Definition of Surety Bond
A surety bond is a contract in which the surety guarantees that a third party (the principal) will faithfully perform its obligations to the obligee. A contractor, for example, may be financially stretched and unable to complete a construction project.
A public official may embezzle public funds, or the executor of an estate may unlawfully convert a portion of the estate’s assets to his or her own use. Surety bonds can be used to cover these losses.
Parties to a surety bond
A surety bond involves three parties:
- Principal Obligee,
- Surety (obligor)
The principal is the person or entity who agrees to perform specific acts or fulfill specific obligations. A construction company, for example, may agree to build an office building for a commercial bank.
Before the contract is awarded, the construction company may be required to obtain a performance bond. The principal would be the construction company.
If the principal fails to perform, the bond proceeds are distributed to the obligee. In the preceding example, the bank would be reimbursed for any loss caused by the construction company’s failure to complete the building on time or according to contract specifications.
The surety is the bond’s final party. The surety (obligor) is the party who agrees to answer for another person’s debt, default, or obligation.
A commercial insurer, for example, may have purchased a performance bond from the construction company. If the construction company (principal) fails to perform, the commercial insurer will reimburse the bank (obligee) for any losses (surety).
Difference Between Insurence and Surety Bond
Surety bonds and insurance contracts are similar in that both provide protection against specified losses. There are, however, some significant differences between them, as given below.
|An insurance contract has two parties.||A surety bond involves three parties.|
|The insurer anticipates paying out losses. The premium reflects the anticipated loss costs.||The surety, in theory, anticipates no losses. The premium is regarded as a service fee, with the surety’s credit substituting for the principal’s.|
|Normally, the insurer does not have the right to recover a loss payment from the insured.||The surety has the legal right to sue the defaulting principal for a loss payment.|
|Insurance is intended to cover unintentional losses that are, ideally, beyond the insured’s control.||The surety guarantees the principal’s integrity, honesty, and ability to perform. These characteristics are under the principal’s control.|
Also Read: 6 Shocking examples of insurance fraud
Types of Surety Bonds
Surety bonds of various types can be used to meet specific needs and situations. Although surety bonds are not uniform and have unique characteristics, they can be broadly classified as follows:
- Contract bonds
- Bid bond
- Performance bond
- Payment bond
- Maintenance bond
- Completion bond
- License and permit bonds
- Public official bonds
- Judicial bonds
- Fiduciary bond
- Court bond
- Miscellaneous surety bonds
Contract bonds are used in the construction industry. A contract bond ensures that the principal will fulfill all contractual obligations. Contract bonds are classified into several types.
A bid bond guarantees the owner (obligee) that the party awarded a bid on a project will sign a contract and provide a performance bond.
A performance bond assures the owner that the work will be completed in accordance with the contract specifications. For example, if a building is not completed, the surety is liable for the project’s completion as well as the additional cost of hiring another contractor. Performance bonds are especially important in the construction industry, where many firms fail each year.
A payment bond guarantees that the contractor will pay the bills for labor and materials used in a construction project when they are due.
A maintenance bond guarantees that the principal’s poor workmanship will be corrected or that defective materials will be replaced. This maintenance guarantee is frequently included in a one-year performance bond.
A completion bond is used for contracts involving project financing and design. The completion bond ensures that a building or project is completed. It is intended to protect lending institutions and property lessors.
License and permit bonds
Parties who are required to obtain a license or permit from a city or town must post a bond. A license and permit bond ensures that the party will follow all applicable laws and regulations. A liquor store owner, for example, may post a bond guaranteeing that liquor will be sold in accordance with the law.
Public official bonds
For public officials who are elected or appointed to public office, this type of bond is usually required by law. A public official bond ensures that public officials will faithfully perform their duties for the public’s protection. A state treasurer, for example, must follow state law regarding the deposit of public funds.
Judicial bonds guarantee that the bonded party will fulfill certain legal obligations. There are various kinds of judicial bonds.
A fiduciary bond guarantees that the person in charge of another’s property will faithfully perform all required duties, provide an accounting of all property, and make up any deficiency for which the courts hold the fiduciary liable.
A court bond is intended to protect one person (the obligee) from loss if the person bonded fails to demonstrate that he or she is legally entitled to the remedy sought against the obligee.
Miscellaneous Surety Bonds
This category contains bonds that do not fit into any other category. An auctioneer’s bond, for example, guarantees an auctioneer’s accounting of sales proceeds; a lost-instrument bond protects the obligee against loss if the original instrument (such as a lost stock certificate) turns up later in the possession of another party, and an insurance agent bond protects the insurer the agent represents from any penalties resulting from the unlawful acts of agents.