A bond is issued by an entity “the Surety” on behalf of a second party “the Principal”, guaranteeing that the second party will fulfill an obligation or series of obligations to a third party “the Obligee”. In the event that the obligations are not met, the third party will recover its losses via the bond.
While Surety bonds are typically issued by an insurance company, they are not insurance. It is financial assurance given by a Surety to an Obligee (typically a government entity) ensuring that money damages will be paid in the event that the Principal either defaults, fails to uphold its promises, or becomes insolvent.
Surety bonds are required for many government jobs, construction jobs or by the court. Additionally, certain industries are also required by federal, state, or local governments to have bonds before a business license will be issued in order to protect its citizens.
The principal pays a premium in exchange for the surety’s commitment to guarantee a bond(s) to an Obligee. If the principal defaults and the surety turns out to be insolvent, the bond worthless. Which is the reason why insurance companies, whose financial strength and solvency is verified by private audit and/or governmental regulation, are typically granted licensing and authority to underwrite Surety Bonds.
In the event of a claim, the surety will investigate, pay, and typically seek reimbursement from the principal for the claim amount paid plus legal fees incurred. In some circumstances, when the principal is unable to fulfill its obligations, the surety has chosen to “Subrogate” which includes substituting for the principal in order to fulfill the terms of an obligation and/or recovering damages.
A bond is typically purchased via local insurance agents who represent the surety. However, many insurance companies have begun to issue Surety Bonds directly to Principals in an effort to reduce risk and commissions paid to agents. Bond costs vary dependent on bond type, the Principal’s credit history, financial performance, and many other factors that are taken into consideration by underwriters. In addition, fees may be assessed by the Obligee and/or the Surety. But typically, the cost (referred to as “the Premium”) is usually between 1 and 4 percent of the total bond amount needed (also known as “the Penalty” or “the Penal Sum”).