Surety bonds are contracts between three parties: the business owner performing the work, the client requesting the bond, and the business issuing the bond. If a client claims the business owner failed to deliver services as promised, the bond issuer pays the damages. Bond issuers typically require business owners to repay the claim costs.
Surety bonds are often industry or project-specific. A national insurance provider such as Nationwide offers most types of surety bonds as well as traditional insurance policies.
How Surety Bonds Work
You can think of surety bonds like insurance that’s for the benefit of one party, paid for by a second, and financed by a third. The first party, called the obligee, wants evidence that the party she’s hiring is trustworthy, so she asks for a surety bond. The party being hired, or principal, buys the bond from a bond issuer. Because an established company backs it, the bond acts as a guarantee of the principal’s work.
For example, say a general contractor works on a commercial construction project. The project owner may ask her to purchase a contract surety bond. If the contractor fails to meet any contractual obligations, the project owner can file a claim, and the bond company pays the financial damages on behalf of the general contractor. After damages are paid, the general contractor usually has to repay the surety bond company.
The Parties of a Surety Bond
To understand surety bonds fully, you need to understand the role each party plays in the bond contract. Every surety bond has a principal, obligee, and surety.
The obligee is the party that asks the business owner to get a surety bond. Obligees are often government agencies but can also be individuals or companies, and they use surety bonds to cover financial damages. For example, an obligee may file a claim if the person she hires fails to pay labor and material bills after a job is completed, doesn’t complete the job, or causes damage while performing the work. Additionally, some state and local agencies require surety bonds to obtain and maintain licensing.
The principal is the party who needs to take out a surety bond at the request of the obligee. Often, the principal of a surety bond is a business that’s trying to obtain a license from a government agency or bidding on a contract, but some businesses buy bonds when they work in their clients’ homes. The bond covers principals if they are accused of contract breaches, unethical business practices, or property damage.
The surety is the insurance company that backs the surety bond. Typically, the insurance company checks the principal’s credit history and requires collateral before issuing the bond. The bond then acts as a financial guarantee that the principal will fulfill the obligations outlined in the contract agreement with the obligee. As compensation for the guarantee, the principal pays an annual premium to the surety.
The surety does not pay the claim and move on. Surety bonds are prepayment for claims, so the bond issuer usually expects the principal to repay. This is why they usually require credit and financial statements as collateral before issuing a bond.
Surety Bond Insurance Bonding Process
Before surety bond providers issue a bond, they evaluate the applicant to determine if he or she can fulfill the contract. As part of that process, a surety typically requires your personal credit score, your most recent year-end financial statement, and three 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, the insurance company underwrites a surety bond based on that financial information. It may ask the principal to post collateral, sometimes up to 100% of the amount of the bonded. 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 must sign an indemnity agreement in favor of the surety. This agreement stipulates repayment terms between the principal and surety should a claim by the obligee be filed. The repayment terms can be monthly installments plus interest, but this depends on the agreement.
“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
How to Get a Surety Bond
Most national insurance providers have bond departments that specialize in surety bonds and help business owners get the right bond for their licensing or contractual obligations. You should look for a provider that understands your industry and can offer the right bond for the best price.
Top Surety Bond Providers
Artisan contractors, agricultural including cannabis, and landscaping businesses
Financial planners and insurance providers requiring bonds for licensing purposes
Interior home designers as well as staging and real estate service providers
JW Surety Bonds
Retail and restaurant businesses requiring protection against employee cash theft
Real estate development and new construction requiring bonds to obtain permits
What to Look for in a Surety Bond Provider
There are typically two types of bond providers: the insurance companies that underwrite bonds and surety bond brokers who sell bonds from multiple insurance companies. When looking for a provider, it’s important to check its:
- 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 your locations
- Bond offerings: There are many kinds of surety bonds, so providers may specialize in a specific type or offer a full range; you may want to work with a surety that not only has the specific bond you need but also other offerings should your needs change
- Costs: The major factor that bond providers compete on is premium; when you’re looking for a surety, always ensure that you’re getting a competitive surety bond premium
- Online application: It’s common for surety bond providers to offer their services through an online portal where you can apply for bonds and receive the funds to cover a claim
Here are five top-rated surety bond providers to help you get the right coverage.
Nationwide is the right bond provider for artisan contractors, cannabis dispensaries, and other agricultural businesses. Bonds obtained through Nationwide meet the state and local requirements for compliance, permits, and licensing for these hard-to-insure businesses.
