that the contractor (principal) will follow certain contract obligations laid out by the obligee. This type of bond might ensure that the bid a contractor submitted is done so in good faith (bid bond).
It can also be used to ensure that the principal will complete the performance scope and project deliverables correctly within the other contractual terms (performance bond). A contract surety bond is also used to ensure that the principal will pay subcontractors and suppliers (payment bond).
Commercial Surety Bond
A commercial surety bond is mandated usually by government agencies and designed to protect the general public from fraud or poor business practices. Many commercial surety bonds are in the form of license bonds, which would require a licensee to purchase a bond to hold a license or certification.
Below are some common industries that would require a commercial surety bond:
- Alcohol beverage sales
- Mortgage broker services
- Financial services
- Tax preparation
- Notary services
A fidelity bond is a type of surety bond that serves more as a traditional insurance policy. It protects businesses against theft, forgery, or other fraudulent acts committed by the firm’s employees.
This type of bond is commonly used in cash businesses like cash checking offices, grocery stores, restaurants, or convenience stores. When a fidelity bond is purchased to protect a bank or financial institution however, it’s known as a financial institution bond.
Court Surety Bond
A court surety bond can be pretty broad in terms of all the subtypes of bonds included. Essentially it is designed to decrease the risk of financial loss for people going through our court or legal system.
There are two main types of court bonds, the first being a judicial bond which is designed to guarantee payment of legal fees to an attorney or costs of appealing a court decision. The second is known as a fiduciary or probate bond, which is used to ensure that individuals appointed by a court will manage an estate’s assets in a proper manner.
Surety Bond Procurement Process
Procuring a surety bond is very similar to procuring other commercial insurance in that it utilizes applications and an underwriting process. The main difference comes down to how the risks are underwritten and how coverage is bound.
Underwriting a surety bond takes into account more financial risk factors as opposed to physical risk factors like fire hazards. A surety bond provider will evaluate credit history and the business financials as well as the type of work being done to determine whether or not to issue a bond and for how much. The premium is usually going to be a percentage of the total bond amount being requested.
If the principal―either individual or owner of the business―has a poor credit rating, the surety may ask them to put up collateral, which can be for up to 100% of the bond amount.
After the underwriting process is completed and quotes are presented to the principal, the surety company may require the principal to sign some type of indemnity agreement prior to the bond being issued, which would lay out repayment terms from the principal to the surety in the event that a claim is filed by the obligee and paid for by the surety.
“Indemnity is an agreed compensation for loss. As part of the surety bond, a principal and surety will enter into an indemnity agreement that outlines the terms of repayment should a claim be filed. Some agreements require collateral while others don’t.”
—Dr. Tenpao Lee, Professor of Economics, Niagara University
Surety Bonds vs. Insurance
Below illustrates the main differences between surety bonds and commercial insurance policies:
Major Underwriting Factors
Usually a percentage of the bond amount requested based on the above underwriting factors
Based on requested coverage, business size―assets or revenue―and underwriting factors
Obligee, principal, and surety
Insured and insurance company
Principal pays premium to surety who will pay the bond amount to the obligee in the event of a covered loss
Insured pays premium to insurance company who will pay claims up to the policy limits―or sublimits―to the insured in the event of a covered loss
Repayment of Damages to Financer
By the principal
Surety Bonds: Cost, Terms & Qualifications
Surety bonds range on a wide spectrum of different types, varying terms, and a range of bond limits. These elements, along with underwriting factors, ultimately dictate the overall premium cost for the bond.
Sample Surety Bond Cost Estimates Based on Industry & Term
While some sureties can offer set prices and terms for businesses and individuals looking to purchase a bond, most of them are going to use a set percentage of the bond amount. For example, if an electrical company is required by the general contractor of a project to have a $100,000 performance bond, and the surety offers the bond at 10% of the limit, then the bond premium cost to the electrical company will be $10,000.
Bond premium percentages are going to range from 1% to 15%, depending on the industry, principal experience, credit history, and past financial performance. Most of the time, the surety will want the bond paid in full upfront. Below illustrates some sample surety bond cost estimates based on industry and credit history:
$320 to $480
$250 to $500
$3,000 to $5,000
$60 to $80
*Bond requirements vary by state and industry. The estimates above are based on online price estimates by bond type, limit, and credit history.
Surety Bond Amount & Terms
There is no actual declared maximum limit on a bond amount that can be purchased. A general rule of thumb, however, is that the principal business has at least 10% of the bonded amount in working capital―current assets minus current liabilities. Another cap on a bond amount that a surety could use is limiting the total maximum amount to 10 to 15 times the value of the total equity of the company.
While bonds generally have a term of one to four years, they may also use a continuous surety bond general term that keeps it active until cancellation by the principal. After the expiration of bonds with set terms, the bond can be renewed if needed by the principal.
