What is Surety?
In finance, surety is a contractual agreement in which one party agrees to become legally liable for another party’s failure to meet an obligation.
Surety is common in situations in which one party (the obligee) does not feel confident in the other party’s (principal’s) ability to hold up his or her end of the bargain. In this case, the principal seeks a surety from a third party (the guarantor, also known as the surety). A surety is a contractual agreement between all three parties. The guarantor promises that, if the principal defaults on a debt or fails to perform promised work, he or she will take responsibility for it. The surety allows the principal to enter into the contract and reduces risk for the obligee. Surety bonds are common in construction contracts and for professions like mortgage brokers and car dealers.
Joe’s Construction, a fictional company, is bidding to work on a local government project. Federal and state law requires that Joe’s Construction obtain surety bonds to make sure the company follows through on the job it’s promising to do and pays laborers and suppliers. The company has a stellar business reputation and credit history, so it’s able to find a surety bond company that will guarantee its work. This allows the firm to get government approval for the project.
A surety is like a safety net…
Say you enter into a contract, and the original deal falls through. Often, this means you’re out of luck. But if you’ve entered into a surety agreement with the other party and a guarantor, you have someone else to fall back on — There’s a safety net to catch you.
A surety bond is a contract between three parties:
Federal and state law often requires construction companies to have surety bonds in order to work on public projects. These protect the government if contractors abandon a job or don’t do what they promised. Basically, the surety company assures the government that the contractor will actually follow through on the contract, and the government can take on less risk. Owners of private construction projects sometimes choose to require surety bonds even though they don’t have to.
The requirement for surety bonds in public construction projects dates back to 1935 with the passage of the Miller Act. This federal law requires companies to have certain surety bonds to win a contract worth more than $100,000. Many states have also adopted their own versions of the Miller Act for contractors working on state public projects.
There are three main types of surety bonds for contractors:
There are other types of surety bonds that you might need for your business or job, depending on what state you live in. These commercial surety bonds exist to protect consumers and guarantee that the principal will perform promised obligations. Examples include surety bonds for mortgage professionals, car dealers, and notaries.
Another type of surety bond is a bail bond, which a criminal defendant can purchase to satisfy bail and get out of jail. When someone is detained for an alleged crime, a judge often sets a bail amount. If defendants post bail, they can leave jail and get the money back, as long as they show up for court dates. In many cases, bail is more than defendants can afford. In this situation, they can buy a bail bond, usually for 10% of the amount of bail — This is the bond premium. The bond company pays the defendant’s bail. If the defendant shows up in court, the bond company gets its money back and keeps the premium as profit. If the defendant doesn’t appear, the bond company can seize the collateral (an asset like a car or jewelry) the defendant provided to get the bond.
A surety company is a company that sells surety bonds. The surety company is the guarantor in the surety contract, meaning it promises to cover the liabilities of the principal if necessary.
Many property and casualty insurance companies sell surety bonds. There are also companies whose entire business model is selling surety bonds. Of those, some specialize in certain types of surety bonds, like construction bonds or bail bonds. Surety companies usually have to be licensed to issue bonds by the states in which they do business. State governments may require that these companies have a minimum amount of capital on hand and file regular financial reports.
There are a few things to keep in mind if you’re looking for a surety bond. First, make sure the surety bond company is licensed in your state. The US Treasury Department maintains a list of surety companies that qualify for federal contracts. The National Association of Surety Bond Producers and the Surety & Fidelity Association of America, both trade agencies for the surety industry, keep a list of member surety companies and can help verify the authenticity of bonds. Finally, private companies like AM Best maintain a list of surety companies and rate their financial health.
The Surety & Fidelity Association of America releases an annual report of the top 100 surety writers, based on the value of bonds they issued. As of 2019, the top surety writers were:
If you own a construction company and aren’t sure you’ll be able to get a surety bond, the US Small Business Administration might be able to help. The agency has a list of preferred surety company companies for which it will guarantee surety bonds. This encourages surety bond companies to sell to businesses that might not otherwise qualify. It’s kind of like a surety bond to guarantee a surety bond.
Once you’ve found a surety bond provider, you can fill out an application and get a quote. The company may review financial statements, works completed or in progress, and reference letters. The cost for a surety bond usually ranges from 0.5 percent to 3 percent of the contract’s value, depending on factors like project size and length. The next step is to sign an indemnity agreement, which says that you’ll repay the surety company if it ends up paying a claim and demonstrates that you’re committed to meeting the contract terms. Once all parties have signed the contract, you’ll pay for the surety bond and send it to whomever is requiring that you get the bond.
A surety is not the same thing as a bank guarantee, which is when a lending institution guarantees the liabilities of a borrower. For example, let’s say that fictitious company HotDogs is trying to make a large purchase from Party Suppliers (also fictional). Party Suppliers has concerns about the ability of HotDogs to make the payment after it delivers the goods. Hotdogs can get a bank guarantee from a financial institution for a small fee. Through the bank guarantee, the bank promises Party Suppliers that it will get its money one way or another. The bank usually requires some sort of collateral — an asset that the bank could seize if HotDogs doesn’t pay the bill.
Surety and insurance policies both deal with risk, but they’re different. In the case of an insurance policy, the person or business taking out insurance is the one who is protected from losses, and the insurance company is the one responsible for paying claims. Risk is spread among all of the company’s clients, with premiums expected to cover losses.
With a surety, the obligee requiring the bond — not the principal paying for it — is the one that’s protected. It’s a contract between just three parties. Ultimately, losses aren’t expected, and the principal must still pay the surety company if any claims result.
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