Liberty Mutual offers competitively priced insurance policies for small business owners, particularly independent insurance agents and financial planners. It’s the right bond provider for anyone in the finance industry who needs a bond to maintain licensing. Individuals, such as notary publics, mortgage brokers, insurance agents, bankers, real estate brokers, and financial advisers, can get competitively priced bonds that meet licensing needs.
State Farm is the right choice for sole proprietors who provide interior design, staging, and home organization services in clients’ homes. Those who contract directly with clients or as subcontractors for realtors are well served by State Farm’s dedication to helping everyone in the community have the resources to succeed.
JW Surety Bonds
JW Surety Bond is a national bond broker dedicated exclusively to providing competitively priced bonds to a wide range of industries. It works with top-rated bond providers, such as The Hartford and CNA, and is a particularly strong option for anyone needing an employee dishonesty bond, particularly those in the retail and restaurant industries. Small businesses where a lot of money moves back and forth daily can fall victim to mishandling and dishonesty. JW Surety Bond has the right bond programs to help mitigate these risks.
Travelers is the right choice for new construction real estate developers or major rehabbers who need construction bonds to obtain permits and financing. Travelers’ extensive experience in real estate insurance make it a natural choice for bonds for any project size.
Surety Bond: Costs, Terms & Qualifications
Different bond issuers usually offer varying rates and terms for bonds, and they base these largely on your business’ financial health and your personal credit score. Qualifications for getting a surety bond can also vary between issuers, but the type of bond is also a factor.
Surety Bond Costs
When you buy a bond, you pay a premium to the surety, or bond issuers, each year. Many sureties offer set prices and terms for small business owners and independent contractors, such as a three-year bond for $10,000 for $40. When they don’t have a set price, the premium is a percentage of the total bond amount, typically between 1% and 15%.
Keep in mind that if there is a claim, you must have the financial resources to repay the insurance company any money it pays out. This means that you will pay more after the claim because you have a contractual obligation to do so.
Sample Surety Bond Costs Based on Industry and Term
Bond requirements vary by state and industry. These estimates are based on quotes in major United States cities with average credit scores.
The percentage you are charged for your bond premiums is usually based on your personal credit score. For example, a business owner typically pays:
- 1% to 3% annual bond premium for credit scores 700+
- 4% to 15% bond premium for credit scores between 550 and 699
In addition to the business owner’s credit score, sureties may take into account the experience of the business owner. Some sureties also look at the company’s performance when calculating the bond premium.
Other factors that a surety may consider include:
- Working capital
- Business’ mix of debt and equity
- Business’ net worth
- Dun & Bradstreet credit report and business credit score
- Small business lines of credit
- Business references
Some construction surety bonds are guaranteed by the Small Business Administration (SBA). If you get a construction surety bond that’s guaranteed, the SBA charges a guarantee fee of 0.75% annually. This guarantee reduces the risk for 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 bond amount. Instead, sureties typically require that a business has at least 10% of the bonded amount in working capital. Furthermore, many sureties limit the total amount to between 10 and 15 times the value of the business’ equity. The maximum bond amount is called the company’s bonding capacity.
Sureties may limit the bond amount of both individual surety bonds and the total of all outstanding surety bonds. With construction surety bonds, for example, a general contractor might have five 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 one to four years. However, some surety bonds denote that they “continue 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 principal.
Surety Bond Qualifications
Your personal credit score also has a big impact on whether you qualify for a surety bond. Applicants typically need credit scores of at least 550. However, the bond issuer may also take into account other factors like your business’s financial performance, existing lines of credit, and your industry experience.
Surety bond qualifications usually include the following:
- Company financial performance: Bond issuers often ask for at least three years of financial statements, including the amount of business’s liquid assets
- Existing business lines of credit: Higher credit limits are 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 and 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 one to two quarters to track how the year is progressing. Contractors may need to prepare a quarterly schedule of work in progress, providing information like:
- 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
Who Needs a Surety Bond?
A surety bond is right for companies that want to minimize risk, ensure both compliance as well as the completion of a project or when doing business with a new partner. For instance, you may need a surety bond when you get a construction license, bid on a public works project, or are part of a specific industry like alcohol and tobacco. You might also want one to minimize an obligee’s risk.
