Surety Bonds have been around in a single form or another for millennia. Some may view bonds as an unwanted business expense that materially cuts into profits. Other firms view bonds as a passport of sorts which allows only qualified firms access to bid on projects they could complete. Construction firms seeking significant public or private projects understand the fundamental necessity of bonds. This informative article, provides insights to the a number of the basics of suretyship, a deeper explore how surety companies evaluate bonding candidates, bond costs, warning signs, defaults, federal regulations, and state statutes affecting bond requirements for small projects, and the critical relationship dynamics between a principal and the surety underwriter.
What is Suretyship?
The short answer is Suretyship is a questionnaire of credit wrapped in an economic guarantee. It's not insurance in the standard sense, hence the name Surety Bond. The purpose of the Surety Bond is to ensure the Principal will perform its obligations to theObligee, and in the case the Principal fails to execute its obligations the Surety steps to the shoes of the Principal and provides the financial indemnification to allow the performance of the obligation to be completed.
There are three parties to a Surety Bond,
Principal - The party that undertakes the obligation underneath the bond (Eg. General Contractor)
Obligee - The party receiving the benefit of the Surety Bond (Eg. The Project Owner)
Surety - The party that issues the Surety Bond guaranteeing the obligation covered underneath the bond will be performed. (Eg. The underwriting insurance company) premium bonds to invest
How Do Surety Bonds Vary from Insurance?
Possibly the most distinguishing characteristic between traditional insurance and suretyship may be the Principal's guarantee to the Surety. Under a conventional insurance plan, the policyholder pays reasonably limited and receives the benefit of indemnification for any claims included in the insurance plan, at the mercy of its terms and policy limits. Except for circumstances which could involve advancement of policy funds for claims which were later deemed to not be covered, there's no recourse from the insurer to recoup its paid loss from the policyholder. That exemplifies a genuine risk transfer mechanism.
Loss estimation is another major distinction. Under traditional types of insurance, complex mathematical calculations are performed by actuaries to find out projected losses on a given form of insurance being underwritten by an insurer. Insurance companies calculate the possibility of risk and loss payments across each class of business. They utilize their loss estimates to find out appropriate premium rates to charge for each class of business they underwrite to be able to ensure there will be sufficient premium to cover the losses, buy the insurer's expenses and also yield a fair profit.
As strange as this will sound to non-insurance professionals, Surety companies underwrite risk expecting zero losses. The obvious question then is: Why am I paying reasonably limited to the Surety? The answer is: The premiums come in actuality fees charged for the ability to obtain the Surety's financial guarantee, as required by the Obligee, to ensure the project will be completed if the Principal fails to meet its obligations. The Surety assumes the chance of recouping any payments it makes to theObligee from the Principal's obligation to indemnify the Surety.
Under a Surety Bond, the Principal, such as a General Contractor, has an indemnification agreement to the Surety (insurer) that guarantees repayment to the Surety in the case the Surety must pay underneath the Surety Bond. As the Principal is obviously primarily liable under a Surety Bond, this arrangement doesn't provide true financial risk transfer protection for the Principal although they're the party paying the bond premium to the Surety. As the Principalindemnifies the Surety, the payments created by the Surety come in actually only an expansion of credit that is required to be repaid by the Principal. Therefore, the Principal has a vested economic fascination with how a claim is resolved.
Another distinction is the specific kind of the Surety Bond. Traditional insurance contracts are manufactured by the insurance company, and with some exceptions for modifying policy endorsements, insurance policies are usually non-negotiable. Insurance policies are thought "contracts of adhesion" and because their terms are essentially non-negotiable, any reasonable ambiguity is typically construed from the insurer. Surety Bonds, on the other hand, contain terms required by the Obligee, and may be subject with a negotiation between the three parties.
Personal Indemnification & Collateral
As discussed earlier, a fundamental component of surety may be the indemnification running from the Principal for the benefit of the Surety. This requirement can also be known as personal guarantee. It is needed from privately held company principals and their spouses due to the typical joint ownership of these personal assets. The Principal's personal assets in many cases are required by the Surety to be pledged as collateral in the case a Surety struggles to obtain voluntary repayment of loss due to the Principal's failure to meet their contractual obligations. This personal guarantee and collateralization, albeit potentially stressful, creates a compelling incentive for the Principal to accomplish their obligations underneath the bond.
Forms of Surety Bonds
Surety bonds come in several variations. For the purposes of the discussion we will concentrate upon the three kinds of bonds most commonly related to the construction industry: Bid Bonds, Performance Bonds and Payment Bonds.
The "penal sum" is the most limit of the Surety's economic contact with the bond, and in case of a Performance Bond, it typically equals the contract amount. The penal sum may increase as the face area number of the construction contract increases. The penal sum of the Bid Bond is a percentage of the contract bid amount. The penal sum of the Payment Bond is reflective of the expense related to supplies and amounts likely to be paid to sub-contractors.
Bid Bonds - Provide assurance to the project owner that the contractor has submitted the bid in good faith, with the intent to execute the contract at the bid price bid, and has the ability to obtain required Performance Bonds. It provides economic downside assurance to the project owner (Obligee) in the case a contractor is awarded a project and refuses to proceed, the project owner would be forced to accept another highest bid. The defaulting contractor would forfeit up to their maximum bid bond amount (a percentage of the bid amount) to cover the fee difference to the project owner.
Performance Bonds - Provide economic protection from the Surety to the Obligee (project owner)in the big event the Principal (contractor) is unable or elsewhere fails to execute their obligations underneath the contract.
Payment Bonds - Avoids the prospect of project delays and mechanics' liens by providing the Obligee with assurance that material suppliers and sub-contractors will be paid by the Surety in the case the Principal defaults on his payment obligations to those third parties.
Cost of Surety Bonds
Every Surety company's rates differ, however you can find general rules of thumb:
Bid Bonds are usually provided at either a nominal cost or on a complementary basis since the Surety is seeking to underwrite the Performance Bond should the contractor be awarded the project.
Performance Bond premium or fees can range anywhere from 0.5% of the contract's final amount to 2.0% or greater. The 2 main factors affecting pricing are the quantity of the bond as higher amounts usually have lower rates, and the caliber of the risk. For instance, a performance bond in the quantity of $250,000 might carry a 2.5% rate translating to a fee of $ 6,250 versus a $30 million bond at a rate of 0.75% which would cost $225,000.
Even experienced contractors sometimes operate underneath the misconception that bond costs are fixed during the time of these issuance. In fact, a connection premium or fee will often adjust with the ultimate value of the contract. The ultimate value is typically, although not exclusively, greater compared to initial contract amount as a result of work change orders throughout the construction process. It's important for contractors to appreciate the prospect of a negative surprise represented being an increased cost of these bonds. This realization should initially occur throughout the bid preparation process, and whenever feasible, throughout the contract negotiation process contractors should explore the feasibility of addressing any incremental upsurge in bond cost that'll derive from increased contract values due to improve orders effectuated by the project owner.
