Surety bonds are a necessary requirement not only for contractors, but also for a variety of small businesses to open. Although required for thousands of businesses to operate, much is unknown about their functions and the process of how to obtain a surety bond. To help clear up the mystery behind the bonding process, the following is look into the most frequently asked questions regarding surety bonding.
What is a surety bond?
Surety bonds are a form of contract. In most cases, they are a financial guarantee that protects customers’ money. In all cases it involves three parties:
- An obligee – the party requiring the bond – most often it’s a government entity
- A principal – the company or individual that is purchasing the bond
- A surety – the agency who writes and sells the bond(s)
If the principal should default on any specifications of the bond, a claim can be made seeking retribution. If the claim is found to be valid, compensation is used by the surety agency who will then, in turn, seek repayment from the principal. Because of this, a risk assessment is always performed in order to ensure principals are financial secure to repay in the event damages should be sought against them.
What are the benefits of becoming bonded?
Even for those that are working on private construction projects, obtaining surety bonds is seen as a validation of the company’s professionalism. Those that are able to acquire a surety bond typically are more financially secure than those who are unable to purchase a bond. Banks and financial lenders also view surety bonds as a form of verification of the company’s trustworthiness and financial stability.
For those that are bidding on a project, surety bonds also help validate the project owner’s financial security. As many know, contractors have faced bankruptcy as the project owner’s funding was not verified. Prior to writing and issuing bonds, the surety will investigate the source and amount of available funds. Sureties also help review contracts to ensure there isn’t any language present that will add unnecessary risk to the project. As a whole, surety bonds help protect project owners and the contracting companies that are preforming the work on the project.
Why are surety bonds required?
Although many have not heard about surety bonds, the fact is they’ve been a necessary requirement for several years. The Miller Act, which was passed in 1935, requires contract surety bonds on federal construction projects. In specific, the law specifies both performance bonds and payment bonds (commonly referred to as material and labor payment bonds). The act specifies these bonds must be in place for projects exceeding $100,000, but many state legislatures have adopted the same theory and require them on smaller projects. These regulations are also known as Little Miller Acts.
Aren't surety bonds another form of insurance?
This is the most common misconception regarding surety bonding. Although both insurance policies and surety bonds have the same goal – to protect consumers – the main difference is where the element of risk lies. In regards to insurance policies, it is traditionally a two-person agreement with the company issuing the policy assuming risk.
However, with surety bonds the principal (or the company purchasing the bond) is assigned risk and the bond protects obligees. If a claim is filed against the bond purchaser, the surety agency will make initial payments to the obligee, and then seek retribution from the principal.
The services bonds and insurance policies provide are also different from one to another. Insurance policies are written to assist in times of loss, however surety bonds are written under the assumption (and hope) no claims will be filed against the principal. Because of this, should a claim be filed against an individual or company, it is extremely difficult for that individual to purchase surety bonds in the future.
Alex Levin is a writer for several surety organizations. Although much is unknown about them, surety bonds are a necessary requirement for many small businesses to open and are required on almost all major construction projects.