In an effort to help consumers better understand the niche surety industry, Insider contributors have created a 7-part series answering the most popular surety questions. In Part 2, we’re going to build off of our understanding of what a surety company is and give you a general, introductory rundown of what surety bonds are. As we covered in the previous entry of this series, surety companies have been issuing bonds in America since the mid 1800’s. Typically, when people hear the term bond, they immediately think of bail or financial bonds. However, surety bonds are an altogether different entity.
What is a surety bond?
A surety bond is a contract between three parties—the principal, the surety and the obligee—in which the surety financially guarantees to an obligee that the principal will act in accordance with the terms established by the bond.
Before getting into what the purpose of bonds are, let’s first take a closer look at the parties involved, beginning with the surety. As written previously on the Surety Bond Insider, the surety company is oftentimes affiliated with a larger insurance company and writes bonds as a guarantee to the obligee on behalf of the principal. Unlike traditional insurance companies where risk is assumed, surety companies write policies with the notion that there will be no loss. In the event that the obligee claims against the bond and the surety pays to settle, the principal is then obligated to repay the surety.
The obligee is the entity that requires the bond from the principal. Typically a local or state agency is the obligee on a bond, though there are some bonds that are required by federal agencies. For example, freight broker bonds are required by the Federal Motor Carrier Safety Administration in order to get a license. In the event that the principal fails to abide by the terms of the bond and loss or damage is incurred as a result, it is the obligee that will present the claim to the surety company.
The principal is the entity that is required to obtain a bond ensuring their faithful adherence to all rules and regulations set forth by the bond. While the obligee is typically a local or state entity, the principal represents a wide variety of people and/or companies—contractors, administrators of estates, notaries, etc.
When it comes to understanding the bonds themselves, the definition above is a good starting point, but it could also benefit from elaboration. Regardless of what kind of bond is required, it is always in place to guarantee a certain amount of money is available in the event of a loss. The bond, unlike an insurance policy, does not benefit the principal in any way, which is one of the most common misconceptions about bonds. They exist solely to protect those with whom the principal will be interacting. Typically, there are specific statutes referenced on the bond form that lay out the expectations of the principal to ensure that no harm—financial or otherwise—takes place as a result of their actions. Many bonds also contain a cancellation clause that allocates the cancellation of the bond by the surety so long as the surety provides the obligee with advance notice—typically in writing.
Although the surety will pay out money in the event of a claim, we previously established that they consider that there is no risk when writing bonds. This is true because it is the principal’s responsibility to reimburse the surety for any money paid out in a claim. Oftentimes, principals are required to sign indemnity agreements, which remove liability from the surety and transferring it to themselves. Therefore, if a principal does not reimburse the surety, the surety may seek to recover money by taking legal action.
Now that we have answered the question, “what is a surety bond?” it is important to know that there are thousands of different types of bonds—each with its own unique stipulations. To learn more about specific bond types and what they are for, please feel free to take a look at our dedicated bond pages.
Thinking of becoming a contractor and need a bond? Stay tuned for an in-depth look at contractor bonds and why they are required!