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WHAT IS A SURETY BOND?
First off, what exactly is a surety bond? A surety bond is an instrument/agreement/contract among at least three parties:
- The principal - the primary party who will be performing a contractual obligation
- The obligee - the party who is the recipient of the obligation
- The surety - who ensures that the principal's obligations will be performed.
Through this agreement, the surety agrees to uphold—for the benefit of the obligee—the contractual promises (obligations) made by the principal if the principal fails to uphold its promises to the obligee. The contract is formed so as to induce the obligee to contract with the principal, i.e., to demonstrate the credibility of the principal and guarantee performance and completion per the terms of the agreement. Surety bonds consist mainly of 4 sub-group of bonds: These 4 sub-groups are commonly known as commercial bonds, court/judicial bonds, contract bonds and subdivision bonds. Commercial bonds usually consist of license and permit bonds and they gurantee the honest and faithful performance of the terms of the bond forms with respect to the particular license or permit that the principal has obtained. Example of commercial bonds are contractor's license bonds, tax preparer bonds, defective title bonds and broker bonds. Contract bonds guarantee a specific contract. Examples include performance bonds, bid bonds, supply bonds, and payments bonds. Court/judicial bonds are required in many court proceedings to ensure that one is protected from possible loss as a result of the outcome of the proceeding. Lastly, subdivision bonds are required by developers to guarantee performance for subdivision projects. These bonds are often referred to as "subdivision bonds", "performance bonds," "site improvement bonds," "completion bonds," or "plat bonds."
How is a surety bond different than an insurance policy? While a surety bond is indirectly an insurance product for the obligee, a surety bond is completely different than a traditional insurance policy in that a surety bond is a 3 party instrument /agreement /contract where as an insurance policy is mainly a 2 party instrument/agreement/contract. In a standard insurance policy, it is a legally binding contract/agreement between an insurance company and the person who buys the policy, commonly called the "policyholder, who also is often the person insured. In exchange for payment of a specified sum of money, called the "premium," the insurance company agrees to pay for certain types of loss or damage as specified by the contract. When a loss occurs which meets all of the requirements described by the terms of an insurance policy, the loss is said to be "covered" by that policy. In a surety bond, it is a straightforward three-way agreement with a surety company guaranteeing that an individual or company (the bond principal) will do exactly what it commits to its customer (the obligee). If the bonded individual or company does not fulfill its obligations, the surety company will compensate the customer for the loss. Another major distinction between a surety bond and a traditional insurance policy is with respect to how a loss is handled. In an insurance policy, the insurance company has already factored in a certain amount of loss, where as with surety bonds, they are underwritten with no expectation of a loss. In our example, we will assume that the insurance company will sell 100 policies for a combine premium of say $1,000,000. The insurance company will then assume that only 5 policies will incur a loss totaling say $800,000 and that the insurance company's overhead will be another $100,000 thus giving the insurance company a profit of $100,000. If the policyholder incurs a lost in an insurance policy, the results will be that the insurance company will increase the premium that the principal/policy holder must pay for their next policy. In a surety bond, the surety company issues the bond under the assumption that no loss occurs. When a loss does occur, the surety company must pay out on the bond and goes back to the principal to make the surety "whole" again. That is if the surety incurs a total payout of $100,000 on the bond, the surety company will go after the principal to collect the $100,000 that was originally paid out on the bond. The principal will then not be able to obtain anymore bonds until that $100,000 is paid back to the surety company. Even if the principal is able to pay back and make the surety company whole again, there is a possibility that the principal will not be able to qualify for another bond with that surety company.