As many contractors know, starting a large construction project isn’t as simple as having your crew show up to the job site to begin work. There is a lot more involved in acquiring the appropriate permits, licensing and legal documents in order to be granted permission to start. To add to the pile of paperwork, surety bonds are usually the starting process to not only begin construction work, but it’s also required of many businesses prior to opening their doors. Although they are a necessity for a wide-range of industries many still ask, what is a surety bond?
Simply put, surety bonds are a three-party agreement, which consists of an obligee, principal and surety company. The surety agency assesses the financial stability of the person obtaining the bond (the principal), and if approved assures the obligee (the party requiring the surety bond) that he/she will hold to the terms specified in the contract. If the principal should default on the agreement in anyway, the surety agency is responsible for payment of financial damages.
In general the surety bonding process can seem overwhelming and confusing, leaving purchasers with questions swirling in their heads. To help clarify the most common concerns raised during the bonding process, we’ve put together the five most common misconceptions in acquiring a surety bond.
Surety bonds are another form of insurance.
Although they both serve to protect parties in an agreement, there are several differences between surety bonds and insurance. With insurance, risk is assigned to the insurance company that is protecting their customer. However, with a surety bond the risk remains with the principal – or the party purchasing the bond and the protection is for the obligee, or the person requiring the bond. Should the principal default on an aspect of their contract, the surety company will provide financial compensation to the obligee and then refund the damages from the principal.
Another major difference between surety bonds and insurance are how rates are determined in pricing structures. Unlike insurance, surety bond rates are not contingent on one’s past history. For example, many insurance policy premiums are determined based on an individual’s claim history. Those fortunate enough to have a flawless record are almost guaranteed to pay the lowest rates for their policies. However, surety bond costs are not written in the same manner as insurance policies. Rates are based upon one’s financial history, credit, and amount in liquid assets. Unlike insurance which is acquired to help in times of loss, bonds are written with the assumption no losses or claims will be filed. The premiums paid by principals for surety bonds are seen merely as service charges, while the surety company serves as the financial guarantor of the project. Because of this, those who have acquired a surety bond and had a claim filed against them, it is likely they won’t be approved to purchase a surety bond again.
Surety bonds protect the purchaser of the bond.
The main service of surety bonds is to protect the person requiring the bond, not the individual who is obtaining it. In surety terms, the person who requires the bonds is the obligee while the purchaser is the principal. Although principals pay a premium to obtain a surety bond, they do not receive protection. Rather, the obligee will be awarded financial compensation should the principal default on the agreement.
Performance and payment bonds serve the same function.
Even though they are typically acquired together, performance bonds and payment bonds are two separate entities. Payment bonds ensure that principals will compensate all laborers on the project. This includes subcontractors and material suppliers.
A performance bond guarantees the principal will perform the work on the project as specified in the contract.
Principals are expected to pay for the bond in full.
Depending on a principal’s financial history, he/she may only be required to pay an annual premium to acquire a surety bond. The amount individuals are expected to pay at once and annual varies by bond type and whether they are considered a bad credit surety bond applicant.
Surety bonds can be used from state to state.
Just as each state has its own set of laws surety bond regulations also vary from state to state. The easiest way to determine your bonding needs is to research your state’s requirements or speak to a reputable surety bond agent.