A surety bond is a way of ensuring that a business completes the work it was hired to do. If it doesn’t, the bond’s guarantor is financially liable to the customer.
Surety bonds are sometimes referred to as business bond insurance and can be purchased from business insurance companies. You may need a surety bond to meet requirements on government contracts if you run a construction company. Other businesses, like auto dealerships and liquor stores, also need surety bonds to comply with licensing and permitting laws.
What is a surety bond?
A surety bond is a written agreement that guarantees a task or service will be completed in accordance with the terms spelled out in the bond. The three parties involved in a surety bond are:
Obligee: The party requiring a guarantee that work will be performed according to certain terms.
Principal: The business that is hired to perform work according to the terms of the bond.
Surety: The entity issuing the bond and guaranteeing that the principal will meet its obligations. The surety, typically an insurance company, is financially responsible to the obligee if the principal fails to meet obligations.
How do surety bonds work?
Here’s an example of how a surety bond works:
Your company is hired for a job. Say a local government agency hires you to build a road.
The government agency wants a guarantee that work will be completed in a certain time frame and in accordance with local laws. In this example, the agency is the obligee and you are the principal.
You enlist a third company, known as the surety. The surety writes an agreement or bond, guaranteeing the work will be done according to the terms spelled out in the bond. The surety’s role is to assure the government agency that you will complete its work as agreed.
The surety compensates the obligee if needed. If you don’t finish the project correctly, the surety will be financially responsible to the government agency. The surety then recoups its costs from you.
What are surety bonds used for?
Surety bonds are used to guarantee that businesses will complete the job they were hired for following certain rules or within a particular time frame.
If you run a small business, a surety bond can help you compete for contracts with larger, more established players. First, by issuing you a bond, the surety confirms that your business meets its underwriting criteria, which include the credit profile of the business, its capacity to meet the obligations of projects, and its character or reputation.
Second, a surety bond reduces the financial risk to the obligee of working with a smaller company because it acts as a guarantee that the obligee will recoup losses if the principal fails to finish the job.
Once a surety agrees to guarantee a business, the relationship can last a long time, over several future projects.
Types of surety bonds
Thousands of types of surety bonds exist, depending on the type of work involved or state or local laws. According to the National Association of Surety Bond Producers, a trade association, there are two main types of surety bonds: contract and commercial.
Contract surety bonds are meant for construction projects, so they are also known as construction bonds. The obligee and principal in this case are the project owner and a contractor hired to carry out the project. Within contract surety bonds, there are four subtypes:
Bid bond: This type of bond covers the project owner if a contractor wins a project bid but does not end up signing a contract.
Payment bond: This bond guarantees a project owner that a contractor will pay bills for labor and materials or to subcontractors and suppliers.
Performance bond: This bond assures the project owner that if a contractor does not perform the work, the surety will find another contractor to ensure the project is completed according to the contract.
Warranty or maintenance bond: The project owner is protected against any material defects or workmanship issues that may be found during the warranty period.
Commercial surety bonds are typically required by federal, state and local governments to ensure work is performed according to specific regulations or to protect public interest. For small-business owners, the most relevant types of commercial bonds are license and permit bonds, which are required by government agencies as a condition for obtaining a license or permit. Professions that may require license or permit bonds include auto dealers, plumbers, liquor store owners and mortgage brokers.
How to get a surety bond
Businesses can buy surety bonds from many construction business insurance companies, including:
Travelers was the largest writer of fidelity and surety bonds by premium value in the first half of 2021, according to the Surety and Fidelity Association of America.
The Hartford has a dedicated bond division that can issue commercial as well as construction surety bonds.
Nationwide offers commercial, construction, and court surety bonds, along with fidelity bonds.
You’ll need to find an independent insurance broker or agent near you to purchase a surety bond from these insurance companies.
The Small Business Administration also guarantees some types of surety bonds. This way, the SBA will reduce the risk for a surety company so that it can offer bonds to more small businesses. The SBA charges the business a small fee — 0.6% of the contract price — for performance and payment bond guarantees.