TLDR: Most people or businesses have never heard about surety bonds until they are told that they need one. The North American Surety Industry was valued at $8 billion in 2019 and is expected to grow at a CAGR (Compounded Annual Growth Rate) of 6.4% from 2020-2027 to reach US $14 billion by 2027. This article is a primer on everything you need to know about surety bonds, including their purpose, their differences from insurance, the different types of surety bonds, how to buy surety bonds, any alternatives to surety bonds, etc.
If you look at the definition of the word “Surety”, you get the following
The definition matches the mission of surety bond. In short, surety bond is a financial guarantee on the performance of an obligation.
Generally, a surety bond is a three party contract in which one party guarantees a second party the successful performance of a third party. Here are the three parties:
1. The Surety
This is the guarantor of the contract. It is usually an insurance / bonding company which determines whether an applicant (principal) is qualified to be bonded for performing a service or obligation. If the applicant is determined to be qualified, the surety would issue the bond. An example of a surety company is CNA Surety.
2. The Obligee
This is the party that requires the surety bond. It is usually a government authority which believes that there is some inherent risk in the work of the principal so it requires a financial guarantee from a surety company. An example of an obligee is California Contractor State Licensing Board, which requires california contractors to obtain a contractor license surety bond.
3. The Principal
This is the party who offers a service that is required to have a surety bond. Once bonded, this party is supposed to perform his or her duty under the regulation of his or her industry. If he or she does something that violates the rules and regulations, the general public can file a claim against his or her surety bond. An example of a principal of a surety bond is contractors in California.
The example below illustrates how a surety bond works:
John is a motor vehicle dealer in Texas. In the state of Texas, to operate legally as a motor vehicle dealer, John (principal) is required by the Texas Department of Motor Vehicle (the obligee) to have an auto dealer surety bond. John would submit bond applications to different surety/insurance companies (the surety) and each surety/insurance company would evaluate his profile. Once accepted, John pays a premium payment to the surety company and the surety company issues John the surety bond in return.
The purpose of surety bonds is many fold, but primarily it is to protect public and private interest against financial loss. It does in two ways:
1. Preventatively through filtering out unqualified applicants from getting bonded so loss don’t happen in the first place
2. Reactively acting as a type of insurance if a loss occurs
Although surety bond is almost a specialty insurance, there are some differences between surety bonds and your regular insurance.
Three party contract: surety bond is a 3-party agreement through which the principal pays the surety a premium amount required by the obligee
Two party contract: insurance is a 2-party agreement where the insured pays a premium amount to the insurance company in case that a loss occurs
Most surety bonds are compulsory: surety bonds are often tied to license & permit or contract project and are often required
Many insurance policies are not required: unless there is loans/mortgage involved, most insurance policies are not required
Selective underwriting: surety companies are very selective in who they qualify as a principal
Underwrite most risks: insurance companies often accept customers of almost all risk profiles. They simply assign higher premium to risky customers
Claim usually not expected: because surety companies have selective underwriting process that aims to weed out unqualified / high risk applicants, they don’t expect many claims
Claim expected: because insurance companies underwrite most risks, claims are expected as the cost of doing business
Premium cover expenses: Because claims are not generally expected, the majority of the premium collected is used to pay for operational expenses
Premiums cover losses and expenses: Because claims are expected, premiums are collected to pay for expenses and expected losses
Losses usually recoverable: After a claim is paid by the surety, it expects to recoup at least part of its loss from the principal.
Losses not recoverable: the insurance company is obligated to pay qualified claims and does not expect to recoup claims from the principal.
Value proposition is “lending credibility”: Giving guarantee to the principal of a surety contract is the main value proposition of surety companies
Value proposition is sharing of risks: Paying for part of the losses is the main value proposition of insurance companies
As mentioned earlier, unlike insurance, a surety bond is not intended to protect the principal. It is to protect the general public. When the principal violates certain rules and regulations of their industry or contract, a 3rd party (i.e., a member of the public or the obligee) could file a claim against the surety bond. Therefore, typically it is the general public who file a claim against the surety bond.
As mentioned above, surety companies don’t expect losses to occur and when they do occur, they expect the losses to be recoverable. When a loss does occur, the surety company will pay for the claim first. Then, the surety company will try to recoup as much of the loss as possible from the principal.
There are alternatives to surety bonds, but they are either hard to obtain or very expensive.
Cash Bond: Rather than obtaining a financial guarantee from a surety/insurance company, you can post cash as a financial guarantee. You basically give cash to the obligee who needs some form of financial guarantee. If you fail to perform the duty, the obligee can take cash away from you. The disadvantage of a cash bond is that you would need to have the full amount of money on hand and you are taking the entirety of the risk yourself. For example, let’s say construction company ABC is required for a financial guarantee of $10,000 to bid for a project. This company has two choices, either give a certified check of $10,000 or purchase a surety bond for $100. If the company has won the bid, in the case of the cash bond, the project owner will not need to return the $10,000 certified check to the construction company ABC until the project has been completed and up to the standard defined in the contract. In the case of a surety bond, the construction company only needed to incur an expense of $100 over the course of the project.
Letter of Credit: Another alternative to a surety bond is a letter of credit from a bank, especially for contract bonds. A letter of credit essentially promises to pay a third party on behalf of a second party. They typically are issued by banks. With a letter of credit, the bank agrees to pay a stated amount upon presentation of the required documentation and compliance with the terms in the letter of credit. In theory, the person obtaining the letter of credit has provided the bank with enough financial resources that the bank believes it can pay a letter of credit and then re-collect the funds.
