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Bonds Information

What Are Surety Bonds?

Surety Bond Definition

Surety bonds are often mistaken for insurance. However, surety bonds are different from insurance, from the way they work to how they are underwritten.

So what are surety bonds? In simplest terms, a surety bond is a guarantee. What the bond is specifically guaranteeing is determined by the bond language. It is important to know that surety bonding differs from insurance in that there are three parties involved.

The first party, referred to as the principal is the party that needs to be "bonded". The second party, called the obligee is the party requiring the bond of the principal to guarantee something. Usually, the obligee is a department within the government. The third party is the bonding company, also known as the surety or carrier. The surety is the party providing the financial backing to make good on any claims that might arise.

How Surety Bonds Work

So let's take a look at all parties involved using an example. A license & permit bond is a common bond type, which will serve as a good generic example. For this scenario, we will assume the state of Utah is requiring a bond of an auto dealer in order to become licensed to operate within the state. The Utah Department of Motor Vehicles is the obligee and the auto dealer is the principal. The auto dealer must obtain the surety bond from an acceptable bonding company. In this case, the bonding company is making a written guarantee to the state that the auto dealer will operate per the terms of the license. Should the auto dealer breach the states regulations, the Utah DMV can place a claim against the bond.

In the event a claim is paid out by the surety, they will pursue the auto dealer for repayment of all costs associated with the claim, including...legal fees! This may come as a surprise, but remember, bonds are not insurance. Suretyship is more a form of credit than insurance. Prior to issuing the bond, the surety will require the principal to sign an agreement for corporate, personal, and spousal indemnification. This indemnity agreement states that the surety shall be held harmless and the principal is fully responsible in the event of a claim.

At this point you may be asking yourself, if the principal ultimately is going to pay for claims, what is the point of the bond? The answer becomes clearer when you look at the most commonly accepted alternative to surety bonds, the irrevocable letter of credit or ILOC. Surety bonds approved in standard markets are typically about 1-3% of the bond amount annually. A letter of credit typically requires a 1% fee. However, surety bonds usually require no collateral whereas a letter of credit almost always requires a full 100% collateral. This difference can greatly change the amount of working capital the principal has available.

Comparing Surety Bond Alternatives

At first glance, it seems surety bonds are more expensive. However, one could invest the liquid cash that would otherwise be frozen by the bank. Doing so easily covers the bond premium, making it less expensive than the letter of credit.

If a claim does arise, bonding companies have claim professionals that will properly investigate claims to ensure they are valid prior to paying the obligee. On the other hand, a bank is not staffed to handle claim situations and will be quicker to pay any claims using the principals' frozen assets.

Obviously, surety bonds are the preferred choice hands down. Suretyship is a form of credit, but does not affect your credit rating whatsoever. An ILOC equates to the principal paying a fee to the bank to guarantee the freezing of their own assets.

Surety Bonds   ILOC
  • 1-3% Fee
  • No Collateral
  • No Impact On Liquidity
  • 3%+ Interest
  • Backing of Surety Claims Professionals
  •  
  • 1% Fee
  • 100% Collateral
  • Reduced Liquidity
  • 0% Interest
  • No Claims Support
  • So let's review!

    1. A surety bond is a guarantee of something
    2. There are three parties involved: principal, obligee, & surety
    3. A surety bond is not insurance, but a form of credit
    4. Surety bonds are the best choice

    Contact us today to talk to a professional agent to help you make sense of it all and sort through your options.