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A party entering into an agreement, may often want to ensure that the other party will properly fulfill all its contractual obligations.  A working solution is to require them to provide a third-party guarantor. The guarantor then enters into a contract of suretyship, taking responsibility for the debt, default, or other financial responsibilities of the non-performing party. This form of suretyship is commonly referred to as a “Surety Bond”.

 

How do surety bonds differ from insurance

Insurance works purely as a two-party contract between the insured and an insurance company, whereby the insurance company guarantees it will compensate the insured if a covered loss occurs.

A surety bond, however, works completely differently. Here the surety is providing an indemnity in the case of a party to the contract not performing satisfactorily. If the surety pays out on a claim, the non-performing party will be liable to repay it for any such payments. In essence therefore, it constitutes a three-party agreement.

 

The three parties to a surety bond

  • The first party, known as the principal, is an individual or business who has undertaken to perform some form of professional service for the second party. It is the principal that pays for the surety bond.
  • The second party is referred to as the obligee. The obligee is the party for whom the service is being performed. and is the one that will suffer if the service is not properly performed.
  • The third party is the surety and is the one that provides compensation to the obligee if the principal fails to perform properly.

 

How does the surety bond work?

The surety bond is thus a legally binding contract entered into by three parties: the principal, the obligee, and the surety. The obligee requires the principal, typically a business owner or contractor, to obtain a surety bond as a guarantee against the due performance of a service or future work.

The surety is the company that provides a financial guarantee to the obligee that the principal will fulfill all its obligations. For example, a principal’s obligations could include complying with state laws and regulations pertaining to a specific business license, or meeting the terms of a construction contract.

In the event of the principal defaulting by failing to fulfill the terms of the contract entered into with the obligee, the obligee has the right to file a claim against the surety bond underwriters to recover any damages or losses incurred. Once it is established that the claim is valid, the surety company will make restitution up to the amount of the bond. The principal will thereafter be obliged to reimburse the surety underwriters for any such claims that they have paid.

 

What is required of a principal before a surety will be granted?

Because a surety bond is not an insurance policy, the surety company will require reimbursement from the principal in the case of a paid loss or claim. Therefore, before underwriting a bond, the surety company will typically require the principal to show they are in good standing, have good credit, and a good prior reputation. In addition, they may require the principal to show it has the equipment, experience, and financial resources necessary, to carry out its contractual obligations.

On the basis of all the information furnished, the underwriting process will then determine the price the applicant will pay for the surety bond. Based on the assessed risk level that the underwriters have determined, the surety will then provide the principal with a quote for the required surety bond.

 

Common types of surety bonds

  • Commercial surety bonds
    These bonds ensure that a business complies with the security requirements of public, legal or government entities. They guarantee that the business or individual will satisfy all required legal obligations, and thus protect the obligee against financial risk
  • Contract surety bonds
    These bonds are often used in the construction industry. They protect the owner (obligee) from financial loss in the event that the contractor (principal) fails to fulfil the terms and conditions of their contract.  The obligee is accordingly protected against a contractor’s inability to complete a job to its full satisfaction.Surety bonds remain valid for the duration of the contract they cover, as well as for any agreed maintenance period that was written into the contract. They could therefore possibly last for a year or more after the contractual obligations had been completed. In this way they would protect the obligee in the event of problems arising during the maintenance period which might require some of the work to be redone or corrected.
  • Bonds known as Fidelity bonds
    Business service bonds – these protect business clients from theft or loss of their funds, valuables, and other assets.Employee dishonesty bonds – these protect a business from fraudulent activities committed by its employees.ERISA bonds – these safeguard employees and their beneficiaries in the event of dishonest or negligent actions financially harming their assets. They do this by setting a minimum standard for pension plans, also guaranteeing the payment of these and similar benefits, to employees.

 

Reasons to Be Bonded

A business needs to be bonded if a state or municipal authority requires it. In particular, if one’s business frequently performs services in customer’s homes or on the premises of other businesses, becoming bonded, to protect one’s customers and business, is strongly recommended

Being bonded provides a business with financial stability in the case of a claim by customers. In the event of a customer making a successful claim against the business, the compensation needed to settle the claim would come from the bond. As a result, this wouldn’t impact the continuation of immediate operations.

Being bonded cements good relationships, building a layer of trust, in the knowledge that one is dealing with a business that is professional, credible, and ethical.