Surety Bonds Explained (2024)

Article by: American Global

Surety Bonds Explained (1)

A surety bond is a comprehensive risk management tool used in countless industries across America. Operating as a three-party agreement, it legally binds together a principal that needs the bond to guarantee work it is performing, the obligee requiring this guarantee, and a surety company that sells the bond, guaranteeing the principal will complete its obligations under that contract.

If the principal fails to complete its obligations, the surety will step in to fulfill those obligations according to the terms of the contract and the bond.

There are four main categories of surety bonds: contract, judicial, probate court, and commercial. But with over 50,000 types of surety bonds in the United States alone, 1 requirements vary drastically by state and span across multiple industries, from freight and transportation to mortgage and finance.

One of the most significant users in the surety bond market is the construction industry. Bonds written in this one industry are known as contract bonds, and they make up more than half of the surety premium generated each year. This article will focus on contract bonds and will share generic descriptions of bonds and how they respond. However, actual contract requirements relating to surety bonds and bond terms and conditions may vary.

Construction and Contract Bonds

While there are a variety of contract surety bond types, the three most common types of contract bonds are the following.

  • Bid bonds. These instruments are provided when a contractor bids on a job. They guarantee that if low and selected, the contractor will enter into the contract and provide the required bonds for that phase. If a contractor is low and awarded the job and fails to do so, the surety is obligated to pay the additional costs incurred to use the next responsible bidder for this job.
  • Performance bonds. Assures an owner that a project will be completed within the allotted time, at the agreed-upon price, and per the contract and bond form's terms and conditions. Assures an owner that a project will be completed within the allotted time, at the agreed-upon price, and per the contract and bond form's terms and conditions.
  • Payment bond. Operates in conjunction with a performance bond, ensuring that the contractor/principal will pay covered laborers, subcontractors, and suppliers the money they have earned on this contract to protect its workers and others from nonpayment.

History of Contract Bond Laws

By law, nearly all public construction work projects in America require surety bonds. It is interesting to review the laws requiring surety bonds to guarantee public contracts.

In 1894, Congress passed the Heard Act to protect federal projects from contractor default and protect subcontractors from nonpayment by contractors. The Miller Act supplanted the Heard Act in 1935 and was recodified in 2002, requiring bid, performance, and payment bonds on all public projects above $150,000 and payment protection for contracts between $30,000 and $150,000. Most states have similar legislation; these statutes are known as Little Miller Acts. The bond threshold varies from state to state. 2

How To Qualify for a Bond

Surety bond underwriting is a form of credit analysis that focuses on an evaluation of past performance, financial strength, and a track record of honoring obligations. While specific underwriting standards and requirements vary, each surety ultimately seeks substantiated assurance that a principal operates ethically, performs its obligations, and runs a well-managed, profitable enterprise. Accordingly, before issuing a bond, a surety underwriter will assess its overall risk in extending surety credit by evaluating what underwriters refer to as "the three Cs": character, capacity, and capital.

An Assessment of Character

Despite being difficult to assess, a person's character is often the most critical factor when evaluating a principal and its indemnitors. A surety will be hesitant to issue a bond without forming a positive view of the company owner's good character, even if the capital and capacity for completing a project are there.

In this evaluation, the intent is to determine whether a company and its leaders have demonstrated a strong track record of fulfilling their contractual obligations and will look to the principal's reputation, project success, and operational integrity, such as promptly paying its suppliers, as confirmation. The surety will also expect ready access to a principal's accounting books, records, and other information, so demonstrating characteristics such as communication, trustworthiness, and honesty will be critical.

The following are some common topics for discussion at a meeting with your surety.

  • Review the timeliness of payments to subs and suppliers on an individual project.
  • Do you have past judgments or liens?
  • What kind of reputation do you have within the construction industry?

An Assessment of Capacity

When a surety evaluates capacity, the principal's past track record is reviewed along with current capabilities to complete their projects. To do this, they will want to determine both skills and resources, evaluating specific factors such as equipment and tools, support and leadership staff, crew, best practices, and relevant project experience similar in size, scope, and complexity.

Although a surety will look for trends demonstrating that previously completed projects were both well managed and profitable, they will be especially eager to learn how the principal addressed complex issues or challenges that may have occurred in previous jobs, how those were addressed, and what the outcome was for the job in terms of profitability and how the company fulfilled its required work under that contract. Underwriters know that in construction, every contractor encounters unanticipated challenges; that is the nature of construction. They want to learn how a contractor dealt with those challenges to better understand both their capabilities and their commitment to honor their obligations.

The following are some common questions related to capacity.

