A surety bond is a contract between three parties known as the principal, surety, and obligee. Surety bonds financially guarantee that a principle will fulfill a predetermined set of obligations to an obligee. The “surety” is an insurance company or surety bond broker that provides the financial guarantee to the obligee on behalf of the principal.
In this article, we’ll discuss the ins-and-outs of surety bonds, including how they work, who can benefit from using them, as well as where to find them. By the end, you should know exactly what a surety bond is and how to use one to protect yourself.
Surety Bonds & How They Work
A surety bond is most commonly thought of as a way to transfer risk. Surety bonds are designed to protect public or private interests from the actions of a third-party. You can think of a surety bond like insurance that’s for the benefit of one party, paid for by a second party, and financed by a third party.
For example, when a general contractor works on a commercial construction project with a project owner, he’ll typically be required to purchase a contract surety bond. This surety bond type protects the project owner from the general contractor’s potential failure to complete the contract as specified.
If this failure occurs, the project owner can file a claim against the surety bond. A surety bond company will pay for the financial damages on behalf of the general contractor. After damages are paid, the general contractor is required to repay the surety bond company. This means that there are three parties involved with all surety bonds.
The obligee is the party that requires a surety bond as protection. Obligees are typically government agencies but can also be individuals or companies. They often use surety bonds to cover financial damages in the case of a claim, such as if a contractor fails to pay subcontractor or labor and material bills after a job is completed.
The principal is the party that the obligee requires to take out a surety bond. The surety bond will protect the obligee against any breaches in contract or unethical business practices on behalf of the principal. The principal of a surety bond is typically a business that’s trying to obtain a license from a government agency or bid on a contract.
The surety is the insurance company that backs the surety bond up to the full bonded amount. The surety provides the financial guarantee to the obligee that the principal will fulfill their obligations outlined in a contract agreement. As compensation for the guarantee, the principal pays an annual premium to the surety.
A surety bond typically works like a hybrid insurance policy and line of credit. A principal takes out a surety bond and pays the surety an annual bond premium between 1% – 15% of the total bonded amount until the obligation is complete. If a principal fails to meet a bonded obligation and a claim is filed, the surety covers the claim and recoups the money via indemnity.
“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 at Niagara University
4 Main Types of Surety Bonds
There are many different types of surety bonds. In fact, almost any contract or obligation can be bonded. However, the 4 most common types of surety bonds include contract surety bonds, commercial surety bonds, court surety bonds, and fidelity surety bonds. Each one of these financially protects an obligee across a range of potential scenarios.
1. Contract Surety Bond
A contract surety bond guarantees that a contractor will follow the specifications laid out in a construction contract. The obligee of a contract surety bond is a project owner and the bond ensures that the principal contractor will perform the work agreed upon and pay for the necessary subcontractors and materials and supplies.
2. Commercial Surety Bond
A commercial surety bond is typically used to protect public interests and are usually mandated by government agencies. These government agencies will require that all new businesses in a specific sector – such as the liquor industry – as well as all businesses with a license get a commercial surety bond. For these types of bonds, the obligee is the public.
3. Fidelity Surety Bond
A fidelity bond protects a company against the malpractice of an employee who handles cash and other valuable assets. Fidelity surety bonds typically protect against the loss of a customer’s money, equipment, or personal supplies. A fidelity surety bond can also protect your company from financial loss due to the fraudulent activity of an employee.
4. Court Surety Bond
A court surety bond can be required by an attorney or similar entity before a court proceeding to ensure protection from a possible loss. These court surety bonds typically guarantee the payment of costs associated with lawyer fees or appealing a previous court’s decision. Other court surety bonds protect an estate against malpractice of the estate’s administrator.
“The most common type of surety bond is a contract surety bond, typically for the construction of buildings or roads. Usually, two contract surety bonds are issued on a single construction project. One is used to ensure performance of the construction contract and the other is used to ensure the payment of suppliers and subcontractors.
— Wendell Jones of Kentucky Surety & Construction Law
How to Know if a Surety Bond is Right for You
The fact of the matter is that depending on your industry or company-type, surety bonds might be a requirement. A surety bond may be required if you’re getting a construction license, bidding on a public works project, or part of a specific industry like alcohol and tobacco. You might also willingly get a surety bond to minimize an obligee’s risk.
