What is a Surety Bond and When Do You Need One?

What is a Surety Bond and When Do You Need One?

A surety bond is a legally binding contract that ensures obligations are met — or in the case of failure, that recompense will be paid to cover the missed obligations. Surety bonds can be used to ensure that government contracts are completed, cover losses arising from a court case or protect a company from employee dishonesty.

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What is a surety bond?

Surety bonds are a promise by a surety company to pay a first party if a second party fails to meet its obligations. Three parties are involved:

  • The principal: The person who must make good on an obligation.
  • The obligee: The person who needs a guarantee that the principal will perform.
  • The surety: The issuer of the surety bond guaranteeing that the principal will meet its obligation.

How does a surety bond work?

At its simplest, a surety bond requires the surety to pay a set amount of money to the obligee if a principal fails to perform a contractual obligation. Obligees are frequently government agencies, but commercial and professional parties can also use surety bonds. Surety bonds help principals, typically small contractors, compete for contracts by reassuring customers that they will receive the product or service promised.

To obtain a surety bond, the principal pays a premium to the surety, typically an insurance company. The surety bond requires the principal to sign an indemnity agreement that pledges company and personal assets to reimburse the surety if a claim occurs. If these assets are insufficient or uncollectable, the surety pays its own money to satisfy the claim.

Role of the Small Business Administration (SBA): The SBA Surety Bond Guarantee Program guarantees several types of contract bonds for a fee of 0.60% of the contract value. If the principal fails to meet contractual obligations, the SBA will reimburse the surety for some of its losses (up to 90%) on contracts up to $10 million.

Types of surety bonds

The surety bond definition encompasses several types of surety bonds used for different situations. Most have a few characteristics in common:

  • Bonding capacity: The maximum bonded amount a principal can obtain. It is determined by the contractor’s working capital, cash flow and managerial experience.
  • Working capital: Sureties usually require principals to have an amount of working capital — that is, current assets minus current liabilities. Though it will depend on the size of the principal, the requirement is generally between 5% to 10% of the total bonded amount.
  • Bond premium: A fee of typically 1% to 15% of the bonded amount charged by the surety and typically paid by the principal upfront for the entire term.
  • Bond term: A surety bond usually has a term of one to four years and can be renewed if needed.

Contract surety bond

A contract surety bond is typically used to guarantee the performance of a contractor (who in this case is the principal) for a construction contract. If the contractor falls through, the surety company must secure another contractor to complete the project or reimburse the project owner for any financial loss. The SBA can guarantee some types of contract surety bonds.

The cost of a contract bond is typically based on the contract amount and will often range from 0.5% to 3% of the contract price. Surety underwriters will also consider the contractor’s character, cash flow, credit score and work history during the underwriting process.

The types of contract surety bonds are:

  • Bid bond: These bonds guarantee that a contractor can meet the specifications contained in the bids they submit and won’t back out of a bid they’ve won.
  • Performance bond: A performance bond protects an obligee when a contractor fails to complete a project as required. These bonds are typically associated with bid bonds.
  • Payment bond: Payment bonds guarantee that the contractor will pay its subcontractors, laborers and material suppliers as specified in the contract. This type of bond is required in most large federal and commercial construction projects.
  • Maintenance bond: Also called warranty bonds, these protect the project owner from losses arising from faulty materials or defective workmanship on the construction project. The typical term is one to two years.

Commercial surety bond

A commercial surety bond is required by governmental entities to protect public interests. These bonds are typically used by licensed businesses to ensure they conform to all regulations and codes as they relate to the well-being of the general public. Typical principals include licensed contractors, automobile dealers, lottery-ticket sellers, liquor stores, notaries and licensed professionals.

The types of commercial surety bonds include:

  • License and permit bonds: These are required by government agencies when professionals apply for a license. Typical principals include pipe layers, electricians and contractors.
  • Mortgage broker bond: This type of bond protects borrowers from improprieties taken by mortgage brokers and ensures that mortgage brokers adhere to state regulations.
  • Other types: Specialized commercial surety bonds apply to liquor companies, utilities, warehouse companies, auctioneers, lottery-ticket sellers, auto dealers, fuel sellers, travel agents and agricultural companies.

Fidelity surety bond

Companies buy fidelity surety bonds to protect themselves from employee dishonesty and theft. They are important for companies that deal with expensive items or large amounts of cash. Credit unions, for example, may obtain a fidelity bond that provides coverage when an employee steals $10,000 by fabricating a fictitious loan. Fidelity surety bonds cover businesses, as well as current, former and temporary employees and directors, trustees and partners.

There are three types of fidelity surety bonds:

  • Business services bond: These protect against employee theft of or damage to client and customer assets, such as money, personal belongings and supplies.
  • Employee dishonesty bond: This type of bond protects a business from losses due to employees’ dishonest behavior. It is often used by nonprofit organizations.
  • ERISA bond: ERISA bonds are required by institutional investors and pension plans to protect participants from malpractice by employees who manage retirement plans.

Court surety bond

Court surety bonds protect persons or companies from losses during court cases. These are typically used by both plaintiffs and defendants, as well as estate administrators. Common types include:

  • Cost bond: Cost bonds guarantee payment of court costs during litigation.
  • Administrator bond: This type of bond ensures that the administrator of an estate performs their court-appointed duties. It is typically used when the estate’s owner died without a will or did not designate somebody to execute the will.
  • Guardianship bond: These bonds guarantee that guardians will act in the interest of incapacitated persons and minors.
  • Attachment bond: Courts are required to have these before they seize a person’s property, as they guarantee that defendants will be paid for any damages resulting from the seizure.

When do you need a surety bond?

Surety bonds are typically required for contractors who seek to work on high-cost government contracts. Even when not compulsory, surety bonds make sense when a contract requires performance, because they help compensate obligees when principals fail to meet their contractual obligations. In the construction industry, some lenders may require the project to be bonded before they extend financing.

Can you cancel a surety bond?

There are several reasons why you might need to cancel a surety bond — for example, if you decided not to seek a necessary license for your business, or if you obtained the wrong bond type. The process for canceling a bond can vary by state, but is typically done in one of the following ways:

  1. The surety sends to the principal a notice of cancellation that outlines the terms of cancellation.
  2. Some bonds, like term bonds, automatically expire after reaching their expiration date.
  3. The obligee provides written notice that approves the bond’s cancellation.
  4. The obligee returns the original bond to the surety.

The process can vary by the bond type. A financial guarantee bond, for example, requires a letter agreeing to the cancellation by the obligee. A court bond, on the other hand, requires a legal affidavit signed by the judge.

Obtaining a refund for a surety bond after cancellation is rare but possible for some companies. There are cases where the principal may receive a partial or full refund. Before agreeing to a surety bond, be sure to ask the surety company about their cancellation and refund policy. When canceling an SBA-guaranteed bond, the SBA returns the guarantee fee and you won’t incur any additional charges.

Where to get surety bonds

Surety bonds are typically underwritten by subsidiaries or divisions of insurance companies. It may be beneficial to work with a surety bond provider that works with surety bond producers. These licensed business professionals possess specialized knowledge of surety products. Surety bond partners approved by the SBA include Nationwide Mutual Insurance Company, Liberty Mutual Surety and Zurich Insurance Group.

As discussed earlier, the SBA offers a guarantee program to make it easier for principals to obtain contract surety bonds when they would otherwise face obstacles.