A surety bond is a contract between three parties—the principal (you, the contractor), the surety (typically an insurance company) and the obligee (the entity requiring the bond)—in which the surety financially guarantees to an obligee that the principal will act in accordance with the terms established by the bond. In this way, the obligee can make a claim to recover losses if the principal fails to fulfill the task. If the claim is valid, the insurance company will pay reparations that do not exceed the bond amount. The principal will then be expected to reimburse the insurance company for any claims paid. It is essentially a promise by one party to be liable for the debt, default, or failure of another party.
Types of Surety Bonds
There are thousands of different types of surety bonds, but no industry involves a greater variety of surety bonds than the construction industry.
You need to obtain a Contractor License Bond in order to legally operate in the state where you conduct business. Each state (and some cities or towns) has its own bond requirements. The bond assures the state and the general public that you will comply with state licensing regulations and statutes.
Surety bonds are also required to bid or work on virtually all public works projects and many private construction projects. There are three major types of bonds for this field: bid bonds, payment bonds, and performance bonds. These bonds provide protection for the project owner and for taxpayers or investors in private projects. Usually, a project requires all these together.
Bid Bonds
Bid bonds protect a project owner if someone submits a bid and gets rewarded the contract, but pulls out of the project before it starts, insists on receiving more money to complete the work agreed upon, or is unable to obtain the agreed-upon construction bonding. Without bid bonds, project owners would have no way of guaranteeing that the bidder they select for a project would be able to complete the job properly. For example, an underfunded bidder might run into cash flow problems along the way. Bid bonds also help clients avoid frivolous bids, which saves time when analyzing and choosing contractors.
Payment Bonds
A payment surety bond is a legal contract that guarantees certain employees, subcontractors, and suppliers are protected in case they do not receive payment. You can think of a construction payment bond as an “insurance policy” in case the contractor cannot or will not pay the other parties on a construction project.
Performance Bonds
A performance bond is issued to one party of a contract as a guarantee against the failure of the other party to meet obligations specified in the contract. It is also referred to as a contract bond. A performance bond is usually provided by a bank or an insurance company to make sure a contractor completes designated projects. A payment bond is often obtained along with a performance bond.
All three of these bonds work in conjunction with each other. It is common that contractors will request all three of these surety bonds for their projects.
The Role of the Surety Bond Agency
There are thousands of bonding agents across the U.S. that offer surety bonds. However, many of them primarily offer insurance, and write surety bonds on the side. Surety agents work with applicants and surety companies to determine which surety best fits your specific bond needs. Since surety companies usually do not work directly with applicants, bond agencies are appointed to represent them. The surety’s obligations are to guarantee the financial obligations listed in the surety bond, to investigate any claims made against a surety bond and determine if the terms of the bond have been violated, and to financially reimburse a claimant for a valid claim against a surety bond—up to the bond coverage amount—if the principal cannot or will not pay.
Misconceptions About Surety Bonds
There are many common misconceptions about surety bonds and how they work between consumers and professionals, although the functionality of surety bonds and the role of surety agencies are very straightforward. One big misconception about surety bonds is that they are basically insurance. Surety bonds are not insurance, as insurance is traditionally understood and defined. Traditional insurance is a means of protection from financial loss. It is a form of risk management, primarily used to hedge against the risk of a contingent or uncertain loss. Insurance protects the purchaser from liability, whereas a bond puts the purchaser at liability — meaning you only want to hold a bond when absolutely required. They are almost never optional.
Surety bonds are crucial for helping to manage and protect your business. It is important to use reliable surety bond companies. Remember that all contractors are required to obtain surety bonds. Most state, municipal or government projects require surety bonds.