Below are some helpful resources to help you understand Surety and the Surety Industry a little better.
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Suretyship is a very specialized line of insurance that is created whenever one party guarantees
performance of an obligation by another party. There are three parties to the agreement.
- The principal is the party that undertakes the obligation.
- The surety guarantees the obligation will be performed.
- The obligee is the party who receives the benefit of the bond.
What is a Surety Bond?
A surety bond is a written agreement that
usually provides for monetary compensation in case the principal
fails to perform the acts as promised. There are many different
types of surety bonds, but the two general categories are contract
and commercial surety bonds.
What characteristics of suretyship are like more common forms of insurance?
- They are both risk transfer mechanisms.
- State insurance commissioners regulate them both.
- They both provide for financial loss.
How is suretyship different from more common lines of insurance?
- In traditional insurance, the risk is transferred to the insurance company. In suretyship, the risk
remains with the principal. The protection of the bond is for the obligee.
- In traditional insurance, the insurance company takes into consideration that a certain amount of the
premium for the policy will be paid out in losses. In true suretyship, the premiums paid are “service fees”
charged for the use of the surety company’s financial backing and guarantee.
- In underwriting traditional insurance products the goal is “spread of risk.” In suretyship, surety professionals
view their underwriting as a form of credit so the emphasis is on prequalification and selection.
How does a surety underwrite?
Each surety company has its own guidelines and underwriting criteria. However, the following basic factors will be taken into consideration in some format.
- Capacity – Does the applicant have the skill and ability to perform the obligation?
- Capital – Does the financial condition of the applicant justify approval of the particular risk?
- Character – Does the applicant’s record show him to be of good character and likely to perform the obligation he or she assumes?
What is Personal Indemnity?
It is common for a surety to request the indemnity of the owners of a closely held corporation. Typically, the spouse’s indemnity also is required because personal assets are jointly owned. The two main reasons for this requirement are that the surety requires all personal assets to be available to back the guarantee and that there is less chance a principal will avoid its responsibilities if its personal assets are at stake.
How does collateral security relate to a surety bond?
If an underwriter is unable to approve a bond request based on the qualifications given by the principal, the company may suggest depositing some form of collateral as an inducement to write the bond. In practice, many bonds are written on this basis, particularly ones that are considered financial guarantees.
What is a financial guarantee bond?
A financial guarantee bond obligates the surety to pay a certain amount of money if the principal does not perform its obligation. Examples include tax bonds and Medicare and Medicaid bonds. These bonds are extremely hazardous and very carefully underwritten.
From the Surety & Fidelity Association of America
- A surety bond is a three-party agreement where the surety company assures
the obligee (owner) that the principal (contractor) will perform a contract.
Surety bonds used in construction are called contract surety bonds.
- There are three primary types of contract surety bonds. The bid bond assures that the bid
has been submitted in good faith, that the contractor intends to enter the
contract at the price bid and provide the required performance and payment
bonds. The performance bond protects the owner from financial loss in the event
that the contractor fails to perform the contract in accordance with its terms
and conditions. The payment bond assures that the contractor will pay certain
workers, subcontractors, and materials suppliers.
- Most surety companies are subsidiaries or divisions of insurance companies, and both surety bonds and
insurance policies are risk transfer mechanisms regulated by state insurance
departments. However, insurance is designed to compensate the insured against
unforeseen adverse events. The policy premium is actuarially determined based on
aggregate premiums earned versus expected losses. Surety companies operate on a
different business model. Surety is designed to prevent loss. The surety
pre-qualifies the contractor based on financial strength and construction
expertise. The bond is underwritten with little expectation of loss.
