Surety Bonds have been around in one form or another for millennia. Some may view bonds as an unnecessary business expense that materially cuts into profits. Other firms view bonds as a passport of sorts that allows only qualified firms access to bid on projects they can complete. Construction firms seeking significant public or private projects understand the fundamental necessity of bonds. This article, provides insights to the some of the basics of suretyship, a deeper look into how surety companies evaluate bonding candidates, bond costs, warning signs, defaults, federal regulations, and state statutes affecting bond requirements for small projects, and the critical relationship dynamics between a principal and the surety underwriter.
What is Suretyship?
The short answer is Suretyship is a form of credit wrapped in a financial guarantee. It is not insurance in the traditional sense, hence the name Surety Bond. The purpose of the Surety Bond is to ensure that the Principal will perform its obligations to theObligee, and in the event the Principal fails to perform its obligations the Surety steps into the shoes of the Principal and provides the financial indemnification to allow the performance of the obligation to be completed.
There are three parties to a Surety Bond,
Principal – The party that undertakes the obligation under the bond (Eg. General Contractor)
Obligee – The party receiving the benefit of the Surety Bond (Eg. The Project Owner)
Surety – The party that issues the Surety Bond guaranteeing the obligation covered under the bond will be performed. (Eg. The underwriting insurance company)
How Do Surety Bonds Differ from Insurance?
Perhaps the most distinguishing characteristic between traditional insurance and suretyship is the Principal’s guarantee to the Surety. Under a traditional insurance policy, the policyholder pays a premium and receives the benefit of indemnification for any claims covered by the insurance policy, subject to its terms and policy limits. Except for circumstances that may involve advancement of policy funds for claims that were later deemed to not be covered, there is no recourse from the insurer to recoup its paid loss from the policyholder. That exemplifies a true risk transfer mechanism.
Loss estimation is another major distinction. Under traditional forms of insurance, complex mathematical calculations are performed by actuaries to determine projected losses on a given type of insurance being underwritten by an insurer. Insurance companies calculate the probability of risk and loss payments across each class of business. They utilize their loss estimates to determine appropriate premium rates to charge for each class of business they underwrite in order to ensure there will be sufficient premium to cover the losses, pay for the insurer’s expenses and also yield a reasonable profit.
As strange as this will sound to non-insurance professionals, Surety companies underwrite risk expecting zero losses. The obvious question then is: Why am I paying a premium to the Surety? The answer is: The premiums are in actuality fees charged for the ability to obtain the Surety’s financial guarantee, as required by the Surety bonding Obligee, to ensure the project will be completed if the Principal fails to meet its obligations. The Surety assumes the risk of recouping any payments it makes to theObligee from the Principal’s obligation to indemnify the Surety.
Under a Surety Bond, the Principal, such as a General Contractor, provides an indemnification agreement to the Surety (insurer) that guarantees repayment to the Surety in the event the Surety must pay under the Surety Bond. Because the Principal is always primarily liable under a Surety Bond, this arrangement does not provide true financial risk transfer protection for the Principal even though they are the party paying the bond premium to the Surety. Because the Principalindemnifies the Surety, the payments made by the Surety are in actually only an extension of credit that is required to be repaid by the Principal. Therefore, the Principal has a vested economic interest in how a claim is resolved.
Another distinction is the actual form of the Surety Bond. Traditional insurance contracts are created by the insurance company, and with some exceptions for modifying policy endorsements, insurance policies are generally non-negotiable. Insurance policies are considered “contracts of adhesion” and because their terms are essentially non-negotiable, any reasonable ambiguity is typically construed against the insurer. Surety Bonds, on the other hand, contain terms required by the Obligee, and can be subject to some negotiation between the three parties.
Personal Indemnification & Collateral
As discussed earlier, a fundamental component of surety is the indemnification running from the Principal for the benefit of the Surety. This requirement is also known as personal guarantee. It is required from privately held company principals and their spouses because of the typical joint ownership of their personal assets. The Principal’s personal assets are often required by the Surety to be pledged as collateral in the event a Surety is unable to obtain voluntary repayment of loss caused by the Principal’s failure to meet their contractual obligations. This personal guarantee and collateralization, albeit potentially stressful, creates a compelling incentive for the Principal to complete their obligations under the bond.