Top 4 Things to Know About Surety Bonds
Being asked to provide a surety bond can be a daunting task. Often times those being asked to provide them might no be familiar with how to secure these surety bonds, the costs and what the process looks like. Below we have attempted to provide some key items in understand the process to secure a surety bond.
1) A Surety Bond is NOT Insurance
Surety bonds are different than insurance. Insurance is a two party arrangement between the insurance company and the insured (person who requires the insurance coverage) where the insurance company agrees to accept a risk in exchange for an insurance premium. The example being a person by insurance on their home to protect it in case of fire.
A surety bond is a three party agreement between the obligee (person requiring the bond) the surety bond company and the principal (the person applying for the bond). An example here would be a construction company providing a performance bond to the City of Toronto. In this case, The City of Toronto is the Obligee, the principal is the construction company and the surety would be the insurance company who issues the bond.
Surety is different than insurance because the surety is agreeing to lend their balance sheet to a contractor (in the example above), in exchange for a premium. The surety in exchange for that premium is guaranteeing to the obligee (City of Toronto) that the contractor will perform the terms and conditions of its contract. If the principal fails the surety will remedy the default. The obligee is asking for this to help avoid financial loss and the bond protects an obligee if a principal fails.
2) To Secure a Surety Bond you will Need to Sign an Indemnity Agreement
Surety Bonds are similar to securing a loan from a bank in the sense that to obtain a surety bond, a principal must agree to provide indemnity to the surety. This means that if there was ever a loss under the bond, the principal would agree to indemnity (or pay back) the surety. This is an important distinction and one everyone looking to secure a bond should understand.
3) Surety Bonds are Specialized!
Surety Bonds are a very specialized product and there is a small pool of brokers and surety companies willing to provide them. Ensuring that you are working with an expert in both areas will ensure that you have the right terms but will also ensure that you understand your rights and options if there was ever to be a claim against your bond.
Make sure you ask your broker questions about their expertise, involvement within the specific industry you are in and specifics on how the bonds work. The person that provides your general insurance isn’t always going to be the best option to provide your surety bond.
4) Surety Bonds vs. Cash or Letters of Credit
Many obligees will offer principals the option to provide a surety bond or other forms of security. These can include providing cash or letters of credit. While it can often be easier to just submit cash or a letter of credit to an owner, it can also leave a principal more exposed. In the case of a surety bond, if a claim is made, in the majority of cases an obligee (or project owner in the City of Toronto example) must prove that a principal is in default with the terms of their agreement.
The principal has an opportunity to respond in this process and provide their side of the story. The surety then will complete and investigation and determine if there is a legitimate claim. This provides the principal some protection in ensuring that if a claim is paid, it is, in fact valid. With cash or a letter of credit, an owner can decide at any time, a principal is in default and cash that secure without any vetting or investigation.