The Basics of Surety
When dealing with surety, it is important to understand suretyship. We will attempt to provide you with basic knowledge about the surety bonds used in the industry, their requirements, and the expectations and legal obligations of the parties bound by them. With this, we trust you will be better prepared to assess the risk elements involved and make informed decisions.
Surety Isn’t an Insurance Policy
While surety companies are for the most part divisions or operations of insurance companies, surety is different from insurance. A surety bond is not an insurance policy as they differ in several key areas. A surety bond is a promise to honor the obligations or another party to the extent of the terms of the bond. It is a three-party agreement whereby one party (the Surety) is bound with the person or entity bonded (the Principal) in the performance and or obligations to a third party beneficiary (the Obligee).
The Differences Between Surety and Insurance
Whereas a surety bond is a three-party agreement, an insurance policy is a two-party agreement. With insurance, the insured pays a premium to the insurance company and receives the benefits of the policy in the event of a claim. With surety bonds, the principal typically pays a premium, but must also pay the loss in the event of a claim. If the principal cannot or will not pay a valid claim, the surety must pay, but the principal is required repay the surety for loss the surety may sustain. The purpose of the surety is not to pay losses, but to provide a service to worthy persons or entities whose affairs or obligations require a guarantor. The basic rule of suretyship is that a surety should never suffer a loss. The surety is in a position of secondary liability, with the principal always remaining primarily liable to the obligee.
At its most basic level, insurance underwriting is actuarially based on the law of large numbers and contemplates some level of losses when pricing its product culminating in a profit. Surety underwriting is at its most basic level, driven by credit guidelines, more akin to the banking industry. It contemplates no losses with the premise that the principal has the capability and capital to perform its obligations. Thus, premiums charged by the surety company should relate to the credit evaluation process and are not calculated to absorb losses.
Another significant difference between insurance and surety is that an insurance company can cancel a policy with proper notice, whereas a surety company cannot cancel a contract bond. Some commercial surety bonds are cancellable with proper notice. Also, an insurance policy is terminated when its term expires, or one of the two parties gives notice to the other. A surety bond, however, typically requires written evidence from the obligee that the underlying obligation has been satisfied.
Two Surety Bond Categories
In general, there are two broad categories of surety bonds: (1) Commercial surety bonds; and (2) Contract surety bonds.
Commercial Surety Bonds
Commercial surety bonds are needed by almost every business that is in existence in the United States. Most business must file some type of bond for their business to function. Most surety bonds are required by statutes created within the local, state, or federal jurisdictions. However, private contracts may also require security in the form of a surety bond to protect against a contract breach. The bonds provided to respond to these statutes either protect the public from the actions of noncompliance or protect a public entity from financial loss of taxpayer moneys. A brief description of these bonds is as follows:
- License and Permit Bonds: Required by state law, municipal ordinance, or the Federal Government as a condition precedent to the granting of a license to engage in business or a permit to exercise a particular privilege where such presents a risk to the public welfare. Some examples contractor license bonds, insurance broker bonds, auto dealer bonds, and mortgage broker bonds.
- Court Bonds: There are two categories of court bonds (Judicial and Fiduciary). Judicial bonds are typically required in a civil proceeding when a litigant seeks some special right or remedy in advance of a final court decision which could ultimately prove financially detrimental to the opposing party. Judicial bonds guarantee that the damaged party will be made whole in case the action is later found by the court to be unjustified. Examples of Judicial bonds include appeal bonds, supersedeas bonds, attachment bonds, and injunction bonds. The second category is Fiduciary Bonds (often called Probate Bonds). A Fiduciary is a person, bank or trust company appointed by order of a court to administer the property of another who is unable to manage its own affairs. A Fiduciary must comply with all laws; exercise due care and not profit from their position of trust. Examples of Fiduciary bonds include executor bonds, guardianship bonds, administrator bonds, trustee bonds, and conservator bonds.
- Miscellaneous Bonds: This category of bonds encompasses a myriad of obligations which do not clearly fall within the scope of other classifications. These bonds can run to many different obligees including government entities, commission or private/public businesses. Examples include lease bonds, self-insured workers’ compensation bonds, warehouse bonds, title bonds, utility bonds, fuel tax bonds, and non-construction performance bonds.
- Federal Bonds: These are bonds running to the US government and required of individuals and firms providing services to or doing business with the Federal Government. They include guarantees for payment of excise taxes and payment of duties and fees on imported goods.
Contract Surety Bonds
Contract surety bonds guaranteeing contracts for construction projects. There are two types of owners (Obligees) – Public and Private. The differentiation being that performance/payment bonds are required by law on publicly financed projects. The Federal Government passed the Miller Act in 1935, which requires all federally funded (or partially funded) projects, over a certain financial threshold, be bonded. Just about all State, County, Municipal and other political jurisdictions have some version of “Miller” act law (typically called “little Miller Act”) on their books requiring bonds on publicly funded projects.
There are different types of contract surety bonds that come into play at various stages of a construction project. The main ones are:
- Bid Bond: In its basic format, the bid bond guarantees that if the owner (obligee) accepts the contractor’s bid, then the contractor will enter a contract with the owner to perform the work at the bid price and furnish the requisite performance/payment bonds for the project. The penalty of the bid bond is typically stated as a percentage of the contractor’s bid amount (usually 10%).
- Performance Bond: This bond covers the obligation of the contractor (principal) and secondarily the surety, to perform the contract in strict accordance with the terms, conditions, and specifications of the contract. This obligation runs to the owner (obligee) but will on occasion be expanded to include a lender when properly added as a Dual Obligee.
- Payment Bond: This bond provides protection to the subcontractors and suppliers on the project – guaranteeing that they will be paid for the product and services they perform, under the terms of the bond and any applicable statute. It also protects the oblige from having to pay for the services of the subs/suppliers more than once.
- Maintenance/Warranty Bond: This bond typically covers defective workmanship and/or materials on the project. The traditional construction project calls for a one-year warranty period, and that exposure is covered by the Performance bond – if one is in place. If no Performance bond is in place, a maintenance or warranty bond may be required to protect against this exposure.
- Supply Bond: This bond guarantees that the supplier of a product will supply that product to the obligee – who is typically a government unit – at the price and in the quantity proposed in its contract.
- Completion Bond: These bonds provide the same type of protection for the obligee as is contemplated in performance and payment bonds; however, there is one major distinction. The bond names as the obligee a lender or other party who can invoke the performance feature of the bond, but who does not have the obligation to provide the funds to pay for the project. There is no underlying contract between the principal and the obligee. The most common type of completion bond is referred to in the industry as a subdivision bond where a developer must post a bond to guarantee that the developer will install (and pay for) the public improvements (lighting, sidewalks, sewer lines, water lines, landscaping, etc.) required to allow it to develop, record, and sell building lots.
- Advance Payment bond: This bond guarantees the repayment of funds paid to the principal by the obligee before the principal has earned the payment and usually involves supply bonds. The funds advances must be used to purchase materials, supplies or the like for incorporation into the project.
The Performance Bonding Advantage
Since Surety is our only focus, your bond needs will always receive immediate attention. As your committed partner, Performance Bonding Surety & Insurance Brokerage will stay one step ahead of your needs and expectations. We have direct appointments with the Top 10 US Surety Carriers, including direct access to upper management/decision makers. We are licensed to write bonds in virtually every state, including the District of Columbia, and are experienced with international surety. Contact us for timely, dynamic, and reliable surety services to meet your immediate and long-term needs.