Surety Bond

Updated on March 27, 2024
Article byWallstreetmojo Team
Edited byWallstreetmojo Team
Reviewed byDheeraj Vaidya, CFA, FRM

What is a Surety Bond?

A surety bond is a contract that protects a creditor from non-performance or non-payment. It is an agreement between three parties—a third party assures the obligee that the principal will fulfill documented obligations.

This third party is known as a surety; the principal is the business entity that purchases the bondBondBonds refer to the debt instruments issued by governments or corporations to acquire investors’ funds for a certain period.read more, and the obligee is the beneficiary. If the principal debtorDebtorA debtor is a borrower who is liable to pay a certain sum to a credit supplier such as a bank, credit card company or goods supplier. The borrower could be an individual like a home loan seeker or a corporate body borrowing funds for business expansion. read more dishonors the obligation, the third party pays compensation to the obligee. Surety bonds are mandatory for entering into contracts with government agencies, regulation departments, state courts, federal courts, and general contractors.

Key Takeaways

  • A surety bond is a legal agreement that assures the obligee that the principal will complete the work. In case of failure, the surety will pay compensation to the oblige.
  • Usually, the surety is an insurance company that issues bonds. Bonds are issued, once contractors meet the required conditions.
  • The four different types of surety bonds include court, commercial, fidelity, and contract bonds.

Surety Bonds Explained

Surety Bonds

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A surety bond is a promise to complete a specific task—as per the contractor’s terms. In order to ensure the completion of work, a bond is used as insurance. This provision safeguards an obligee in case the principal fails to comply with the agreed terms. An obligee is usually the government; the principal is a contractor or business owner. A surety acts as a middleman between the two parties—principal and obligee.

The principal requires a formal assurance from a surety; only then will the obligee proceed with the business activityBusiness ActivityBusiness activities refer to the activities performed by businesses to make a profit and ensure business continuity. read more. To acquire a surety bond (insurance) the principal must meet the following requirements:

The bond rider is the only legitimate method of updating surety documentation. The following changes can be made:

  • Increase in the bond amount.
  • Change in bond date.
  • Change in bond terms.
  • Error rectification in the original bond.

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Parties to a Surety Bonds

A surety bond involved three parties:

  1. Obligee: It refers to the person or company protected by such a bond. This party is the beneficiary of the assurance.
  2. Principal: The principal is the person or company who has to fulfill the obligation (to accomplish a task or refrain from doing it). The principal purchases a surety bond to assure the obligee.
  3. Surety: It is an insurance company that backs a business contract. They issue bonds—a form of indemnificationIndemnificationIndemnity insurance refers to the insurance coverage that safeguards an insured against the monetary losses arising from professional negligence. Like any other insurance, this also provides coverage in exchange for regular premium payments from the insured.read more. Thus, the surety assures the obligee that the principal will successfully complete the documented obligations. If the principal fails, the surety compensates the obligee for the incurred losses.

Types of Surety Bonds

Four prominent subtypes are as follows:

Types of Surety Bonds

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  1. Court Surety Bond: They are required before a civil court proceeding. The parties are financially liable if they fail to behave in accordance with the court’s orders.
  2. Commercial Surety Bond: These assurances are compulsory. Government bodies enforce these checks to ensure public welfare. It is a security measure against misrepresentation, fraud, and dishonesty.

    For example, when new firms enter a particular industry that is sensitive to public health, they require a license to function—liquor shops.
  3. Contract Surety Bond: The surety assures that the contractor will fulfill construction according to agreed terms and conditions. The third party also makes sure that the obligee pays in time. Therefore, two surety bonds are issued.
  4. Fidelity Surety Bond: This assurance safeguards company owners against employees’ defaults—theft, illegal actions, or mismanagement. They are a fundamental component of risk controlRisk ControlRisk control basically means assessing and managing the affairs of the business in a manner which detects and prevents the business from unnecessary calamities such as hazards, unnecessary losses, etc. that may occurread more.

Example

Now let us look at an example to understand the practical application.

Let us assume that a local USA authority (obligee) wants to construct an office building and hires XYZ contractor (principal) for the job. In accordance with local USA Authority regulations, it is mandatory for XYZ contractor to secure a construction performance bondPerformance BondPerformance bonds are financial instruments used by the investor to have guaranteed the contractor's successful execution of a contract. Financial institutions, such as insurance companies and banks, are the issuers of these types of bonds.read more.

This assurance guarantees the fulfillment of contract terms. Therefore, XYZ contractor buys a construction performance bond from a reliable third party. The third party or surety is usually an insurance company.

The guarantee protects the local USA authority. Even if XYZ contractor fails to satisfy the contractual terms, the obligee is compensated. In such a scenario, the surety company must pay the local USA authority, mitigating the incurred losses.

Frequently Asked Questions (FAQs)

How to get a surety bond?

A contractor should first find a third party (insurance company) and determine the required conditions. Then, the contractor furnishes relevant financial records (with the help of a CPA) to qualify for the guarantee. Similarly, the principal must perform a cost-benefit analysis for each construction project. This way, the principal can decide upon the appropriate bond amount.

What is the purpose of a surety bond?

The guarantee is a security provision. The obligee enters a contract with a principal. A third party provides security for both parties. The third-party assures the obligee that the principal will complete the project in accordance with the terms. The surety also ensures timely payment once the principal completes the task.

What does a surety bond cover?

It covers losses. If the principal (contractor) defaults on the contract terms, the third party will compensate the obligee for incurred losses. Usually, insurance companies act as the buffer.

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