For many people, surety bonds are shrouded in mystery. In this post we talk about what a surety bond is and discuss some of the different types of surety bonds. Moreover, we define some of the applicable terms, such as “principal,” “obligee,” and “surety.”
What Is a Surety Bond?
A surety bond represents a kind of risk management.
To give an example, let’s say that a small city wants to hire a contractor to make repairs on a municipal building. In order to mitigate the risk they’re taking, the city requires the contractor to take out a surety bond. The contractor applies to a surety company for that bond.
The surety company, in turn, checks out the contractor’s credit history and the financial soundness of his or her business. They might even go so far as to check with the contractor’s former clients. That’s because they will want to make sure that this contractor can be counted on do what the city needs him to do.
If the contractor’s business checks out well, the surety company issues the surety bond. In other words, they assure the city that the job will get done properly, within budget and on time. If the contractor fails to make that happen, the surety company will pay the city a certain amount, up to the limit of the surety bond.
In this example, in the lingo of the surety bond business, the surety company is the “surety.” The city is the “obligee,” and the contractor is the “principal.”
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Getting a Surety Bond Requires Screening
Each surety bond company has a unique set of specific guidelines for the principals they bond. These guidelines screen for principals’ risk levels. If a principal doesn’t meet the criteria for that surety bond company’s guidelines, they won’t issue the surety bond.
How a Surety Bond Works
The surety bond company pays compensation to the obligee when the principal doesn’t meet the specifications detailed in the bond. Further, when this happens, the principal must repay the surety company the amount they paid to the obligee.
There Are Multiple Types of Surety Bonds
Some surety bonds are required by law, and others are requested by private individuals or companies. A contract surety bond ensures that the principal will meet the obligations of a construction contract, as in the example described above.
On the other hand, a commercial surety bond ensures that a licensed company will comply with required codes. A fidelity surety bond protects companies and their customers against employee theft. And a court surety bond protects plaintiffs from loss in court proceedings
Obtaining a Surety Bond Is Usually Not Expensive
The principal generally pays the premium for a surety bond. However, they are not expensive to obtain. What’s more, if the principal has a good credit score, the premium may be only a small percentage of the total bond amount. Moreover, it is usually only a one-time payment.
A Surety Bond Is Not Insurance
Surety bonds are a little like insurance in that they pay out to the obligee if the principal does not fulfill the obligations described in the language of the bond. However, since the surety company can research the principal ahead of time, the surety company minimizes its risk.
Insurance companies, on the other hand, generally insure against damages from less predictable events. Moreover, if the surety company has to pay the obligee for the principal’s failure to perform, the principal must then repay the surety company. In this way, a surety bond resembles credit to the principal instead of insurance for the obligee. That’s why principals who have issues with their credit scores may not be approved for some surety bonds.