Specifically, surety bonds are right for the following types of companies:
- Construction and other businesses with government-issued licenses
- Construction companies with government projects of more than $100,000
- 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
Surety Bond Example
Contractors who work in clients’ homes often need surety bonds. For example, let’s say a homeowner hires an electrician to replace her electrical power panel so that it meets all current safety codes. The contract estimates the job will cost $7,500, and the electrician has a bond for $10,000. After the job is complete, and the homeowner has paid the bill, she decides to get a second opinion.
It turns out that the electrician updated the panel but failed to meet the latest building codes. The homeowner files a claim with the surety bond company who pays her. The surety bond company then seeks the $7,500 back from the electrician.
4 Types of Surety Bonds
There are many different types of surety bonds. Almost any contract or obligation can be bonded. However, the four 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 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, materials, and supplies.
Typical claims made on a contract surety bond include:
- Not completing the job correctly
- Failure to meet job deadlines leading to financial harm
- Breach of contract by the service provider
“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; Kentucky Surety & Construction Law
2. Commercial Surety Bond
A commercial surety bond is typically used to protect public interests and is often mandated by government agencies. These government agencies require that all new businesses in a specific sector, such as the liquor industry, get a commercial surety bond. For these types of bonds, the obligee is the public.
Commercial surety bonds are commonly required in industries like:
- Liquor sales
- Financial services
- Tax planning
- Artisan contractors
- General contractors
3. Fidelity Bond
A fidelity bond protects a company against the malpractice of an employee who handles cash and other valuable assets. These 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.
Companies in the following industries can protect their interests with fidelity surety bonds:
- Check cashing offices
- Convenience stores
- Retail stores
- Food trucks
- Cafes and restaurants
There is also a specific type of fidelity bond called a financial institution or bankers blanket bond that is purchased by banks, insurance companies, trading companies, mortgage lenders, and other financial businesses.
4. Court Surety Bond
Court surety bonds are often 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.
When to Get a Surety Bond
There are two scenarios when business owners typically get a surety bond. The first is when someone else requires a bond, and the second is when a business owner willingly takes out a bond to reduce the risk of their clients. 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’re often 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.
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 should get surety bonds before they place any bids.
Surety Bond vs 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 three major differences are the underwriting qualifications, the purpose of the financial guarantee, and the party being insured.
1. Underwriting Qualifications
When an insurer writes a policy, its underwriter uses statistical probabilities to determine the average likelihood of a claim. The insurance premium is then based on the insurer taking over that risk and spreading it out among its policyholders.
With surety bonds, the underwriting qualifications are based on the creditworthiness of the person buying the bond. Surety bond companies typically want to see the past three years of 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, or the person buying the bond. With traditional business insurance, when a claim is filed, the obligation falls on the insurance company. The insured isn’t required to pay anything in a covered claim except the deductible. With surety bonds, however, the principal is responsible for repayment to the surety.
2. Purpose of Financial Guarantee
Traditional business insurance is typically used to cover unexpected accidents. An insured party pays 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 pays 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 a policy that covers you in the case of an accident or accusation of malpractice. With a surety bond, the principal takes out a bond that protects another party, the obligee, from a breach of contract or general malpractice on behalf of the principal.
Surety Bond Frequently Asked Questions (FAQs)
Surety bonds are pretty simple once you understand you use them like guarantees for your clients and that another party backs them. That said, you wouldn’t be alone if you had more questions. Here are the answers to a few of the ones we’ve heard most often.
How does a surety bond work?
The surety bond is a financial guarantee backed by the surety (insurer) for the work a business (principal) performs for someone else (obligee). Under most circumstances, the surety pays the claim to the obligee when the principal has not completed work according to contractual terms. The principal must then repay the surety for the claim.
What are surety bonds used for?
Surety bonds are limited financial guarantees that work will get done as agreed upon in a contract. Many licensing agencies require them for service providers who work in people’s homes or have fiduciary and cash handling duties. Claims often revolve around breach of contract, employee mishandling money, and errors in work.
Is surety bond refundable?
Most surety bonds can be partially refunded within the first year of owning it. These are prepaid insurance products, often extending three to five years. The surety company will determine a refund schedule based on milestones, where the bond premium is “fully earned.” A fully earned premium is nonrefundable.
A surety bond is an economical way for a principal to protect the interests of an obligee financially. It’s good business for those working with consumers who want to know that the service provider stands behind their contracts with a bond and is often a requirement by state and local business licensing agencies.
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 that offers a wide range of surety bonds as well as traditional business insurance to cover all your risk needs.