Surety bonds are essential in many industries because they protect consumers and stakeholders from fraud and malpractice. To ensure professionals maintain a high standard, many industries have instituted a surety bond requirement as part of the licensing process. Bonds not only protect consumers from being misled, but they also help protect the reputation of the industry as a whole.
However, there is a lot of misinformation surrounding the bonding process, getting bonded, and what a surety bond does. Here’s what consumers and professionals need to know about common surety bond misconceptions so they can make informed decisions.
Common Misconceptions About What Surety Bonds Do
Misconception #1: Surety bonds are basically insurance.
Surety bonds are not insurance, as insurance is traditionally understood. Traditional insurance is a form of risk management among two parties that protects the entity buying the insurance. For example, car insurance financially protects vehicle owners from potential damage in case of an accident or theft. A surety bond is a form of risk management among three parties that protects the entity requiring the bond.
In other words, insurance protects the purchaser from liability, whereas a bond puts the purchaser at liability — meaning you only want to hold a bond when absolutely required. They are almost never optional.
“A surety bond is a form of risk management among three parties that protects the entity requiring the bond.”
A surety bond is a three-party agreement issued by the surety (first party) guaranteeing that a principal (second party) will complete an obligation to the obligee (third party). For example, a bond issued (by the surety) for a construction project financially protects the obligee (project owner) in case the principal (builder) fails to meet contract expectations.
Another thing that sets surety bonds apart from insurance is the consequence of a valid claim made on a surety bond. While the surety will front the money for the damages of a valid claim (up to the full bond amount), the principal has to pay the surety back in full. This differs from traditional insurance, in which the insured may just see a monthly premium increase after a claim is filed on the insurance.
Misconception #2: Surety bonds protect the person purchasing the bond.
Surety bonds do notprotect the person purchasing the bond. A surety bond financially protects the obligee (the entity requiring the bond) by ensuring the principal will meet the terms and conditions of the bond.
Again, insurance protects the purchaser from liability, whereas a bond puts the purchaser at liability.
Misconception #3: There’s a surety bond for everything.
We get a lot of surety bond requests when a bond isn’t necessary. An indicator that a surety bond isn’t necessary is a situation with greater or fewer than three parties involved. Surety bonds are always a three-party agreement and do notexist for larger or smaller groups. In the case that greater or fewer parties are involved, a standard contract would work sufficiently.
Misconception #4: Surety bonds are needed to start a new business.
Commercial surety bonds are not required to start a new business, but they are typically a requirement for a license that you apply for once your business is already established.
When starting a new business, the business needs to be incorporated and file its articles of incorporation with the state. The company must also apply for and receive a tax identification number in order to file tax returns with both the state and the federal government.
Once a business has been legally established, it can become bonded.
Certain bond types, such as auctioneer bonds and adjuster bonds, can be issued to an individual. In these cases, establishing a business is not necessary.
Misconception #5: Surety bonds are trust accounts.
Surety bonds are not trust accounts. A trust account is a financial account opened by an individual, but managed by a designated trustee in accordance with agreed-upon terms. If a business were to shut down, whatever is left in the trust would be considered an asset of the company and would be liquidated and returned in accordance with the terms of the trust.
Surety bonds do not function as trust accounts, and funds can’t be withdrawn for business needs. Surety bonds don’t offer refunds in the case of business closure because they are premium-based instruments in which the nonrefundable premium is paid initially to cover any liability or lack of performance under the bond. The premium is earned by the surety company when it is paid, whether or not there is any future payout against the bond.
It’s important to note that premiums are not deposits. A premium is a fee that is paid to have a surety post the bond; unless there’s collateral (an uncommon occurrence), the premium paid is not part of a deposit or funds that can be refunded.
“Surety bonds do not function as trust accounts, and funds can’t be withdrawn for business needs.”
Common Misconceptions About Getting Bonded
Misconception #6: Surety agencies determine license bond requirements.
Surety agencies do not determine license bond requirements. Surety agencies do not advise on any specific licensing process and can only quote and issue bonds based on the information that clients are provided by the obligee (the entity requiring the bond).If the bond amount or specific bond form is not known by the client, the client will be asked to verify this information with the obligee office prior to getting a quote or submitting an application.
Misconception #7: Surety bonds are always optional.
Surety bonds are typically not optional. In the case that a surety bond is available, it is most commonly necessary because it is a requirement of obtaining a professional license. For example, contractors are required to obtain a surety bond or a letter of credit as part of the licensing process.
Misconception #8: Surety bonds can be transferred between requirements.
Surety bonds cannot be transferred between requirements. Because each state, city, and county has a different level of risk and an individual set of requirements associated with being bonded, surety bonds are not always transferable. Licensed professionals who are eligible to practice in multiple locations must check their local requirements to determine whether they need to obtain another bond.
For example, a contractor may be required to obtain a $20,000 bond in one city, but then a $30,000 bond in a neighboring city. Similarly, a New York auto dealer may need a $100,000 dealer bond to meet requirements; if this dealer also becomes a broker, he would still need to purchase the $100,000 broker bond required by New York. Although the amounts of coverage and the state remain the same, the bonds cover completely different requirements.
Misconception #9: All surety bonds cost the same.
Surety bonds do not cost the same across industries, locations, or coverage amounts. Depending on the risk, bonds may require more protection and, in turn, have larger premiums. For example, a mortgage broker operating in both Texas and Florida may pay more for her Florida bond than she does for her Texas bond because there’s more risk in guaranteeing mortgages in Florida.
“Depending on the risk, bonds may require more protection and, in turn, have larger premiums.”
Some bonds are a flat rate for issuance and require no underwriting at all. Others that do require underwriting cost about 1% to 25% of the bond (coverage) amount; the cost is determined according to the applicant’s credit score, the underwriting regulations enforced, or both, depending on the type of bond. For example, if a bond is $5,000, you can expect to pay anywhere from $50 to $750.
Misconception #10: Surety bonds have to be paid in monthly installments.
Surety bonds are not paid in monthly installments — they are paid for in full upon purchase and cover the bond’s whole term. For example, a two-year term surety bond is paid for upfront for the whole two-year period.
Misconception #11: Surety bonds are refundable.
Typically, surety bonds are not refundable. Once a surety bond is issued, the premium is nonrefundable, regardless of time in effect. Surety companies and agencies do not prorate premium refunds.
Common Misconceptions About the Bonding Process
Misconception #12: Surety bonds can affect your credit score.
Surety bonds don’t affect your credit score. Credit scoring is typically based on how often individuals make late payments and by how much, as well as how many accounts they have open and how much available credit they’re using from those accounts. Because surety bonds are paid once upfront, they don’t affect credit scores.
However, to determine bond prices, a soft credit preview is done when a bond is underwritten; this helps the surety company gauge how likely an individual is to pay the company back should a claim be made on the bond. This preview does not affect an individual’s credit.
Misconception #13: Performance and payment bonds are the same.
Performance and payment bonds are not the same thing. A performance bond ensures contractors will meet their contracted expectations in accordance with the terms and conditions of the agreement they signed with their clients. A payment bond, on the other hand, protects against non-payment for subcontractors, laborers, and suppliers.
Surety bonds are required in a variety of industries. It’s important to have a basic understanding of what a surety bond does and how a person or company becomes bonded to evaluate how you should move forward. The consumers who are best informed, after all, are best protected.