Overview of Surety Bonds

Principles of Surety Bonding

Surety bonding has much more in common with commercial lending than it does with insurance. Unlike insurance coverage and fidelity bonding, surety bonding is essentially a three-party obligation. It consists of:

•        Obligee

This is the first party, the party to whom the indemnity is provided.

Note: A.I.A. construction bonds use the term Owner in place of Obligee.

•        Principal or Obligor

This is the second party, the party that performs or complies with contractual or statutory obligations for the obligee.

Note: A.I.A. construction bonds use the term Contractor in place of Obligor or Principal.

•        Surety

This is the third party, the party that guarantees that the principal will perform or comply with the contractual or statutory obligation.

The surety bond is a joint and several financial undertaking of the principal and surety. The principal bears full responsibility to perform the obligation.

Unlike most insurance coverage forms and policies that consist of many pages, the surety bond rarely exceeds one page.

UNDERWRITING

The surety underwrites the risk based on the three C’s: Capital, Character, and Capacity. Most grantors of surety credit, commercial bank loan providers, and many other firms that extend credit as a normal business risk use these credit evaluation standards.

Many grantors of credit use a fourth C, Collateral, to support unusually hazardous surety obligations. Collateral is also routinely used with the extension of many commercial bank loans. The additional support collateral for a credit risk does not necessarily challenge the credit worthiness of the bond principal or the party that seeks a loan. However, under contract suretyship, the requirement for collateral by standard surety markets (defined as conventional underwriters usually affiliated as members of or subscribers to the Surety and Fidelity Association of America) is highly unusual. One situation when such requests are made is when a contractor previously defaulted in performing bonded work.

Surety obligations (and contract bonds in particular) frequently depend on the officers and directors of a corporation to personally indemnify the surety against any loss it may sustain by reason of executing the bonds on behalf of a corporate principal.

The surety’s and lender’s respective means of recourse against default is similar. An unsecured lender has essentially the same legal remedies available to it against its defaulting borrower in civil proceedings as the surety does against its defaulting principal. In the surety business, this is known as the right of equitable subrogation. If the lender had a guarantor or co-maker supporting the borrower on its security instruments, these third parties are the equivalent to the surety as the guarantor to the obligee on a bond.

SURETY PREMIUMS VERSUS INSURANCE PREMIUMS

The law of large numbers is a key integral component to most primary insurance lines of coverage. This law anticipates collecting sufficient premium from all policyholders to cover the losses of the few. Pooling premiums to respond to injury or damage sustained by certain members of that pool is how insurance works.

However, that approach does not necessarily apply to corporate suretyship. The premium for any type of surety bond is not treated as an amount that can be held in reserve to make payments. On the contrary, it should be considered as a fee for the bond. When losses occur, they are paid out of the surety’s assets, surplus investment income, and contingency reserve. After the surety fulfills its obligation, it assumes the principal’s rights, because it has already handled the principal’s financial responsibilities. Once an obligee receives a surety bond, that bond is valid, even if the principal never pays for it. The surety bond does not have any cancellation provisions for nonpayment of premium. In addition, the rights of the obligee cannot be invalidated unless the bond has an express provision that permits it.

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Source: ©The Rough Notes Company, Inc.