Surety bonding is a type of collateralized financial obligation that insurance companies, banks, and other entities may require. A surety bond is a signed contract between the principal (the entity requesting the surety bond) and an insurer. The principal is referred to as the “surety” and the insurer is known as the “principal” or “creditor” in this context. If you have ever purchased car insurance or homeowner’s insurance, you are likely familiar with what a deductible is. A surety bond functions similarly, in that it reduces the risk for the creditor in exchange for money from the principal (you). In this blog post, we will go over what exactly a surety bond is and why they are important when underwriting new business ventures.
What is a Surety Bond?
A surety bond is a type of collateralized financial obligation required by many entities. A surety bond functions similarly to insurance, in that it reduces the risk for the entity requesting it (the creditor) in exchange for money (premium) from the principal. This is why they are referred to as “financial guarantees”. A surety bond is an agreement between the principal and the surety company. The specific details of each agreement vary depending on the type of bond. The surety bond obligates the surety to compensate the creditor in the event that the principal defaults on whatever agreement the bond was used to facilitate. This could be one of many different types of agreements, including but not limited to Contract Bonds, Performance Bonds, License Bonds, and Insurance Bonds.
Why do Entities Require Surety Bonds?
Entities require surety bonds as a type of security to mitigate their risk of doing business with other parties. This is common in industries where there are a lot of contractors and builders, as well as in the construction, financial, and insurance industries. For example, a construction company may require a surety bond from a contractor bidding on a project to ensure that the contractor will complete the project correctly and if need be, pay back the project investors in full. A surety bond is used to mitigate the risk that a contractor won’t be able to finish the job correctly or finish the project in a timely manner. In this situation, a contractor’s surety bond acts as collateral. In the event that the contractor fails to complete the job correctly and on time, the surety bond would pay the project investors.
Types of Surety Bonds
- Contract Bonds: Contract Bonds cover damages related to a contractor’s failure to complete a construction project correctly. These are typical in the construction industry, but also applicable to other industries.
- Performance Bonds: Performance Bonds are used to ensure that a vendor, contractor, or supplier will complete a project correctly and on time. This is often used in industries such as the construction industry, telecommunications, and the oil and gas industry.
- License Bonds: License Bonds are used to protect a licensing authority, such as a government agency, from being defrauded or otherwise defying the law. This type of bond is often used in the medical, childcare, and real estate industries.
- Insurance Bonds: Insurance Bonds are used to protect policyholders in the event that a company goes out of business or is no longer able to pay claims. This is done by requiring insurance companies to post a surety bond.
When Should You Use a Surety Bond?
Depending on the type of business you are opening, you may need to post a surety bond. You can typically ask your underwriter ahead of time, but below are some general guidelines:
- If your business is receiving financing from a bank, you will likely need a surety bond.
- If you are working on a large, multi-state project and will be contracting with another company, you will likely need a surety bond.
- If you are in a regulated industry like healthcare, telecommunications, or finance, you will likely be required to post a surety bond.
Final Words: Understanding the Importance of Surety Bonds
The main purpose of surety bonds is to protect and indemnify your business partners. Once you have established trust with all the people you do business with, it makes the entire process a lot easier. Additionally, using surety bonds will increase your chances of getting approved for a business loan. If the company you are applying to borrow money from is under the impression that you are reliable and trustworthy, they will be more likely to give you the money you need. If you are applying for a loan from a bank or another type of financial institution, it is important that you make sure you have a strong surety bond.