What is a Surety Bond?
A surety bond is a promise to be liable for the debt, default, or failure of another. It is a three-party contract by which one party (the surety) guarantees the performance or obligations of a second party (the principal) to a third party (the obligee).
Suretyship in its simplest form is created when one party guarantees the performance of another party. The surety bond is what guarantees the performance. The parties to a surety bond are the principal, the person or organization primarily bound by the bond given by the surety; the obligee, the party to whom the bond is given and is therefore protected against loss due to the guarantee of performance; and the surety, the party who answers to the obligee in the case of a lack of performance who then is indemnified by the principal after payment for failure to perform an obligation to the obligee.
The surety is the party that becomes obligated to the obligee upon failure of the principal to perform. This seems like a standard insurance occurrence. But what makes the surety agreement unique is that after the surety pays for that failure to perform, the principal indemnifies the surety for the amount paid on the claim by the principal. Underwriters strongly consider the principal’s ability to indemnify the surety in making their decision on whether to bond the principal.
The bond is the surety’s form of vouching for the principal’s trustworthiness and ability to perform while functioning as a form of protection for the obligee. The surety, however, is not expecting any losses on these bonds. Either the principal performs as expected, and nobody suffers any losses, or the principal fails to perform and the surety is indemnified by the principal.
Surety bonds usually do not terminate until the obligation has been fulfilled or completed. Underwriters have to consider the length of the obligation in their determination as to whether the principal is likely to complete the obligation adequately.
The bond amount is the amount of which the surety’s obligation on the bond extends to. The surety’s obligation usually does not exceed the bond amount even if damages for failure to perform exceed this amount. A financial guarantee bond, however, obligates the surety to pay a certain amount if the principal does not perform. Medicare and Medicaid bonds are an example of these. They are very carefully underwritten due to this hazardous nature.
Despite indemnity differentiating surety from general insurance, there are multiple similarities between the two. They are both risk transfer mechanisms, state insurance commissioners regulate them both, and both provide for financial loss. The main difference is who pays for that loss ultimately. In regular insurance, the insurance company pays; in surety, the principal is ultimately responsible.
Surety Bond Underwriting Process
So how exactly is the underwriting done on surety bonds? Each company has its own guidelines and criteria but the same basic factors are taken into account by most surety companies. First, they look at capacity: whether the prospective principal has the skill and ability to perform. Then they look at capital: does the company have the financial condition to justify approval of the risk here? Lastly, they look at character: are there any indications that the applicant isn’t of good character and unlikely to perform due to those reasons?
If the underwriter can’t approve the bond based on the principal’s given qualifications, collateral might bridge the gap to gain them approval. Many bonds are written on this basis and provide protection in the case of failure to perform.