If you’re like most people, you probably have no clue what a “surety bond” is. There are a lot of people out there that may have been required to purchase a surety bond, or currently have one, but still do not completely understand what it is or why they were required to purchase the bond.
So why are people required to purchase surety bonds?
The simple answer is that you (the principal) would like to do work with someone, or some government entity, that is requiring you to purchase a surety bond (the obligee). However, WHY is the obligee making you obtain the surety bond? The answer to this question will vary depending on the type of business you are involved in, and the specific type of surety bond you are required to purchase. There are literally dozens of different types of surety bonds, but for simplicity we can break them down into three major categories: Commercial Bonds, Contract Bonds, and Court Bonds. Commercial bonds are required to cover the person the principal is doing with work, known as the obligee. Contract bonds are a means to ensure that the principal will complete the work for the obligee per the terms of their signed agreement. The last category of surety bonds, court bonds, can be required by the obligee for numerous different reasons. Guardianship bonds, a type of court bond, are in existence to guarantee that a guardian acts in the best interest of the minor and/or incapacitate person who they are responsible for. Another type of court bond, appeal bonds, are required to ensure that someone found guilty in a court of law does not flee from authorities. And the list goes on…
As you can see, different surety bond types are required for numerous reasons. If need to purchase a surety bond, and would like to know more about what it is and why you are required to obtain the bond the best thing you can do is take a close look at the blank bond form for that specific surety bond to find out what exactly it is guaranteeing. These forms will provide detailed information for each bond type. The previous paragraph only provides general information on the three major surety bond categories.
A “surety bond” is a three-party agreement between the following people or entities:
The principal is the person who is trying to purchase the bond. The obligee is the person or entity that requires the principal to purchase a surety bond. Lastly, the surety is the carrier that financially backs the guarantee.
While the principal is required pay a bond premium to purchase the surety bond, they do NOT receive financial support from the surety in the event that claim arises. The surety bond itself covers the obligee, or in other words the client of the principal. To further understand this concept, I’ll use a real world example. Let’s say a construction company (the principal) is hired to build a structure for someone (the obligee). If for whatever reason the construction company wasn’t able to finish the job, a claim would arise on their surety bond. In this case, the person/entity that hired the construction company to do the work would receive money to pay someone else (another construction company) to complete the work. The surety would then require the principal to provide the requisite payment for the claim in addition to any legal costs that may arise.
Not everyone that applies for a surety bond will be qualified for one, because underwriters do not want to write bonds in cases where the possibility of a claim arising is highly likely. This is something that differentiates surety bonds from insurance. When dealing with customers, insurance companies come up with premiums/rates assuming that claims will take place in the future, and therefore their rates are adjusted based on the likelihood of such losses actually occurring.
With insurance, a person is required to pay an insurance premium to their insurance company which essentially transfers most (if not all) risk from the individual purchasing the insurance to the insurance company. The only similarity between insurance and a surety bond is the payment of a premium, because when a person pays a bond premium for a surety bond they (the principal) do not transfer risk to the surety, and instead the payment of claims will fall on the principal’s shoulders. When dealing with surety bonds, the protection goes to the person or entity that requires the principal to purchase the bond (the obligee).
When dealing with losses, insurance companies typically expect to make payment for a certain percentage of a given claim. However, surety companies do not expect to make such payments on claims, and instead treat the premiums paid for surety bonds as service charges. The premiums essentially authorize the principal to use the surety’s deep pockets for financial backing, which provide the required guarantee.