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What Are Surety Bonds, and How Do They Work?

For small business owners, surety bonds are a useful tool. They’re a legally enforceable guarantee that allow one party to recoup payment if another party doesn’t fulfill an obligation. Surety bonds have varied applications in the marketplace, like contractors making bids or license requirements. Here’s a look at the most common surety bond types applicable to small business owners, along with how they work and how to tell if you need one.

What are surety bonds?

Surety bonds are legally enforceable three-party written agreements that guarantee compliance, payment or performance. 

There are many surety bond types, but for small businesses, generally, a neutral third party (the surety), acting as the bond’s issuer, guarantees that one party (the principal) will perform the terms of the contract for the other party (the obligee). 

If the principal doesn’t fulfill the obligation, the obligee can file a claim. If the claim is deemed valid, the surety will pay damages, and then the principal will repay the surety. 

A surety bond’s three parties

Here are the three main parties involved in a surety bond:

  • Principal. Purchases the bond that guarantees they’ll fulfill an obligation for compliance, payment or performance.   
  • Obligee. The party that requires the principal to buy the surety bond to guarantee the obligation’s fulfillment. The obligee can be the principal’s client or customer; a court; or a local, state or federal government organization.
  • Surety. The insurance company or surety company acts as a neutral third party in the transaction. The surety guarantees that the principal will perform the obligation and sends a bond certificate to the obligee. If the principal fails to deliver and the obligee files a claim that is deemed valid, the surety company will pay out the claim to the obligee. 

Surety bonds and how they work

Surety bonds help small businesses win contracts by providing the customer with a guarantee that the business will complete the work, according to the U.S. Small Business Administration (SBA). Many public and private contracts require surety bonds, and the SBA guarantees surety bonds for certain surety companies. This allows those companies to offer surety bonds to small businesses that might not otherwise meet the criteria to get a surety.

Aside from strict financial guarantees, some surety bonds are used with contractor agreements, providing guarantees on compliance with permit requirements and licensing on the local, state or federal level. 

Other contract surety bonds required by many project owners and government agencies guarantee that a project or service will be completed as per the agreement’s stipulations and with all required payments made to subcontractors or suppliers.

The SBA guarantees contract bonds but not commercial bonds. The agency explains: “Contract bonds ensure the terms of a specific contract are fulfilled. Commercial bonds ensure all applicable laws and regulations are followed. Government agencies require certain companies or individuals to obtain commercial bonds, which protect the general public against things like fraud.”

FYI: Besides surety bonds, contractors should ensure they have the right contractor insurance policies to protect them.

Major types of surety bonds

Just like there are different types of insurance policies, there are also various types of surety bonds. According to the National Association of Surety Bond Producers (NASBP), these are the most common surety bond types:  

  • Bid bonds. These bonds guarantee that a contractor has submitted a bid in good faith, will honor the bid’s terms, and will provide the required performance. Bid bonds are usually 5%, 10% or 20% of the amount bid. Bid bonds are a way to prevent contractors from submitting low bids to get a job and then raising their prices.
  • Performance bonds. Performance bonds protect a business owner from financial loss if the contractor fails to perform the contract in accordance with its terms and conditions, including its specifications and plans.
  • Payment bonds. A payment surety bond guarantee assures that the contractor will pay specified subcontractors, laborers and material suppliers associated with the project.

Other surety bonds

These are some other surety bonds used in small business projects and operations:

  • License bonds (permit bonds). Local and state governments often require license bonds when a contractor or business offers a service to the public. This type of bond guarantees the business owner will conduct their business in compliance with all local, state and federal regulations. License bond costs are typically 1% of the total bond amount. 
  • Construction bonds. A construction bond, or contractor license bond, is a type of license bond required to start a construction project. It provides assurance that the contractor will perform in accordance with the construction agreement.
  • Completion bonds. These offer assurance that a contractor will complete a project on time, within budget and free of liens. Otherwise, a claim can be filed to compensate the obligee.
  • Payment bonds. Payment bonds guarantee that the principal will pay for all associated work in connection with the contract, including subcontractors and all required materials and supplies.
  • Ancillary bonds. Ancillary bonds guarantee that the principal stands by its work and will provide maintenance or corrections in a timely manner.

