At Schmalz & Associates, we want to assist you in understanding surety bond basics. In this article, we’ll cover how to obtain a surety bond and discuss the different types of surety bonds.
The first step in obtaining a surety bond is contacting a professional surety bond agent. Typically, surety companies work with a select group of surety-specific agents to represent them. Schmalz & Associates is a surety-only agency and we represent many of the top surety companies. This diversity allows us to find the best match for our clients. You begin the underwriting process by completing an application. Then, we select the appropriate surety company for your needs.
To better understand the underwriting process click here.
Surety Bond Basics
An important aspect of understanding surety bond basics is that Insurance and Surety bonds are very different products. Insurance is a two-party contract between an insured and an insurance company. Insurance premiums are calculated based on loss experience for that particular risk, or actuarial data. This approach assumes losses will happen. If an insured has a claim and the insurance company pays out then the insurance company is fulfilling their obligation.
Surety bonds are a three-party contract between the Principal, obligee, and surety company. The premium you pay for a bond is considered an “underwriting fee” for the service. This is because surety companies underwrite assuming there will no losses. If a surety company provides a bond for a Principal they are providing a guarantee to the Obligee that the surety has done there due diligence and the Principal is qualified for that particular obligation. Should there be a claim on the bond that leads to a loss by the surety company, the surety company will look to the Principal to indemnify them or make them whole. This is a major difference between surety bonds and insurance.
Understanding Surety Bonds
When it comes to understanding surety bonds, there are a few things to keep in mind. A surety company’s duty to the Obligee is that the surety will underwrite the Principal and has deemed them worthy of surety credit. And that the Principal is qualified to perform the obligation under the terms of the bond.
Surety bonds are not insurance
Surety bonds provide a third party guarantee that a Principal will perform an obligation. A surety company will look to be made whole should there be a loss. Insurance assumes there will be losses and charges a premium accordingly. Insurance losses are paid regularly.
Because surety companies are assuming zero losses in their underwriting, they require what is called indemnification through an indemnity agreement. If the surety were to suffer a loss, they will look to the principal to make them whole. In other words they will look to be paid back for their loss. And they use the indemnity agreement as a legal basis for doing so.
The “3 C’s” are the foundation of all surety bond underwriting. The three C’s are:
- Character – people of high moral and ethical standards.
- Capital – having solid financial resources.
- Capacity – your ability to perform the obligations.
Some of the ways that a surety company underwriter may use the 3 C’s in the underwriting process are:
- Obtaining references (Character & Capacity)
- Reviewing your business and/or personal credit report (Character)
- Reviewing your business and/or personal financial statements (Capital)
- Verifying business and/or personal cash and lines of credit (Capital)
How to Obtain a Surety Bond
These steps will walk you through how to obtain a surety bond:
- Contact a professional Surety Bond Agency (like Schmalz & Associates!!)
- Complete an Application (link to Application)
- Provide any necessary underwriting information. Such as personal or business financial statements, copies of contracts, etc.
- Pay the bond premium
- Receive your bond
Types of Surety Bonds
There are many different types of surety bonds. We will categorize these types of bonds into three main different classes:
- Contract Bonds
- License & Permit Bonds
- Court Bonds
Contract bonds – This type of surety bond is most often found in the construction arena. Contract bonds are regularly required at the federal, state or municipal level in accordance with the Miller Act. The Miller Act requires performance and payment bonds on government projects exceeding a certain size.
Payment and Performance Bonds
For example, most Federal construction projects with contracts exceeding $100,000 must provide performance and payment bonds. Performance bonds guarantee that a Principal will perform to the terms and specifications of the underlying construction contract. Payment bonds guarantee that the Principal will pay all of their subcontractor and suppliers related to that project. You cannot put a mechanic’s lien on government property so a payment bond helps protect subcontractors and suppliers.
Bid bonds are a type of contract bond as well. This type of bond is needed when a contractor is interested in bidding on a public works project. The bid bond amount is typically a percentage of the bid estimate (usually five to twenty percent). The bid bond guarantees that if the Principal is the low bidder on the project that they will enter into the contract and provide performance and payment bonds. If they are not able to enter into the contract or provide payment and performance bonds they will have to pay the bid bond penalty. This is a really important point that we would like to emphasize. If the Principal cannot post the performance and payment bonds they will have to pay the bid bond penalty to the Obligee. For example, let’s say that a Principal bids $1,000,000 on a public works project with a bid bond penalty of 10% and they are the low bidder. If they are unable to post the performance and payment bonds they will have to pay $100,000 to the Obligee as a penalty.
Maintenance bonds guarantee against defective workmanship or faulty materials related to a construction project. Maintenance bonds (also known as warranty bonds) are usually written for one year. The one-year period usually begins when the owner has accepted the construction project. Some maintenance bonds may require a longer maintenance period but any period exceeding three years can be very challenging to obtain.
Subdivision Bonds can be used for the benefit of a City or County when a real estate developer is required to complete improvements associated with a project. These improvements (like a new road, sidewalks or sewer system) will be turned over to the public entity to own upon completion, so they want to ensure it’ll get done.
Supply bonds are a contract type of bond. Supply bonds will guarantee the supply of certain goods referenced in a contract. Supply bonds are a helpful tool when the goods are specialized and must arrive by a certain date.
License and Permit Bonds
License & Permit Bonds – These types of bonds are generally required by statute. Many different government organizations require that a Principal meet certain rules and regulations in order to obtain a license. A license or permit bond provides a guarantee that the Principal meets those requirements and will follow the regulations of their industry.
Court Bonds – As the name suggests, these types of bonds are required by a court. They often guarantee a fiduciary responsibility. The fiduciary is required to comply with the court order. Examples of court bonds include Administrators bonds, executors bonds, Trustees of a Will bond, guardian bonds, etc.
Surety Bonds at Schmalz & Associates
Schmalz & Associates offers a variety of resources relating to surety bond services, including:
- Bid Bond
- License Bond
- Maintenance Bond
- Payment and Performance Bond
- Permit Bond
- Subdivision Bond
- Supply Bond
Uncover More Surety Bond Resources
We hope we’ve helped you in understanding surety bond basics and how to obtain a surety bond for your business. If you’re interested in learning more about the different types of surety bonds, be sure to check out these articles for more info:
- Surety & Fidelity Association of American (SFAA) – How to Get a Surety Bond
- Surety Information Office (SIO) – Surety Bond Basics
- U.S. General Services Administration (GSA) – The Miller Act and the introduction of surety bonds
- Construction Financial Management Association (CFMA) – How is surety bonding capacity determined?