We caught back up with Dr. Tenpao Lee, professor of economics at Niagara University, who told us that a good rule of thumb is that a surety bond is right for companies that want to minimize risk, ensure the compliance and completion of a project, or do business with a new partner. Specifically, surety bonds are right for the following types of companies:
- Construction & other businesses with government-issued licenses
- Construction companies with government projects over $100k
- General contractors who are bidding on new projects
- Businesses in high-risk or high-tax sectors, such as alcohol and tobacco
- Businesses that need to insure customer property, such as auctioneers
- Companies that want to protect themselves against employee theft
- Companies that expect to face litigation in the near future
When to Get a Surety Bond
A surety bond is either required or willingly taken out by a principal to reduce the risk of an obligee. This means that there are two scenarios in which you might get a surety bond. However, regardless of whether it’s required, a surety bond should be taken out prior to the initiation of a contract.
For example, if you’re a contractor trying to get your license from the state government, you’ll be required to take out a surety bond as part of the application process. This means that the surety bond is obtained before the process is complete. This is the case for all situations where a surety bond is required.
There are other cases, however, where a surety bond isn’t required but still might be a good idea. For example, when a general contractor is bidding on a new project, he or she might “bond” the bid to show the project owner that there is little risk. In these scenarios, contractors will have to get surety bonds before they place any bids.
Surety Bond: Costs, Terms, & Qualifications
The rates, terms, and qualifications of a surety bond ranges based on the bond-type as well as the insurance company. Regardless, the specific components of a surety bond that you’ll want to look at include the bond premium, the maximum bond amount, the length of the bond, and the minimum qualifications. Let’s take a look at each.
Surety Bond Costs
The only cost typically associated with a surety bond is the surety bond premium. This premium is paid by the principal to the surety each year and is based on a percentage of the total bond amount. For example, you might get a $10k surety bond at a 1% bond premium, meaning you pay $100 per year.
It’s common to find the following bond premiums based on the personal credit score of the business owner below:
- 1% – 3% annual bond premium for credit scores 700+
- 4% – 15% bond premium for credit scores between 550 – 699
However, sureties will also take into account the experience of the business owner. In addition, some sureties will include the performance of a company when calculating the bond premium. Business items that a surety will consider include the following:
- Business’s working capital
- Business’s mix of debt and equity
- Business’s net worth
- Business’s D&B credit report and business credit score
- Small business lines of credit
- Business references
In addition to the bond premium, some construction surety bonds are guaranteed by the SBA. If you get a construction surety bond that’s guaranteed, you’ll be charged an SBA guarantee fee of 0.75% annually. This guarantee reduces the risk of the surety and makes it easier for you to obtain a construction surety bond.
Surety Bond Amount and Terms
There is no hard cap on the size of a company’s bonded amount. Instead, Sureties typically require that a company has at least 10% of the bonded amount in working capital. Further, many sureties limit the total amount to 10x – 15x the value of a company’s equity. The maximum bonded amount is known as a company’s “bonding capacity.”
Sureties will typically limit the bonded amount of both individual surety bonds as well as the aggregate bonded amount of all outstanding surety bonds. With construction surety bonds, for example, a general contractor might have 5 projects, each with its own surety bond. A surety might limit each bond to $5 million and the total bonded amount to $25 million.
The term of a surety bond is between 1 – 4 years. However, there are some surety bonds that denote that they’re “continued until cancellation.” This means that the surety bond protects the obligee indefinitely until the principal cancels the bond. For surety bonds with an expiration date, the bond can be renewed by the principle.
Surety Bond Qualifications
A surety bond’s qualifications are largely dependent on a business owner’s personal credit score. Scores of 550+ qualify and the score typically dictates the amount of the bond premium. However, depending on the principal, they’ll also take into account other factors, such as a business’s financial performance, existing lines of credit, as well as the business owner’s industry experience.
Specifically, the other surety bond qualifications can include the following:
- Company financial performance – Past 3 years financial statements, including the amount of business’s liquid assets.
- Existing business lines of credit – Higher credit limits is seen as a benefit since it decreases the likelihood of financial distress during a project.
- Industry experience – The past experience of both the business owner as well as the company is assessed, including the number of similar past projects completed.
Once you’re approved, a surety might also require that you submit interim financial statements every 1 – 2 quarters to track how the year is progressing. Additionally, contractors will need to prepare a quarterly schedule of work in progress, which includes:
- Total contract price
- Approved changes to orders
- Amount billed to date
- Costs incurred to date
- Revised estimates of the cost to complete
- Estimated gross profit and completion date
How to Get Surety Bond Insurance
Surety bonds are underwritten by insurance companies and offered either directly by these insurance companies or by surety bond brokers. Often times, these companies that offer surety bonds compete on the annual surety bond premium. It’s therefore prudent to shop around for the best premium when looking for a surety bond. This will help you save money.
