Surety bonding is an inexpensive way a contractor can guarantee that a job will be performed up to specifications within the time frame allotted. The main benefit to contractors is their low cost, freeing their assets from being tied up guaranteeing job performance, which would severely limit their ability to do multiple jobs. From the customers’ perspective, surety bonding means timely payment to get a job back on track if contractors fail to live up to their contractual obligations. Another benefit, often overlooked, is that a surety bond can be written to guarantee the customer’s payment to the contractor.
Common to the construction industry, surety bonds are used in many other industries as well. They can be used for performance of work, like shingling a roof or installing plumbing in a structure, or timely and complete delivery of supplies, equipment or other goods. In some cases, they’re required by the customer of a contract, and in other cases they’re required by a government as a prerequisite to issuing a business license. Companies whose business licenses require that they be bonded often advertise that fact as an illustration of their reliability and integrity.
There are three parties to a surety bond: the obligee, or customer; the principal, or contractor; and the surety, which is the company that places the bond. When a principal applies for a surety bond, the surety investigates the application much the same way a loan application is reviewed, examining the principal’s history of past performance, credit history and financial stability. The principal pays the premium, which is set based on the surety’s investigation, and is usually a small percentage — from 1% to 5% — of the total bond amount, although higher-risk bonds may cost as much as 20% of the bond total.
The relatively low cost of surety bonding is one of its main benefits. Without the bond, the obligee would be justified in requiring that the principal pledge his own funds and secure them in a letter of credit (LC) to guarantee performance. This would impose an onerous burden on all but the largest principals, and in most cases, would needlessly tie up vast amounts of money for long periods of time, because the obligee can file a claim for poor performance long after a job is complete. The alternative approach to recovering money in the case of inadequate performance is for the obligee to pursue legal action, a costly and time-consuming process that’s often an exercise in futility, especially if the principal is bankrupt.
If an obligee files a claim against a surety bond because of alleged inadequate performance by the principal, the surety will investigate the claim and, if justified, pay the obligee. Once this happens, the surety seeks repayment of the claim and any associated costs from the principal. Thus, the surety bond isn’t an insurance policy; it's a credit arrangement. When buying a surety bond, the principal essentially arranges for a short-term loan from the surety in the event of inadequate performance. This is one of the reasons for the thorough examination of the surety bond application; the surety wants to be certain that the principal can satisfy any claims the surety may have to pay.
Surety bonding, then, is a valuable tool in guaranteeing contract performance, but there are many other types of surety bonds as well. Called commercial surety bonds, they generally fall into one of three categories: license and permit bonds, required by governments before issuing licenses or permits; court bonds, such as bail bonds and fiduciary bonds; and public official bonds, issued to guarantee faithful and honest job performance by elected and appointed public officials such as law enforcement officers and treasury officials. Bonds that don’t fall into these categories, such as those guaranteeing self-insurance, can properly be categorized as “miscellaneous” commercial surety bonds.