A Brief Synopsis of Surety Bonds… 09.23.2015
What is it about Surety Bonds that seems to cause people equal parts angst and frustration? Even insurance professionals, who don’t deal with surety, look to “wholesale” business to agents that specialize in it. When you think about it, that’s the prudent course of action, because, even though surety is considered a form of insurance the actual workings of surety are based on credit and risk – much more similar to the banking and credit business.
In simplest terms a surety bond is a 3 party agreement consisting of: Principal (usually the client asking for the bond) * Owner/Obligee (the entity requiring the bond with whom Principal has a contract with) * Surety (our third party guarantor). It is the Surety that guarantees the principal’s obligation to the Owner/Obligee. Unlike typical insurance policies people are familiar with, the surety does NOT expect to have a loss on bonds that it supports.
So, who needs surety bonds and what is the benefit of such bonds? A detailed answer would be much too long and boring so here is the old Readers Digest version…There are many versions of surety bonds but they are mostly categorized in three subsections: Contract Bonds, Miscellaneous Bonds & Court Bonds. From these subsections there are even more variations. Suffice it to say that surety bonds are much more prevalent than you think. A few examples of who needs surety bonds:
Trade contractors are required to post License bonds which basically guarantee that the contractor will adhere to ethics and providing professional services to clients. There are many variations of this bond and each state has its own take/requirements. The below examples are broad based explanations and are intended to provide an idea of what is out there from a surety bond perspective.
Lost instrument bonds are usually required when someone loses stock certificates or large checks, etc… The bond guarantees that if the original lost item is found it will not be “cashed in” as well.
Appeal bonds guarantee that the amount a defendant lost in a court case will be paid if the case is again lost in the court of appeal.
Performance and Payment bonds are required for Public works contractors. Required to protect public funds by law “The Miller Act” the bonds guarantee that the contractor will perform the work as specified in the contract with the Owner/Obligee.
What’s the benefit? In the purest sense, the surety bond protects public and in some cases private dollars from being wasted. The reason an owner requires a surety bond is usually to protect its investment (dollars) or the public’s rights as in a license bond. Remember Enron?
The Surety industry really stepped in big time and provided a lot of dollars back to the burned investors. While the surety industry considered this a debacle, it really lost an opportunity to market the industry as protection against such situations.
Notice that in all the examples above, the Surety is the one “Guaranteeing” the bonds. Unlike insurance, which is a two party obligation based on actuarial statistics, there is a specific amount attached to a bond. If the bond is defaulted (meaning the Obligee has indicated that the Principal has not performed its obligations as per the bond/contract) the surety compensates the Owner/Obligee up to the bond amount. Unfortunately if there is nothing left with the Principal (back to Enron) the Surety(s) can take a tremendous financial blow.
Generally if the Surety has a loss (default) on a bonded risk it expects to be compensated for the loss incurred by the Principal (you). Why? Consider the underwriting process. The underwriter has reviewed your credit (personally and/or corporately), looked at your financial well being, and depending on the type of bond risk - your ability to meet the bonded obligation both financially and experience wise. Based on the information it has compiled, you are financially capable of handling the Obligation on the bond and if you fail (default) the surety believes you are capable of paying the surety back for the loss it absorbed on your behalf. This is known as subrogation. That is why you will be asked to sign what is commonly known as a General Agreement of Indemnity (GIA) for the surety when you are looking to obtain a single bond or bonding credit. In many ways it’s just like obtaining a mortgage , the difference being your house is the bank’s collateral should you fail (default) on your payments while the surety has the GIA.
Surety bonds should not be looked on with so much trepidation. If you understand that it is really a credit based industry you can better prepare yourself for obtaining the surety bond you need. You would really do well for yourself if you look for a professional surety agent, especially if your surety need will be large or frequent. It will save you a lot of time and anxiety as you will be walked through the process in a way that will not have you on the verge of panic.