License and permit bonds are a type of surety bond that are required before a professional can obtain their license in their respective industry. Many industries (i.emotor vehicle dealership, contractors, medical equipment providers, insurance agencies) are regulated by government agencies. In such industries, a license tends to be required before conducting business. License & Permit bonds “put teeth” into licensing rules and regulations for public protection. For example, a motor vehicle dealer in Texas must conform to the laws and regulations defined for them by the Department of Motor Vehicle. If they violate some rules, then a claim can be made against them for financial compensation.
There are three categories of license and permit bonds
Fidelity bond generally protects against any dishonest act of an employee. The employee may steal money, merchandise or any other property. Fidelity bonds, with the exception of ERISA bonds, are not always required to be purchased by government agencies. Sometimes, people purchase fidelity bonds to show credibility to their customers. For example, a common type of fidelity bond is the janitorial service bond. It is generally purchased by cleaning businesses to provide a financial guarantee for potentially theft of customers’ properties by their employees. If a theft happens, the customers of the cleaning business can make a claim against the janitorial service bond. Having this bond adds to the credibility of the janitorial company.
Public official bond provides a financial guarantee that the official will perform his or her duty according to law. Some common examples of public official bonds are for court clerks, commissioners, notary publics, deputies, sheriffs, tax collection personnel, city managers, treasurers, judges, mayors, or other types of city officials.
Judicial / court bonds are written for parties to lawsuits or other court actions, so there are two types of judicial / court bonds: plaintiff’s court bond and defendant’s bond.
Plaintiff’s court bond: required to provide a financial guarantee that the plaintiff will return the properties of the defendants that the plaintiff temporarily possess will be returned to the defendants. Types of plaintiff bonds include Indemnity to Sheriff Bonds and Cost Bonds.
Defendant bond is to provide a financial guarantee against some potential negative impact as a result of the action of the defendant. Bail bonds are the most common type of defendant’s bonds.
Contract bonds are generally required by commercial construction projects, i.e., building a mall , apartment building, or public roads. There are the following types of contractor bonds.
This provides a financial guarantee to the project owner (obligee) that the contractor submitting the bid will enter into a contract to perform the work at the price and terms defined in the bid, if they are awarded the project. If a contractor does not enter into a contract after being selected by the project owner, the project owner can make a claim on the bid bond for compensation. The compensation amount is typically the difference between the bid amount of the disloyal contractor and the next lowest bid.
Performance and Payment Bond:
Performance and Payment Bond, despite being two separate bonds, are often categorized together.
The Performance Bond guarantees a contractor will complete a construction project based on the terms and conditions of a contract, i.e., time frame and required quality. IIf the contractor fails to do so, the surety company would need to provide a financial compensation to the project owner.
Payment Bonds provides a financial guarantee that subcontractors and suppliers are paid for their work and materials on the construction project, in a timely and proper manner. If the general contractor does not pay a subcontractor or supplier for work performed or material provided for the project, a claim can be made on the payment bond.
With over 90 years of experience, Merchant Bonding Company is one of the few insurance companies specializing in surety bonds. Even though Merchant is not the largest issuer of contractor bonds, it has an outstanding digital platform for e-bonding. All California Contractor Bonds can be e-filed online using an easy-to-use digital platform. Once your bond is filed to the Contractor State Licensing Board of California, Merchant’s digital platform will inform you through email, giving you peace of mind. However, Merchant Bonding Company’s focus is on the contractor license & permit bonds but does not offer much contract bonds such as bid bonds, performance bonds, payment bonds, maintenance bonds, and supply bonds.
Most surety / insurance companies don’t sell surety bonds directly. Instead, they sell bonds through independent insurance / surety agencies. Only licensed insurance / surety agents can sell surety bonds.
Typically, given surety bonds are mostly to serve state, county or municipal jurisdictions, the agents who can sell surety bonds not only need to be licensed in that particular state but also need to be appointed with a particular insurance carrier in that same state.
Licensing and carrier appointment keeps unscrupulous and incompetent people from selling surety bonds.
Agents are typically granted a Power of Attorney, which gives them the authority to execute bonds. Each agent is limited in the amount and type of bonds that can be expected.
There are two different types of agencies that sell surety bonds:
1. Agencies that focus on selling insurance but sell surety bonds on the side
2. Agencies that focus on selling surety bonds only
Agencies that sell surety bonds only tend to be more knowledgeable and have better prices due to their negotiating power.
Most people or businesses have never heard about surety bonds until they are told that they need one. Once you are told you need a bond, you should contact an agency that specializes in surety bonds, such as suretynow.com.
As a part of the bonding process, you would fill out an online application that provides basic information such as your legal name, your address, business name and address. Some bonds are credit-based so you may need to provide your SSN.
Surety Bonds has a long history. In fact, the first form of a surety bond occurred in 2750 B.C. among a few farmers in Mesopotamia. One farmer went off to serve in the army and needed someone to take care of his field while he was away. Therefore, he created an agreement with a merchant to guarantee that his farmer friend would take care of his fields.
In 1790 BC., the Code of Hammurabi was the first legal surety document in the world.
Moving back to the United States, In 1837, William L. Haskins founded the first American surety company, New York Guarantee Company. By the early 20th century, many states had passed laws requiring contractors to provide for surety bonds for public projects.
Today, surety bonds are required in licensing and permitting, court and legal proceedings, construction projects, and government contracts.
Surety Agency: a company that provides surety bonds to individuals, businesses, and other organizations on behalf of the surety carriers. Most of the time, surety carriers won’t sell surety bonds directly to end users
Surety Carrier: a company that underwrites surety bonds. Surety carriers are typically insurance companies that specialize in providing surety bonds to businesses and individuals.