Surety Bond


What is Surety Bond?

The term “surety bond” refers to a written agreement that guarantees an act’s payment, compliance, or performance. It is a unique tripartite contract involving three parties – the surety, the principal, and the obligee. In a surety bond agreement, the surety guarantees the obligations or performance of the principal to the obligee. It can be seen as an insurance or a risk management tool.

Key Takeaways

Some of the key takeaways of the article are:

  • It is a legally agreed contract between the surety, the principal, and the obligee.
  • It assures the obligee that the principal will perform the job successfully. However, if the principal fails to complete the work, the surety will ensure that the obligee is compensated adequately.
  • The agreement’s purpose is to protect, indemnify, or provide financial guarantees to the obligee, such as suppliers, customers, etc.
  • The premium charged for a surety bond is determined based on the coverage amount of the guarantee, the type of the surety bond, the applicant’s credit score, and the applicant’s financial track record.

Purpose

A surety bond is a legally binding contract that ensures that commitments are kept. If the principal fails to fulfill the obligation, the loss incurred due to the non-performance of the act is recompensated by the surety bond. Typically, these guarantees are used to ensure the completion of government contracts, cover losses about litigations, or protect firms from dishonest employees. In addition, it helps small contractors compete for big-ticket contracts as it assures the customers that they will receive the promised service or be adequately recompensated.

How does it work?

To obtain a surety bond, the principal must pay a premium to the surety (such as an insurance company). Besides, the principal also needs to sign an indemnity agreement pledging the company’s assets and personally reimburse the surety in the case of a claim. If the pledged assets are insufficient to cover the claim, the surety becomes responsible for paying off the shortfall and satisfying the obligee’s claim.

Example of Surety Bond

Let us assume that a local authority (the obligee) had floated a tender to construct an office building. Based on their technical expertise, the management hired ABC Partners (the principal). According to local regulations, the contractor has to provide a performance bond a type, to secure the job.

This performance bond guarantees the fulfillment of the terms and conditions mentioned in the contract. Hence, ABC Partners purchased a construction performance bond from a trustworthy insurance company.

The guarantee ensures that the local authority will be protected if the contractor fails to deliver. In short, if ABC Partners fails to fulfill the agreed terms of the contract, the insurance company will ensure that the local authority is compensated to cover their losses due to the missed obligation.

Surety Bond Cost

The premium or cost of a surety bond a business pays is a percentage of the coverage amount. The premium charged by the surety usually depends on the following factors:

  • Coverage amount of the guarantee
  • Type of the surety bonds
  • A credit score of the applicant
  • Financial track record of the applicant

Who does a Surety Bond protect?

Although it seems like an insurance product, a surety bond doesn’t intend to protect the bond’s owner or principal. The agreement’s purpose is to protect, indemnify, or provide financial guarantees to the obligee, such as suppliers, customers, etc. It intends to protect these parties if the principal violates the terms and conditions of the contract.

In such a case, the third parties can file a claim which the obligee will investigate. If the claim is valid, the obligee and the principal are jointly obligated to cover the damages up to the full coverage of the bond.

Who buys Surety Bonds?

A wide variety of individuals and businesses purchase surety bonds. In most cases, they are obtained to meet job-related licensing requirements prescribed by a government authority. Companies, also referred to as the “principal,” purchase surety bonds to demonstrate their commitment to meeting the financial implications of their non-performance of the subject act. Often these guarantees are required as per the terms outlined in the contract, which are aligned with the state laws and statutes.

Frequently Asked Questions (FAQs)

Given below is the FAQ:

Q: How to cancel a surety bond?

A: It can be canceled in one of the following ways:

  • The surety can send a cancellation notice to the principal.
  • The obligee presents a written notice to cancel the surety bond.
  • The obligee gives back the bond to the surety.

Q: How to get surety bonds?

A: Typically, these bonds are underwritten by insurance companies or their subsidiaries.

Q: What does a surety bond cover?

A: In case the principal breaches the terms and conditions of a pre-determined contract, the surety ensures that the surety bonds cover the losses incurred by the obligee due to non-performance by the principal.

Conclusion

So, it can be seen that a surety bond helps transfer the risk of non-performance by the principal from the obligee to the surety. It is similar to insurance products in the claims process but quite different regarding the expectation of losses due to the claims. Unlike insurance products, the funds required to settle the claim of surety bonds are expected to be recovered from the principal.

Recommended Articles

This is a guide to Surety Bond. Here we also discuss the definition, purpose, working, example, and cost, along with who does protect and buys Surety Bond. You may also have a look at the following articles to learn more –

  1. Credit Enhancement
  2. Credit Analysis
  3. Coupon Bond
  4. Defined Benefit Plan

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