Surety Bond Qualifications
The credit history of the principal is going to hold a huge weight on whether the surety will issue a bond. The other important qualification factors include company financial performance―past and current―and industry experience.
If underwriters can see that the business can do well from a financial standpoint, and that the business owner has relevant experience that can reduce the chances of an issue occurring, then the underwriter will take that into account in their risk evaluation.
Keep in mind that even after a bond is issued, the surety may require the principal to send updated information periodically. This might include items specific to the project like change orders and overall completion progress as well as financial information like revised cost estimates and estimated gross income.
Who Needs a Surety Bond?
For most businesses, the reason a surety bond is attained is for compliance or due to contract requirements. For example, if a business is selected to work on a construction project, the project owner will likely require them to hold a few types of contract surety bonds in addition to their other insurance requirements.
Additionally, businesses trying to attain licenses, permits, or are part of a particular high-risk industry, such as alcohol or tobacco, will be required by the specific governing body to hold certain types of commercial surety bonds.
Another reason to hold a surety bond is for marketing or branding purposes. You may see contractor trucks saying “we are bonded” in an attempt to show that they practice solid risk hygiene that, ultimately, would protect their customers.
Surety Bond Example
ABC Plumbing Company has just won a contract for $20,000 of plumbing work for John’s General Contractor, Inc. John’s General Contractor, Inc. is requiring ABC Plumbing Company to maintain a performance surety bond of $20,000 for that specific plumbing work.
ABC Plumbing Company has a great financial history, and the owner has a near-perfect credit score. Surety Bond Corp. sees ABC Plumbing Company as a solid risk and offers a surety bond for 2% of the bond amount for one year, which is the equivalent of a $400 premium.
ABC Plumbing Company pays the $400 premium in full to Surety Bond Corp. After completion of the work, it is discovered that ABC Plumbing Company installed everything incorrectly in terms of what was laid out in the contract. John’s General Contractor, Inc. files the claim with Surety Bond Corp and receives the full $20,000 bond amount.
After the claim is paid, Surety Bond Corp requires that ABC Plumbing Company repay the $20,000 of damages, referencing the signed indemnity agreement in favor of the surety made prior to issuing the bond.
When To Get a Surety Bond
There are two main scenarios for when businesses acquire surety bonds. The first and more common one is for when a bond is required for government or contractual compliance.
The second is when a business owner willingly purchases a bond for financial risk-management reasons. This type of reasoning, which encompasses protecting their customers, can be used as a branding tool.
Where to Get Surety Bonds
The surety bond market is loaded with many providers. So, when looking at where to obtain a surety bond, you’ll want to consider the fact that bond providers generally have specific targets or “sweet spots” that they want to focus their book of business on.
Below are just a few bond providers that can be considered:
Specialty contractors and landscaping businesses
Philadelphia Insurance Companies
Notary businesses looking for easy commercial bonding for licensing
JW Surety Bonds
High-risk businesses struggling to be underwritten
Startup construction businesses
Businesses with poor credit history
What to Look for in a Surety Bond Provider
Surety bonds are issued by either banks or insurance companies, which will distribute them by using brokers or insurance agents on a commission basis. When looking for a surety bond provider, you’ll want to check that the surety bond provider:
- Has obtained a bonding license for your location
- Offers the specific bond type that you need and can provide specialized offerings relevant for your business
- Is getting you the most competitive rates available on the market
- Can ensure a smooth process from underwriting all the way to potential payment of a claim
Here are five surety bond providers that can help get you the coverage you need.
Nationwide offers businesses peace of mind in terms of meeting state and local licensing requirements when seeking a surety bond. It works especially well with some of the specialty artisan contractors as well as landscaping businesses.
Philadelphia Insurance Companies
Philadelphia Insurance has a pretty easy online system for quotes and allows certain industries to generate bond quotes with errors & omissions (E&O) insurance. One of these industries is for notary services that also can provide automatic renewals on loss-free businesses.
JW Surety Bonds
Thanks to partnerships with large surety companies like The Hartford and CNA, JW Surety Bonds can offer competitive rates for a wide range of industries. Its width of capabilities can even assist higher-risk businesses that have had trouble with underwriting.
Travelers tends to be known for its range of capabilities in terms of what it will write for surety bonds. It can take more risk with less-experienced businesses and has a sizable book of business with smaller contractors. This makes it a solid fit for startup construction businesses that might struggle procuring bonds.
Any individual starting a business that has poor credit ratings will want to try Liberty Mutual first for their bonding needs. It tends to have a less gruesome underwriting process that asks minimal questions relative to other providers. It also can handle a plethora of different bonding types.
A surety bond is a financial risk-management product designed to allow a principal to protect an obligee. This is a similar coverage to traditional insurance but involves three parties and uses different underwriting factors for evaluation. Potential customers and clients will want to know that they are doing business with firms that can guarantee their contract terms.