- In 1984 Congress passed the Heard Act to protect federal projects from contractor
default and protect subcontractors from nonpayment by contractors. The Heard Act
was supplanted by the Miller Act in 1935, which basically requires performance
and payment bonds in excess of $100,000 and payment protection for contracts
between $30,000 and $100,000. A corporate surety company issuing these bonds
must be listed as a qualified surety on the Treasury List. Also, almost all 50
states, the District of Columbia, Puerto Rico, and most local jurisdictions have
enacted similar legislation requiring surety bonds on public works. These
generally are referred to as "Little Miller Acts." Owners of private
construction also manage risk by requiring surety bonds.
- Construction is a risky business. Of 1,155,245 contractors in business in 2006 only 919,848 were
still in business in 2008 - a 20.4% failure rate. Surety bonds offer assurance
that the contractor is capable of completing the contract on time, within
budget, and according to specifications. Specifying bonds not only reduces the
likelihood of default, but with a surety bond, the owner has the peace of mind
that a sound risk transfer mechanism is in place. The burden of construction
risk is shifted from the owner to the surety company.
- Surety bond premiums vary from one surety to another, but can range from 0.5% to 2% of the contract
amount, depending on the size, type, and duration of the project and the
contractor. Typically, there is no charge for a bid bond if performance and
payment bonds are required on the project. In many cases, performance bonds
incorporate payment bonds and maintenance bonds.
- The surety company's rigorous pre-qualification of the contractor protects the project owner and
offers assurance to the lender, architect, and everyone else involved with the
project that the contractor is able to translate the project's plans into a
finished project. Surety companies and surety bond producers have been
evaluating contractor and subcontractor performance for more than a century.
- Their expertise, experience, and objectivity in pre-qualifying contractors is one
of a bond's most valuable attributes. Before issuing a bond, the surety company
must be fully satisfied that the contractor has, among other criteria:
- good references and reputation;
- the ability to meet current and future obligations;
- experience matching the contract requirements;
- the necessary equipment to do the work or the ability to obtain it;
- the financial strength to support the desired work program;
- an excellent credit history; and
- an established bank relationship and line of credit.
- Contractor default is an unfortunate, and sometimes unavoidable,
circumstance. In the event of contractor failure, the owner must formally
declare the contractor in default. The surety conducts an impartial
investigation prior to settling any claim. This protects the contractor's
legal recourse in the event that the owner improperly declares the
contractor in default.
- When there is a proper default, the surety's options
often are spelled out in the bond. These options may include the right to
re-bid the job for completion, bring in a replacement contractor, provide
financial and/or technical assistance to the existing contractor, or pay the
penal sum of the bond.
- That owners have been shielded from risk is evidenced
by the fact that surety companies have paid more than $10.5 billion due to
contractor default since 1994, according to The Surety & Fidelity
Association of America, Washington, DC. In 2008, the surety industry paid
more than $13 million in losses on private construction and more than $1.5
billion since 1995.
- When bonds are specified in the contract documents, it is the
contractor's responsibility to obtain them. The contractor generally
includes the bond premium amount in the bid and the premium generally is
payable upon execution of the bond. If the contract amount changes, the
premium will be adjusted for the change in contract price. Contract surety
bonds are a wise investment - providing qualified contractors and protecting
public owners, private owners, and prime contractors from the potentially
devastating expense of contractor and subcontractor default.
- After analyzing the risks involved with a construction project, consider
how surety bonds protect against those risks. Owners, lenders, taxpayers,
contractors, and subcontractors are protected because:
- The contractor has undergone a rigorous pre-qualification process and is judged capable of fulfilling the obligations of the contract;
- Contractors are more likely to complete bonded projects than non-bonded projects since the surety company may require personal or corporate indemnity from the contractor;
- Subcontractors have no need to file mechanics' liens on private projects when a payment bond is in place;
- Bonding capacity can help a contractor or subcontractor grow by increasing project opportunities and providing the benefits of assistance and advice of the surety bond producer and underwriter;
- Surety companies may prevent default by offering technical, financial, or management assistance to a contractor; and
- The surety company fulfills the contract in the event of contractor default.
