What is a Surety Bond?

Are you wondering what a surety bond is used for? At Schmalz & Associates, we understand that surety bonds can be a confusing topic. When most people hear “bond” they think ‘stocks and bonds’. In the case, a bond is essentially a loan to be paid back with interest; however, this is not a surety bond! A surety bond can be viewed similarly to insurance in that it is a risk transfer product which protects one party against the failure of another.

What is a surety bond? A surety bond is a financial contract in which a surety company guarantees a principal will fulfill its duties to the obligee. Simply put, a surety bond is a guarantee. This contract involves three parties:

Principal – you or your business, the party needing to perform.
Obligee – entity requiring the bond, the main party benefiting from the protection of the bond.
Surety – company backing the guarantee. Whether an insurance company, bank, or individual, a common element of a surety is a pool of money from which to pay losses.

Guarantees & Obligations

Have you ever heard the phrase “my word is my bond?” A surety bond guarantees a wide range of obligations. These are obligations that the Principal must abide by or perform. Many bonds are required by statute. Other bonds are required by construction contracts.

Bonds required by statute are commonly referred to as Commercial bonds.
Bonds required by construction contracts are referred to as Contract bonds or Performance & Payment bonds.

What is a Surety Bond Used For?

What is a Surety Bond used for? The protections offered by surety bonds are used in a wide range of obligations. A surety bond may guarantee that a contractor will complete a construction project adhering to the underlying contract while paying all subcontractors and suppliers. Other surety bonds guarantee you will abide by certain rules and regulations specific to your industry or profession.

Examples of Surety Bond Usage

Public Official Bond

Public Official bond – in most cases a surety bond is required for a public official to hold office. We expect our public officials to uphold their duties faithfully and with trustworthiness as they frequently deal in sensitive information and tax payer funds. If the public was harmed by an official, a claim could be made on the bond for those damages and then the surety would hold them personally responsible. The bond guarantees the official will act honestly and with our best interest in mind.

Bingo Tax Bond

Bingo Tax bond – if you want a license to operate a bingo business in your state, Texas for example, you would need to post a bond to the State Lottery Commission. This bond ensures that the games are fairly conducted and all net proceeds are used for a charitable purpose.

Polygraph Examiner Bond

Polygraph Examiner bond – some states require a Polygraph examiner to post a bond as a requirement of getting their license to operate. The bond protects the public against any fraudulent activity or misuse of information while conducting a activities like a lie detector test. The consequences of dishonesty or lack of following proper procedure while conducting a polygraph test could have severe consequences on those being tested. This bond protects them.

Certificate of Title for Motor Vehicles Bond

Certificate of Title for Motor Vehicles bond – what if you bought a vehicle with no title or the title to your vehicle is lost or stolen? Most State Department of Motor vehicles are willing to issue a certificate of title that is backed by a surety bond.

Three-Party Agreement

A surety bond is a three-party agreement between a Principal, Obligee and a Surety:

The Principal

The Principal on the bond would be you or your business; the person/entity who needs to post the bond and perform certain duties and responsibilities laid out in the bond form.

The Obligee

The Obligee is the entity requiring the bond. The Obligee generally requires the bond to protect the general public and taxpayer dollars. Examples of an Obligee include: a state, court or other governing entity.

The Surety

The Surety is the company that provides the bond. It backs the guarantee with its financial strength. The Surety company is often an insurance company or another entity regulated by the insurance department. The Surety will underwrite the Principal to determine if they qualify for the Surety Bond.

Surety Bond Agent

Most Surety bond companies use a professional Surety Bond Agent to distribute surety bonds, basically their sales and marketing. The Surety Bond Agent is the intermediary between the Principal and the Surety, and has specific expertise in the surety industry. Since every client’s situation is unique, a professional agent will guide you, the Principal, to an appropriate surety company.

Fiduciary Relationships

A fiduciary relationship is a special relationship of trust and confidence. In these relationships there is a high degree of care and responsibility owed by the trusted party. Often times we see fiduciaries in our court systems, such as the executor of an estate in probate or guardian of a minor. If the fiduciary failed to uphold their responsibilities the injured party could make a claim on the bond.

Business Bonds

Surety bonds are typically used in business transactions. It’s not often you’d see a surety bond in your personal life. Bonds are frequently used to guarantee construction contracts. They are also used to guarantee obligations required when securing a license to do business in a particular state, a license or permit bond.

Municipal Benefits

Bonds can also 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 or sewer system) will be turned over to the Public entity to own upon completion, so they want to ensure it’ll get done. These are often referred to as Subdivision or Completion bonds.

If banks are making a loan for the construction of a private facility, they will often require a Contract surety bond from the builder. Contract surety bonds ensure completion of the projects pursuant to the contract and make sure all subcontractors and suppliers are paid.

Complex Transactions

While surety bonds have traditionally been used in the United States, they are being incorporated into complex business transactions in foreign countries with greater frequency. Bank letters of credit are the typical financial product used as a guarantee in countries outside the U.S. Large risks, such as a hydro-electric dam or nuclear power plant, can stress a banks capacity creating the need for alternative solutions like a surety bond. Surety bonds can offer more diverse defenses and options for resolution, so it is imperative that the surety community understands the local laws.

Common Types of Surety Bonds

There are generally two broad categories of surety bonds:
Contract Bonds;
Commercial bonds.

Contract Bonds

Contract bonds are commonly needed by contractors. We will expand on all of these later but the most common types of contract bonds are: bid, payment and performance, maintenance, subdivision and supply bonds.

Commercial bonds

There are so many different types of commercial bonds, we can’t list them all here. Commercial bonds are often license and permit bonds, court bonds and other miscellaneous bonds. They are often required by a regulating entity to guarantee that the Principal will abide by those regulations.

For example, a contractor may need to obtain a Contractor’s License Bond to guarantee that he/she will follow the building regulations in your State. If the contractor fails to follow the building regulations when building your home you may be able to file a claim on the bond. The Surety will investigate the claim and you may be entitled to recourse. The Surety will then turn to the Principal (the contractor) to be indemnified. We discuss more about Indemnity here.

Surety Bonds at Schmalz & Associates

At Schmalz & Associates, we offer resources on a variety of surety bonds:

Discover More Surety Bond Resources

Now that we’ve answered your question, “what is a surety bond used for?”, we encourage you to learn more about surety bonds. Visit these articles for more information:

What is a Surety Bond? What is a Surety Bond Used For?