Surety Bond Insurance Bonding Process
The “bonding process” is the vetting process that surety bond providers conduct as part of the application process. Before a surety bond is issued, a surety will evaluate and qualify the principal to ensure that he or she has the resources and capacity to fulfill the terms and conditions of a bonded contract at the benefit of the obligee.
As part of the bonding process, a surety will require your personal credit score, your most recent year-end financial statement, as well as the past 3 years of your company’s year-end financial statements. If there are multiple business owners, the individual creditworthiness of each owner is taken into account during the bonding process.
From there, insurance companies will underwrite a surety bond based on the financial information gathered during the bonding process. Often times, a principal will be required to post collateral with the surety, sometimes up to 100% of the bonded amount. However, this isn’t always the case and is largely based on the personal credit score of the business owner.
Once the surety bond is underwritten, the principal will be required to sign an indemnity agreement in favor of the surety. This agreement stipulates the repayment terms between the principal and surety should a claim by the obligee be filed. Repayment terms can be monthly payments of principal plus interest like a line of credit but is dependent on the agreement.
What to Look for in a Surety Bond Provider
There are a wide range of surety bond providers available. There are typically two types of bond providers, which include insurance companies as well as surety bond brokers who work with multiple insurance companies. When looking for a provider, it’s important to check a potential surety’s bonding license, bond offerings, average bond premiums, as well as online capabilities.
- Proper bonding license – All surety bond providers are required to have a bonding license. Make sure that your potential surety has the proper bonding licenses for the locations in which they offer surety bonds.
- Adequate bond offerings – Surety bond providers can specialize in a specific bond or offer a full range of surety bonds. Make sure that the surety you work with not only has the specific bond you need but also other offerings should your needs change.
- Competitive surety bond premium – The major factor that bond providers compete on is the surety bond premium. When you’re looking for a surety, always ensure that you’re getting a competitive surety bond premium.
- Online application & draw capabilities – It’s typical for surety bond providers to offer their services with an online portal where you can apply online as well as receive the funds to cover a claim in the form of a line of credit.
Differences Between a Surety Bond & Business Insurance
Even though a surety bond is issued by an insurance company and often referred to as “surety bond insurance,” there are many differences between a surety bond and traditional business insurance. The 3 major differences are the underwriting qualifications, the purpose of the financial guarantee, as well as the specific party being insured.
1. Underwriting Qualifications
Traditional business insurance is risk-based while surety bonds are credit-based. When an insurer writes a policy to cover workplace injuries, for example, the underwriter will use statistical probabilities to determine the average likelihood of injury. The insurance premium is then based on the assumption that risk is spread out among the different policyholders.
With surety bonds, the underwriting qualifications are based on the creditworthiness of the principal. Insurance companies will typically want to see the past 3 years financial statements as well as the personal credit score and year-end tax return of the business owner. The higher the creditworthiness the lower the annual bond premium.
This also means that the cost of the surety bond is placed fully on the principal. With traditional business insurance, when a claim is filed the obligation falls on the insurance company the insured entity isn’t required to pay anything except for a deductible. With surety bonds, however, the principal is responsible for repayment to the surety in the case of a claim.
2. Purpose of Financial Guarantee
Traditional business insurance is typically used to cover unexpected accidents. An insured party will pay a monthly or annual premium to an insurance company for financial coverage in the case of a claim against the insured.
A surety bond, on the other hand, is used to protect a third-party against the chance that a company fails to meet contractual obligations or otherwise acts in an unethical manner. In this case, the principal will pay an annual bond premium to the surety so that the surety will cover the cost of a claim if a contractual obligation isn’t met.
3. Covered Party
The most confusing difference between a surety bond and traditional business insurance is the covered party. With traditional business insurance, you typically take out your own policy that covers you in the case of some accident or malpractice. With a surety bond, the principal takes out a bond that protects the obligee from a breach of contract or general malpractice on behalf of the principal.
Bottom Line: Surety Bonds
Overall, a surety bond is a way for a principal to financially protect the interests of an obligee. This is sometimes a requirement, such as when applying for a business license, but is also sometimes a good idea even if it’s not required. This is because it reduces the risk to an obligee and might make them more likely to work with you.
Surety bonds are offered by insurance companies as well as surety bond brokers. If you need a surety bond for your business, check out the insurance company Nationwide as well as the surety bond broker SuretyBonds.com. Both offer a full range of surety bonds for your company.