Frequently Asked Questions: Surety Bonds
What is suretyship?
What is a surety bond?
What is a contract surety bond?
Is a surety bond the same as insurance?
What characteristics of suretyship are like more common forms of insurance?
How is suretyship different from more common lines of insurance?
How does a surety underwrite?
What is personal indemnity
How does collateral security relate to a surety bond?
What is a financial guarantee bond?
What happens if a claim is filed against a surety bond?
What is suretyship?
Suretyship is a very specialized line of insurance that is created whenever one party guarantees performance or an obligation of another party. There are three different parties to the agreement.
- The principal is the party that undertakes the obligation.
- The surety guarantees the obligation will be performed.
- The obligee is the party who receives the benefit of the bond.
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What is a surety bond?
A surety bond is a written agreement that usually provides for monetary compensation in case the principal fails to perform the acts as promised. There are many different types of surety bonds, but the general categories are contract and commercial.
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What is a contract surety bond?
A contract surety bond is an extension of credit under which one party (surety) guarantees to another party (obligee) that a third party (principal) will perform a contract. Such assurance may be required by federal, state, or local government agencies before the granting of certain licenses, permits, or contracts. In some cases, a court appointed fiduciary or public official may be required to obtain a surety bond before being entrusted with fiduciary duties, such as the administration of public funds. A surety bond provides protection to the obligee but not the principal.
Examples of contract surety bonds include Bid Bonds, Performance Bonds, Payment Bonds, Maintenance Bonds, and Supply Bonds.
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Is a surety bond the same as insurance?
No, a surety bond is not an insurance policy.
A surety bond is an extension of credit involving a three-party agreement between a surety, obligee, and principal. Since there is no assumption that the contract will go unfulfilled, the bond premium only covers the underwriting expenses of the surety. The obligee is responsible for reimbursing the surety of any loss and expense resulting from a claim and the surety has the same recourse against the principal as any other creditor.
Insurance is a two-party contract between an insurance company and the insured. The insurance premium is calculated to cover losses since an insurance policy assumes a loss will occur. Usually the insured is not obligated to reimburse the insurance company for any claims that result in loss.
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What characteristics of suretyship are like more common forms of insurance?
They are both risk factor mechanisms that provide for financial loss and are regulated by state insurance commissioners.
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How is suretyship different from more common lines of insurance?
In traditional insurance, the risk is transferred to the insurance company. In suretyship, the risk remains with the principal. The protection of the bond is for the obligee.
In traditional insurance, the insurance company takes into consideration that a certain amount of the premium for the policy will be paid out in losses. In true suretyship, the premiums paid are "service fees" charged for the use of the surety company's financial backing as a guarantee.
In underwriting traditional insurance products the goal is "spread of risk." In suretyship, surety professionals view their underwriting as a form of credit so the emphasis is on prequalification and selection.
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How does a surety underwrite?
Each surety company has its own guidelines and underwriting criteria. However, the following basic factors will be taken into consideration in some format:
Capacity. Does the applicant have the skill and ability to perform the obligation?
Capital. Does the financial condition of the applicant justify approval of the particular risk?
Character. Does the applicant's record show him to be of good character and likely to perform the obligation he or she assumes?
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What is personal indemnity?
It is common for a surety to request the indemnity of the owners of a closely held corporation. Typically, the spouse's indemnity also is required because personal assets are jointly owned. The two main reasons for this requirement are that the surety requires all personal assets to be available to back the guarantee and that there is less chance a principal will avoid its responsibilities if its personal assets are at stake.
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How does collateral security relate to a surety bond?
If an underwriter is unable to approve a bond request based on the qualifications given by the principal, the company may suggest depositing some form of collateral as an inducement to write the bond. In practice, many bonds are written on this basis, particularly ones that are considered financial guarantees.
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What is a financial guarantee bond?
A financial guarantee bond obligates the surety to pay a certain amount of money if the principal does not perform its obligation. Examples include tax bonds, Medicare bonds, and Medicaid bonds. These bonds are extremely hazardous and very carefully underwritten.
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What happens if a claim is filed against a surety bond?
Under the bond, the obligee can usually make a claim against the surety if the principal fails to fulfill its obligation. Since a principal is legally obligated to reimburse the surety of any loss and expense resulting from a claim, the principal's obligation to the surety can be greater than the original obligation to the obligee.
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