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Common Insurance Terms – What is a Guarantee Bond?

July 18, 2012

If you will remember, we’ve been talking lately on the Avanti Reader about bonds. Here at Avanti, we’re always fielding questions from business owners about different types of bonds and why they are required to conduct business in certain industries. Our hope is that, by offering a bit of basic knowledge about the most common bond types, we can empower business owners and ensure that they seek an appropriate amount of protection from unwanted risks.

Last week, we discussed surety bonds in general. This week, we’ll be talking about a specific subcategory of surety bonds called “guarantee bonds.” Quickly recall that a surety bond has at least three parties: the obligee, the principal and the surety. A guarantee bond obligates the surety to pay a certain amount of money if the principal does not perform its obligation under a contract. Thus, the main purpose of a guarantee bond is to act as a guarantee from a surety to the beneficiary of some contract (the obligee) that a contractor (the principal) will perform their obligation under the contract and abide by the contract’s terms.

This may bring to mind last week’s example of the general contractor hired to build a construction project, and you’d be right. In fact, guarantee bonds are used extensively in the construction industry to protect the terms of intricate, high-value contracts, where straying from such contracts can have disastrous financial results. Specific examples of guarantee bonds used in the construction industry include:

Bid bonds that guarantee a contractor will enter into a contract if awarded the bid,

Performance bonds that guarantee a contractor will perform the work as specified by the contract, and

Maintenance bonds that guarantee a contractor will provide facility repair and upkeep for a specified period of time.

These types of guarantee bonds from the construction industry are useful in that they help to explain why guarantee bonds can be extremely hazardous for the surety and why they are very carefully underwritten.

In a way, it would be easier to write insurance policies and bonds if underwriters could assume that everyone was honest, predictable and motivated by the best of intentions. Unfortunately, we all know this isn’t the case. That’s why you’ll hear insurance professionals use the term “moral hazard” to refer to those gray areas where the terms of a contract may give rise to abuse. Simply put, we don’t want the tools of our trade to incentivize bad behavior. This is a big concern with guarantee bonds. Consider the case of a general contractor who bids on a job and does not complete it on time. If the surety will pay the cost, why should the contractor bid correctly or pay extra labor to fulfill the contract? Without a personal financial guarantee on the part of the contractor, there is a huge moral hazard for the insurance company. This is why guarantee bonds often allow the surety to come back to the principal, or to the principal’s owners, and seek reimbursement for any amount paid out to the obligee. Now consider, on the other hand, the case of a dishonest obligee who sets up a contractor to default on an obligation, forcing a claim against the bond. It’s precisely because there is a potential for abuse on both sides that a guarantee bond is very carefully underwritten.

A great resource for further reading on all things surety bonds is The Surety and Fidelity Association of America. For more info, be sure to follow our Blog via RSS or connect with us on Twitter or Facebook to get automatic notification of our latest posts. Thanks for reading.

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. 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.

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