A Surety bond is a contract issued by an insurance company that provides a financial guarantee to an interested party (usually a government agency) that a named person or business will adhere to the terms established by the bond.
Surety bonds have three parties; (1) the person or business required to purchase and file the bond (the “Principal”), (2) the insurance company providing the financial guarantee (the “Surety Company”) and (3) the government agency (or other interested party) requiring the bond (the “Obligee”).
The Surety Company provides the Obligee with a financial guarantee up to the dollar amount of the bond (“penal sum” or “bond amount”) that the Principal will comply with the requirements defined in the bond form. When the Principal violates the provisions of the bond, the Obligee files a claim with the surety company for financial damages and the Surety Company is responsible for making payment to the Obligee. Ultimately, the Principal is responsible for their actions and required by law to reimburse the Surety Company for any payments made under the bond.
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Surety bonds cost between 0.5% and 15% of the bond amount. If you do the math, that’s a pretty large spread. For example, a $20,000 surety bond could cost between $100 and $3,000.
Why such a large rate variation? The cost (“premium”) is determined by the Surety Company after evaluating factors that may increase the risk that a loss may occur. These factors include:
Profession/Industry Risk – The profession of the Principal is an important factor in determining the bond rate. A business that performs high-risk services (e.g. mining or construction) typically pays a larger percentage of the bond amount as a premium than one that performs low-risk services (e.g. insurance adjustment or notary public).
Bond Type Risk – Often closely correlated with profession/industry risk, underwriters will analyze the loss history of specific bonds or categories of bonds; those that have poor track records of losses (i.e. higher frequencies of claims) require higher premiums.
Bond Coverage Risk – The language in the bond form and underlying statutes outline the responsibilities of the Principal and Surety Company. The more stringent the requirements, the higher the surety bond cost. While many bond forms use similar language, each bond form can be customized by the government agency requiring the bond and may contain provisions that increase potential costs for the surety company, which will ultimately be passed on to the Principal via higher bond premiums, stricter underwriting or collateral. The primary provisions of a surety bond that impact cost include: (1) aggregate limits, (2) cancellation provisions and (3) forfeiture clauses.
Principal Risk – Last but not least, Surety Companies assess the risks associated with the Principal purchasing the bond. Because the Principal is expected to reimburse the Surety Company for all losses, their credit history and financial stability are key in determining the final rate offered. Reputation and past performance, which speak to the likelihood of the Principal to incur a claim, are also important indicators of overall Principal risk.
Surety bonds are not an insurance policy. Most people make the assumption that a surety bond is insurance because they are issued by insurance companies and involve payments when things don't go as planned. However, surety bonds and insurance policies are different for four key reasons: (1) the number of parties involved, (2) the protected party, (3) the party responsible for claims and (4) the expectation of claims.
Insurance policies involve two parties: the insurer and the insured.
Surety bonds have three parties; (1) the person or business required to purchase and file the bond (the “Principal”), (2) the insurance company providing the financial guarantee (the “Surety Company”) and (3) the government agency (or other interested party) requiring the bond (the “Obligee”).
Insurance policies exist to protect the insured from loss due to unexpected events such as accidents, medical emergencies, or natural disasters.
The majority of surety bonds exist to deter individuals and companies from violating the law. They protect the Obligee (the party requiring the bond)—and sometimes the consumer—when such violations occur.
When a claim is made against an insurance policy, the insurer pays the claim. The insured is not expected to reimburse the insurance company.
When a Principal fails to meet the obligations of a surety bond, the Surety Company initially pays the claim. However, and this is crucial to understand, the Surety Company requires the Principal to repay the claim in its entirety. In other words, the Principal not only purchases the bond, but is also legally responsible for reimbursing the Surety Company for any claims paid out on the bond.
Insurers expect claims. Premiums pooled from large numbers of policyholders are structured to absorb this loss and to minimize risk.
Surety bonds are primarily utilized to provide financial payment for inappropriate or illegal conduct. Therefore, Surety Companies approach the transaction with the expectation that a claim is unlikely.