Updated July 6, 2023
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:
- The surety, the principal, and the obligee have legally agreed upon a contract.
- 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 aims 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 bond, the applicant’s credit score, and the applicant’s financial track record.
Purpose
A surety bond enforces a legally binding contract to fulfill commitments. If the principal fails to meet their obligation, the surety bond compensates for the loss resulting from the non-performance of the act. Typically, these bonds guarantee the completion of government contracts, address losses related to litigations, or safeguard firms against dishonest employees. Moreover, they enable small contractors to compete for significant contracts by assuring customers they will receive the committed service or appropriate compensation.
How Does it Work?
To obtain a surety bond, the principal must pay the surety (such as an insurance company) premium. 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 cannot 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. The management hired ABC Partners (the principal) based on their technical expertise. According to local regulations, the contractor must provide a performance bond 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 insurance company ensures that the local authority is protected if ABC Partners fails to deliver, thereby compensating the local authority for any losses resulting from the contractor’s failure to fulfill the agreed terms of the contract.
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 aims 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 have a joint obligation 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 called the “principal,” purchase surety bonds to demonstrate their commitment to meeting the financial implications of their non-performance of the subject act. The terms outlined in the contract require these guarantees, which align with the state laws and statutes.
Frequently Asked Questions (FAQs)
Given below is the FAQ:
Q1. 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.
Q2. How to get surety bonds?
A: Typically, these bonds are underwritten by insurance companies or their subsidiaries.
Q3. 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
Surety bonds transfer the risk of non-performance by the principal from the obligee to the surety, actively shifting the burden. They resemble insurance products in the claims process but differ significantly in the expected losses resulting from the claims. Unlike insurance products, the surety bond anticipates recovering the necessary funds to settle the claim from the principal.
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