  • How do you view your company's knowledge, technical skills, equipment, and personnel? How does that prepare you to successfully complete this project or the larger work program you are pursuing? What are the most significant challenges your company faces right now (for example, hiring labor, costs, or timing of acquiring necessary commodities or equipment)?
  • Please review your estimating and project management team and help us understand how you will be able to perform all the projects you currently have on hand and the new work you intend to pursue while your current backlog is being built?
  • How do you review the work your company is performing to make sure it is being built to ensure you will earn your anticipated profit, or walk us through how and how frequently do you review your work in progress?

An Assessment of Capital

An analysis of current and future capital helps ensure a principal has the financial resources to complete a project and fulfill its contractual obligations. You can expect a surety to evaluate cash on hand, assets, and current lines of credit.

The following are some common questions related to capital assessment.

  • Does your company have financial statements and job schedules prepared by a reputable contractor-oriented certified public accountant firm?
  • Is your company able to operate with sufficient liquidity to cash flow your projects without constant reliance on a bank line of credit?
  • As you pursue a larger backlog, you must demonstrate the ability to cash flow your projects comfortably.

Even after a bond is issued, the surety will continue to monitor these three evaluation factors using financial statements, project status reports, and regular meetings. Although this process for obtaining a bond can be rigorous, the stringency of these underwriting standards is not constant but instead will become more or less stringent depending on the financial and operational performance of the contractor, as well as changes in the surety market cycles.

For example, one can expect strict underwriting, increased premiums, and limited capacity during a hard market where losses sureties are paying for other companies who have defaulted, causing them to become more strict in their underwriting. In contrast, a soft market will accompany a period of relaxed underwriting, reduced premiums, excess capacity, and increased competition among sureties. Understanding these cycles is essential for any player in the construction industry.

Working with Your Broker

While surety support is highly dependent on a firm's business performance, the role of the surety broker is an integral component. As advisers, brokers need specialized knowledge of the construction industry to pick the appropriate surety, best prepare a client for the qualification process, and facilitate a strong, long-lasting partnership with the surety. These recommendations will help you gain control in optimizing those efforts.

Communication Is Key

Commit to communicating regularly and transparently with your surety broker, providing them with timely and accurate financial statements; the best brokers become trusted advisers to their clients. They will help you share news, both good news and the challenges you may encounter, in a way that builds trust and has the best chance to develop a long-term, mutually profitable relationship.

  • Evaluate your broker. Ensure your broker is asking "powerful" questions, taking the time to listen, and keeping your surety underwriter informed.

Utilize Your Broker as a Resource

When finalizing a business plan, share a draft with your broker and, when finalized, spend some time going over that with your underwriter. Both your broker and underwriter may have valuable insights to share that help develop a stronger plan.

  • Evaluate your broker. A good broker will review the terms and conditions of each contract, highlighting areas of concern and, when applicable, provide recommendations for negotiation.

Highlight Company Strengths

Don't presume the surety solely relies on financial results and projections to evaluate risk. Instead, underwriters look at the whole picture, paying careful attention to organizational strength, risk practices, company sophistication, and continuity plans. Sureties certainly evaluate a company's track record of successful performance, but they can also buy into a growth plan so long as it is properly presented to them.

  • Evaluate your broker. Is your broker spending significant time understanding your business and presenting your company's past performance and future plans in a way that best positions you to obtain surety support?

Ask Questions

Surety relationships are a two‐way street. Don't be afraid to ask about a surety's business plan, financial results, and changes in risk appetite.

  • Evaluate your broker. Ask your broker if it might make sense to establish a backup surety relationship. If changes outside your control impact a surety's ability to be responsive, having a broker with an active backup strategy will likely prevent disruption to your business.

Understand the Surety's Credit Model

Financial statements are vital to any business that grants credit, and sureties are no exception. With the help of your broker, you and your accountants can understand how a surety analyzes financial information and which factors they find most critical. Doing so will help you hit specific benchmarks and emphasize crucial points when reporting projections and results.

  • Evaluate your broker. A broker that isn't regularly analyzing and discussing your work-in-progress schedule is missing an opportunity to maximize your surety credit and grow your program.

Measure Your Broker's Value

The cost of using the wrong broker is more than you might think. Wielding a competitive advantage will require a well-positioned broker who specializes in construction and continuously thinks about your business the way you do.

  • Evaluate your broker. Expect more than merely good service and look for a broker who can add to your bottom line. Is your broker a trusted business adviser or merely the person you call to get a bid or final bond?

Conclusion

Maintaining surety capacity sufficient for a growing business plan will require the right partner and basic knowledge of contract bonds, their financial requirements, and the ongoing market cycle. Invest time in the selection of your broker and surety and use them as business advisers, investing time to develop these relationships. The best relationships in this area can last for decades, with all parties enjoying a mutually beneficial relationship.

Final thought: expect more from your broker.

