Surety bonds – a brief introductory guide

Surety bonds – a brief introductory guide | Insurance Business

Surety bonds – a brief introductory guide

Surety is a form of financial credit known as a bond guarantee. The transaction always involves three parties: the obligee, the principal, and the surety. A surety bond protects the obligee (the party to whom the bond is paid to in the event of a default) against losses, up to the limit of the bond, that result from the principal’s (the party with the guaranteed obligation) failure to perform its obligation. The surety, for example an insurance company, assumes the obligation if the principal cannot.

How do surety bonds work?  

Surety bonds are designed to ensure that principals act in accordance with certain laws. They provide obligees with financial guarantees that contracts and other business deals will be completed in accordance with mutual terms. If the principal breaks those terms, the harmed obligee can make a claim on the surety bond to recover losses incurred. The surety company then has the right to reimbursement from the principal in the case of a paid loss or claim.

Common types of surety bonds

Two of the most common forms of surety are contract surety and commercial surety. A helpful explanation by the Surety Association of Canada describes the two as the following:

Contract surety - Contract surety bonds are used primarily in the construction industry. These bonds protect the owner (obligee) from financial loss in the event that the contractor (principal) fails to fulfil the terms and conditions of their contract.  The obligee is protected against a contractor’s inability to complete a job.

Commercial surety - Commercial surety bonds satisfy the security requirements of public, legal and government entities and protect against financial risk. These bonds guarantee that the business or individual will comply with all required legal obligations.  

Construction bonds

Surety bonds are especially important in the construction industry. They typically come in three types:

  • Bid bonds – these are sometimes required by governments to guarantee that contract bids are made in good faith.
  • Performance bonds – these ensure the construction work will be completed on time and to the required standard.
  • Payment bonds – these give financial protection to subcontractors and others who provide services and
  • materials to the construction company.

What is required of a principal before surety will be granted?

Principals have to show they have good credit and a good reputation before a surety company will grant them a bond guarantee. Surety companies often require principals to show they have the equipment, experience and financial resources to carry out the contractual obligations.

The benefits of surety bonds

Global insurance brokerage, Lockton, describes surety bonds as “one the most cost-effective ways to finance contract security obligations.” The firm explains on its website: “Unlike a bank, surety providers do not require security over your company’s assets and do not require the bonds to be supported by cash or other collateral. This allows you to free up funds, reduce debt and tender for additional contracts. Surety bonds can also represent a cheaper alternative to bank guarantees with lower base rates and no utilisation or line fees.”

How long does a surety bond remain valid?

A surety bond will stay valid for the duration of the contract. It will often extend for a maintenance period, which can sometimes last for a year after the contractual obligations have been met. That maintenance period is built in to protect obligees in case problems arise or something needs to be changed or re-done. It also gives principals a time to object claims over problems or complaints filed by obligees.   

Which global brokers offer surety solutions?

Most of the major insurance brokerages around the world offer surety services, including sourcing surety bonds, providing advice on bond wordings and indemnity negotiation, and arranging bond facilities and ensuring adequate capacity. The following brokers (plus many more) have developed long-standing relationships with some of the world’s leading surety providers:

An alternative to letters of credit (LoC)

Commercial entities are starting to see surety bonds as an attractive alternative to traditional letters of credit (LoC). This is due to concern around interest rates in many global markets, causing companies to look for more reliable, cost-effective credit solutions.

David Hewitt, US Surety Practice Leader at Marsh, told Insurance Business in 2018: “The universe where LOCs are used is huge and the different types of obligations parties are required to meet are almost too many too count. Many who previously looked to manage their risk through an LOC are finding that surety bonds provide a really good alternative in lieu, which often comes at a cost advantage, leaving borrowing space available for other financial necessities.”

Technology in the surety space

In the digital era, more and more contractors are being asked to submit electronic documents to procure work. This means that, in some jurisdictions around the world, surety bonds also need to be submitted electronically. In 2017, Canadian insurer Trisura Guarantee Insurance Company, which focuses on small to mid-market surety business, became the first surety company to deliver an e-bonding platform to facilitate electronic delivery of surety bonds. This idea is starting to catch on in other jurisdictions around the world.