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Common Insurance Terms – What is a Surety Bond?

July 10, 2012

One of the most common questions we get at Avanti from the owners of young businesses is “What is a bond?” Most professional businesses need to pay a bond in order to receive a business license, but it can be difficult to find information on exactly what a bond is, especially on the internet. Some of this confusion arises because the word “bond” can refer to many different types of contracts, including bail bonds and the financial bonds used as investment tools. Our purpose here is to differentiate these types of “bonds” from “surety bonds,” the type of bond that most concerns start-up businesses applying for business licenses or permits.

The Surety and Fidelity Association of America offers a reliable source for information on surety bonds. The terms of individual surety bonds may vary in price and complexity, but the core purpose of such bonds is essentially the same. A surety bond is a contract among at least three parties:

The Obligee The party who is the recipient of an obligation.

An example would be the purchaser of a construction project.

The Principal – The primary party who will be performing the contractual obligation.

This would be the contractor hired to construct the project.

The Surety – Who assures the Obligee that the Principle can perform the task or else promises to offer restitution should the Principle default on their obligation.

This could be an insurance company or other financial institution that promises to pay a monetary sum in the event our contractor fails to live up to his end of the contract and deliver on the project.

In effect, then, a surety bond acts like other forms of insurance in that it shifts the risk of a loss (the risk associated with entering into a failed contract) from one party (the Obligee) to another (the Principal) in exchange for payment (the Premium) to an intermediary (the Surety). In the event that the Obligee suffers a loss and makes a claim to the Surety, the Surety will investigate it. If it turns out to be a valid claim, the Surety will compensate the Obligee up to the bond amount and then look to the Principal for indemnification of any additional costs, including legal fees. If need be, this collection can take the form of a lien against personal property owned by the Principal. That way, the Principal suffers the consequences of its breach and not the Obligee.

A key term in nearly every surety bond is the “Penal Sum”. This is a specified amount of money which is the maximum amount that the Surety will be required to pay in the event of the Principal’s default. This allows the Surety to assess the risk involved in giving the bond; the premium charged is determined accordingly.

A Surety underwriter may also look closely at the Principal’s finances and at the personal property of its owners when evaluating a risk. This is normal. During the assessment process, the Surety underwriter needs a full financial picture of where it can seek indemnification should a Principal’s default produce costs over and above the bond amount.

That’s all well and good, you may say, but you’re talking about a bond between two private parties. What does this have to do with my business paying a bond to the government? Well, in the case of a new business applying for a license, you assume the role of the Principal purchasing a bond whose benefit will be held by the local, state, or federal government (who becomes the Obligee). This bond ensures that you will abide by all local, state, and federal laws and regulations governing your industry. In the event you break the law, the Penal Sum paid by the Surety will help to defray any costs the Government faces in righting your wrong. That way, your business is held financially responsible for its actions and not taxpayers.

A Quick Caveat: The information provided in this post should not be construed as professional insurance or business management advice. We seek only to offer a basic understanding of the risk management tools business owners are bound to encounter. Surety bonds can be vastly different in scope and operation, and decoding the complexities of these instruments is a job best left to your insurance broker or financial agent. That being said, if you enjoy the discussion of such common insurance definitions join us next week when we’ll be discussing “guarantee bonds.” You can also follow our Blog via RSS or connect with us on Twitter or Facebook to get automatic notification of our latest posts. Thanks for reading.

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