Understanding Surety Bond
Surety bonds are required for businesses that have relationships with suppliers, vendors, or subcontractors.
A Surety Contract Defined
Surety bonds ensure that one party will meet its bonded obligations to another. In contrast to an insurance contract, a surety bond involves three parties: the Principal, the Obligee, and the Surety.
With a surety bond, the Principal is guaranteeing payment or performance of its bonded obligation to the Obligee. The Surety, or bond issuer, evaluates the Principal's ability to fulfill its promises and agrees to compensate the Obligee for financial loss if the Principal fails to deliver.
Consider the following scenario involving a general contractor and a flooring subcontractor to better understand how a surety bond ensures the performance of a bonded Principal:
A general contractor (Obligee) requires a flooring subcontractor to install commercial carpet and tile in a newly constructed office building.
The flooring subcontractor (Principal) is expected to finish the job by a specific date.
After analyzing the Principal's financial position, performance history, and prior business relationships, the insurer (Surety) guarantees the Principal's performance.
If the Principal fails to fulfill its contractual obligations, the Obligee may incur additional costs or suffer losses as a result of project delays or having to replace the subcontractor. A surety bond would cover these losses in part or entirely. The surety has the right to seek compensation for its losses through the indemnity agreement signed by the Principal.
An Obligee is typically a business owner, project owner, or general contractor who requires assurances that a subcontractor, supplier, or service provider will fulfill its contractual obligations. The Obligee is the party who requests the bond from the Principal and would be compensated by the Surety if the Principal failed to meet its contractual obligations. In the preceding contractor example, the general contractor (Obligee) stands to lose money and reputation if the flooring subcontractor (Principal) fails to complete its work.
The Principal is the entity that either provides goods or services to a customer or manages or oversees projects on their behalf. The flooring subcontractor would be the Principal in the context of the contractor example above because it is the party required to provide a guarantee to the Obligee and whose performance is guaranteed by the Surety.
In turn, the Principal applies to the Surety for a bond that guarantees timely delivery and performance on the part of the Principal. Before issuing this type of performance bond, the Surety investigates the Principal's financial records, business references, track record, and reputation, among other things.
If the Principal fails to perform the contracted services and the Obligee files a claim, the Obligee may use claim payments from the Surety to complete the work in accordance with the contract's specifications.
The entity that issues the bond is known as the Surety. The Surety's first step in the bonding process is to gain a thorough understanding of the Principal's business from multiple angles. In this manner, the Surety makes an informed decision about the Principal's ability to successfully carry out its contractual duties and obligations.
Typically, the Surety maintains a team of experts in each industry for which it issues bonds. The Surety is able to quickly assess the performance risk and prequalify the Principal due to this specialized knowledge.
Businesses seeking surety bonds frequently look to Sureties with a local presence in their markets. This enables the Surety and the bond applicant (Principal) to establish a long-term business relationship.