Did you know?Did you know? Insurance companies often write surety bonds, but surety bonds don’t perform like policies you’d get from the best liability insurance providers, where an aggrieved party files a claim. After a principal buys a bond, the insurance company doesn’t assume the risk. The principal still holds all the risk and has to repay the surety if the company pays out a claim related to the principal not delivering upon the agreement.

Who needs a surety bond?

Various small business types will deal with surety bonds. Some surety bonds fulfill a professional license (under commercial surety bonds), and some enforce construction terms (under contract surety bonds). 

In general, any business that works under a contractual agreement with another party, or provides a public service, could be required by the obligee to obtain a surety bond. 

According to providers, common surety bonds (commercial surety bonds) used within professional industries to meet certain obligations, such as obtaining licenses (other than construction as discussed earlier in this article) include the following:

  • Auto dealer license surety bonds
  • Real estate broker surety bonds
  • Credit repair service surety bonds
  • Mortgage broker and loan originator license surety bonds
  • Public insurance adjuster license surety bonds

How long does it take to get a surety bond?

The time it takes to get a surety bond depends on the entity providing the bond. However, applicants that use online providers with quick quotes and streamlined applications can apply and get approved on the same day if they have their documents ready. They can receive the surety bond as soon as the next day. 

TipTip: When applying for a surety bond, be sure you know what bond the obligee is requiring, as well as the name of the business, the number of years in business, and the names and addresses of the parties in the agreement. Also make sure you have your Social Security number on hand.

How long does a surety bond remain valid?

A surety bond’s validity period depends on the specific bond needed. Many surety bonds have a set term period with an expiration date, which can be renewed for another term with a reevaluation of the principal and credit risk. This is common for surety bonds needed for professional licenses or permits. 

Typically the set time period ranges from one- to two-year terms for these types of bonds, and the premium could increase or decrease upon reevaluation of the principal. 

With contract bonds, the principal must renew the bond until the obligee releases them, usually at the job’s satisfactory completion. Upon renewal, there’s generally no reevaluation of the principal. During renewal, the principal must pay the premium, or the account could end up in a collections department. After the bond is renewed, it’s active for 12 months.

How much do surety bonds cost?

Although prices may vary, the surety bond’s premium is usually a percentage of the bond’s coverage amount. Once underwriters review your application, they’ll assign it a risk category with an associated premium amount. 

Surety Bonds Direct says its final premium amount is determined by several factors:

  • The coverage amount required by the bond
  • The type of surety bond
  • The applicant’s credit score
  • The applicant’s financial history

Several bond providers note that quoted contract bond rates usually reflect the bond’s size and the contractor’s financial stability, experience and reputation. Typically, contract bonds cost between 1% and 3% of the contracted amount or, for larger bonds, are tiered based on the size of the bond.

Surety Bonds Direct estimates that commercial license and permit bonds have a statutory amount (coverage) that usually ranges from $5,000 to $100,000. According to the bond provider, contract surety bonds typically range from about $50,000 to several million dollars based on the size of the construction project to be bonded. The states with the most surety bond requirements are California, Florida and Texas.

Finding a surety provider

To help you find a surety provider, the NASBP offers the online Surety Pro Locator, where you select your state or country to find bond producers near you.

Also, the SBA guarantees contract surety bonds for private surety companies. To learn more and find out if your small business qualifies (up to $6.5 million for non-federal contracts and up to $10 million for federal contracts), visit the SBA surety bonds page, where you can also find authorized agents. 

When searching for a surety bond provider, consider the financial health of the company providing your bond before making a purchase. AM Best Rating Services is a great place to find surety bond ratings. Bonds with an A++ or A+ have superior financial health and the ability to meet their obligations. 

Source: on 2021-10-06 12:18:45

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