Opinions expressed in Expert Commentary articles are those of the author and are not necessarily held by the author's employer or IRMI. Expert Commentary articles and other IRMI Online content do not purport to provide legal, accounting, or other professional advice or opinion. If such advice is needed, consult with your attorney, accountant, or other qualified adviser.

Footnotes

1 G. Scott Walters and Parker A. Lewton, "Miller Act Bonding: Requirements and Waiver," ConsensusDocs, December 4, 2020.

2 "What Is a Surety Bond?" SuretyBonds.com, accessed on March 28, 2022.

Surety Bonds Explained (2024)

FAQs

How do you explain a surety bond? ›

A surety bond is a three-party written agreement by which one party (the surety) guarantees another party (the obligee) that a third party (the principal) will perform according to the bond, statute, contract or other obligation.

What are the 3 C's of surety? ›

A number of these factors fall under what the Surety industry calls “The Three C's”; Character, Capacity, and Capital. All three of these are important to the underwriting process. The principal needs to exhibit the Character, Capacity, and Capital to qualify for surety credit.

Are surety bonds risky? ›

Surety bonds offer assurance that the contractor is capable of completing the contract on time, within budget, and according to specifications. Specifying bonds not only reduces the likelihood of default, but with a surety bond, the owner has the peace of mind that a sound risk transfer mechanism is in place.

What is a real life example of a surety bond? ›

One of the most common uses of surety bonds is to protect the public, by guaranteeing important obligations will be fulfilled. For example, a construction surety bond will ensure that a building construction project that benefits the public will be completed.

What is the main purpose of the surety? ›

Usually, a surety bond or surety is a promise by a surety or guarantor to pay one party (the obligee) a certain amount if a second party (the principal) fails to meet some obligation, such as fulfilling the terms of a contract.

What are the two common types of surety bonds? ›

There are two main categories of surety bond: Contract Bonds and Commercial Bonds. Contract bonds guarantee a specific contract. Examples include Performance Bonds, Bid Bonds, Supply bonds, Maintenance Bonds, and Subdivision Bonds. Commercial Bonds guarantee per the terms of the bond form.

What is liability of surety examples? ›

Example: S guarantees to C the payment of a bill of exchange by P, the acceptor. The bill is dishonoured by P. S is liable not only for the amount of the bill but also for any interest and charges which may have become due on it. Co-Extensive: The surety is liable for what the principal debtor is liable.

What is the difference between collateral and surety? ›

Collateral is used to support the applicant's indemnity or agreement to repay the surety if the surety has to pay a claim. As a surety bond isn't insurance, the applicant/principal must pay the surety back.

What are the disadvantages of a surety bond? ›

Disadvantages of Commercial Surety Bonds:

Costs and fees: Obtaining a commercial surety bond may involve the payment of premiums and fees to the insurer, which can increase the costs associated with a transaction or project.

Do surety bonds hurt your credit? ›

The answer is no—surety companies perform what is called a soft credit check, which does not affect customers' credit scores. Jet Insurance Company, along with most of the surety industry, runs credit checks through Experian.

Is a surety bond worth it? ›

Surety bonds provide financial assurance for both the obligee requiring the bond and the principal obtaining the bond. They can increase your credibility and the competitiveness of your bids.

What is a surety bond for dummies? ›

A surety bond is simply an agreement between three parties: Principal, Surety and Obligee. The surety provides a financial guarantee to the obligee (i.e. government) that the principal (business owner) will fulfill their obligations.

What is the primary purpose of a surety bond? ›

Surety bonds provide financial guarantees that contracts and other business deals will be completed according to mutual terms. Their primary purpose is to protect consumers and government entities from loss due to poor workmanship, malpractice, theft and fraud.

How are surety bonds calculated? ›

Surety bond premiums (the amount you pay) are often calculated as a percentage of the total bond amount, usually between 0.5% and 5% of the bond amount for applicants with good credit, and between 5% up to as much as 20% of the bond amount for applicants with poor credit.

What is the best explanation of a bond? ›

Bonds are investment securities where an investor lends money to a company or a government for a set period of time, in exchange for regular interest payments. Once the bond reaches maturity, the bond issuer returns the investor's money.

How would you describe the liabilities of a surety? ›

Liability of surety is same as that of the principal debtor. A creditor can directly proceed against the surety. A creditor can sue the surety directly without sueing principal debtor. Surety becomes liable to make payment immediately when the principal debtor makes default in such payment.

What is the bond for surety? ›

A surety bond is a risk transfer mechanism wherein an insurer provides a guarantee to a bene ciary or obligee that the principal or contractor will meet his contractual obligations. In case the principal fails to deliver his promise, a monetary compensation is paid to the obligee by the insurer.

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