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

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

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Surety bonds are legally binding contracts that ensure 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 government contracts are completed, to cover losses arising from a court case or to protect a company from employee dishonesty.

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.

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. It also helps 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. Obligees are frequently government agencies, but commercial and professional parties also use surety bonds. 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: The SBA’s Surety Bond Guarantee Program guarantees several types of eligible surety bonds for a fee of 0.729% of 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

Different types of surety bonds address specific situations. Most have a few characteristics in common:

  • Bonded Amount: Sureties typically cap the bonded amount at 10 to 15 times the principal’s business equity, which is the amount invested in the company plus retained earnings. Sureties generally have an absolute cap on the bonded amount.
  • Working Capital: Sureties usually require principals to have an amount of working capital—that is, current assets minus current liabilities—equal to at least 10% of the total bonded amount.
  • Bonding Capacity: The maximum bonded amount a principal can obtain. It is a function of business equity and working capital.
  • Bond Premium: A fee of 1% to 15% of the bonded amount charged by the surety and paid by the principal annually.
  • Bond Term: A surety bond usually has a term of one to four years. Some are perpetual, with no expiration date.

Contract Surety Bond

A contract surety bond is typically used to guarantee the performance of a contractor, who is the principal, for a construction contract. The contract surety bond protects the obligee, the project owner, from harmful business practices and failure of the contractor to finish or to properly complete the specified work. Sureties typically base bond premiums on the principal’s credit score: 1% to 3% for scores above 700, 4% to 15% for lower scores. Other factors that affect bond premiums include the contractor’s financial performance, industry experience and existing lines of credit. The SBA can guarantee some types of contract surety bonds.

The types of contract surety bonds are:

  • Bid Bond: These guarantee that a contractor can meet the specifications contained in the bids it submits and won’t back out of a bid it has won.
  • Performance Bond: A performance bond protects an obligee when a contractor fails to complete a project as required. These bonds are typically combined 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 federal and commercial construction projects.
  • Maintenance Bond: 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 are:

  • License and Permit Bonds: These are required by government agencies when professionals apply for a license. Typical principals include plumbers, 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. These bonds are used by companies like casinos, ones with employees who make home visits and ones that hire seasonally or have mass hirings. Fidelity surety bonds cover businesses, 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 employee 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

This bond protects persons or companies from losses during court cases. Typically used by plaintiffs and defendants, as well as estate administrators. Common types include:

  • Cost Bond: Cost bonds guarantee payment of court costs during appeals.
  • Administrator Bond: This type of bond protects an appointed estate administrator when the estate owner dies without a will.
  • Guardianship Bond: These guarantee 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 government contracts. They are also required for persons and companies that are licensed by a governmental entity. 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. They do not make sense if the amount of possible damages is negligible.

Where to Get Surety Bonds

Surety bonds are insurance policies. As such, they are sold by insurance companies that are either specialized for this product or are general purpose insurers. As discussed earlier, the SBA offers a guarantee program to make it easier for principals to obtain surety bonds when they would otherwise face obstacles. Surety bond companies employ underwriters to approve and price bond applications. Some of the top surety bond companies are Travelers Bond, Liberty Mutual Group and Zurich Insurance Group.