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Performance Bonds and Payment Bonds – The Performance Bond Experts
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Last Updated: August 12, 2017. Simply put, it’s a bond issued by a surety company (think large insurance company) that guarantees the satisfactory completion of a project or a job (i.e., a construction project).
We are the nation’s leading provider of performance bonds and bid bonds. Our expertise spans the entire range of bonds and we’ve worked extremely hard over the years to develop deep relationships so that we can offer you the absolutely best bond rate available. We work with you to present the best case scenario to the surety bond company. Then, we utilize our deep relationships with those companies to get the right bond suited for your specific needs.
How are we able to do this? Through a lot of hard work.
That’s how we’re successful. That’s why we’re the best. Hard work. Dedication. Experience. We’re the EXPERTS when it comes to bonds. Apply today by clicking the Apply Online box below:
Here are some of the most Frequently Asked Questions that we got about Performance Bonds
What does it cost? Can I get one with bad credit?
The cost can vary widely from company-to-company, but some general guidelines are that the rate is 3% for all bonds that are $250,000 and less. For bonds over this amount, we use a graduated scale for the bond rate. In general, most bonds are going to cost between 0.75%-3%. For companies with bad credit, the bond rate can be higher as there is more work involved to get a bond issued (and that work is much preferred to an expensive bank guarantee). We work with you to present your financials in the best light to the surety so that you can get on with your work.
What is a Payment Bond?
Payment bonds are a subset of surety bonds. These bonds are typically required on construction projects (and many times are required along with a performance bond). They provide assurance that the contractor (also known as the obligee) will pay all laborers, material supplier and contractors. Thus, the owner of the property knows that there will not be a mechanic’s lien placed on the property (which would interfere with their ability to market the property once the project was completed).
What is the difference between a payment bond and performance bond?
This may be easiest to explain with a good example.
Let’s assume that Gotham hires Falcone Contracting as the general contractor to build a mental hospital (and let’s call that facility, um, Arkham Asylum). Falcone Contracting then hires several other subcontractors to work on Arkham, such as Joker Construction, Penguin Plumbing and Supply, and Mr. Freeze’s HVAC.
Let’s further assume that after constructing half of Arkham, Falcon Contracting goes out of business, leaving the other half to be finished later. Further, let’s assume that 20% of what was actually done was defective (10% of the total). Finally, let’s assume that Falcone Contracting did not pay Joker, Penguin for their work at all, and only paid Mr. Freeze for his labor, but not his supplies.
The performance bond would protect the owner (in this case, the city of Gotham) from the non-performance of Falcone Contracting, as well as the defective work of Falcone. Thus, the surety would have to find someone who would fix the 10% completed as well as complete the remaining 50% of the project (or pay damages to Gotham in the amount of the bond). However, the performance bond would not provide any protection for Joker, Penguin or Mr. Freeze. They would be forced to put a mechanic’s lien on Arkham.
Fortunately, Gotham was smart about this. Not only did they require Falcone to get a Performance Bond, but they also required them to get a Payment Bond. Thus, the surety company now has to pay Joker Construction, Penguin Plumbing and Supply in their entirety, and Mr. Freeze’s HVAC for the materials that they purchased.
How are Claims Made on Performance and Payment Bonds?
Performance and payment bonds are a type of indemnity bonds and should not be confused with an insurance policy. In a typical insurance policy, the insurer has to defend the insured as well as indemnify them. More importantly, they are not able to get repaid from the insured for the amount of any loss or any costs associated with the claim. Compare that to a claim on a bond. First, the surety looks to the contractor to make sure that there it is a valid claim and, more importantly, the surety will ask the contractor to indemnify it for any claim damages and lawsuit fees.
Who benefits from a Payment Bond?
Subcontractors, laborers and suppliers are the ones that benefit from a payment bond.
The problem generally arises for a general contractor as they are unaware that there is a problem until they get a claim filed against them. Sureties also do not like payment bonds as they can, in some cases, end up paying for work twice.
Let’s go through an example. Let’s assume that Riddler Materials was not paid by Joker, even though Falcone made sure that Joker received their payment on time. So, Falcone would not even know that there was a problem (and would further assume that everything was just fine) until Riddler made a claim on the payment bond.
Falcone, if they were being diligent, would require a payment bond from Joker so as to eliminate this double payment risk.
How does a Bond differ from Insurance?
Insurance is written so that the risk of loss is spread among multiple parties while a bond is written with the assumption that there is not going to be any loss (although loss does occur). Thus, bond premiums are MUCH lower than insurance premiums. If bond rates were written in the same manner as insurance, then the cost would be somewhere in the 40% range – which is simply not sustainable for any construction activity.
Can I get a Performance Bond online?
Of course! What do you think we are, chopped liver?
What about a sample bond form?
How do these bonds work?
These bonds come with guarantees from a third-party guarantor instead of the construction contractor. This type of security bonds are usually taken out with the help of an insurance company or bank institution and this will cover the entire cost of the construction project if the contractor fails to deliver. These types of bonds generally take a much longer approval because they need to go through various institutions. They may also be associated with extra costs as an agency may need to be used to create the security bond. If the contractor is unable to complete work it can be extremely costly for them. Because of the extended approval process and extra costs only a few different types of construction projects may require a bond.
- Bond insurance cover – What does bond insurance cover? It covers the loss associated with one party not living up to the terms of any contract
- Bank performance guarantee – A bank performance guarantee is another name for a performance bond.
- Bid bond bank guarantee – a bid bond bank guarantee is another name for a bid bond.
- Performance security form – this form is used by most Obligees to show what is being covered under the bond.
- Surety agreement sample – we have lots of sample forms that we use to help everyone understand what it is that we do and what is covered.
- Performance guarantee – the surety will provide a performance bond to make sure that the contractor lives up to the terms of the contract
- Difference between bonded and insured – a bond is specific to a single entity and is underwritten based on that job and the risk of loss, which is assumed to be zero. Insurance on the other hand is a risk sharing tool where losses are assumed. If bonds were written like insurance they would be much, much more expensive.
- Obligee surety bond – the Obligee is the party that gets assurance under the performance bond
- Company guarantee – a company guarantee can be used in lieu of a surety bond, but is much riskier to the Obligee
- Bond premium – the bond premium is based upon the size of the job. For bonds under $400k, a good rule of thumb is 3% of the job; larger jobs are cheaper
- Bonds and guarantees – a surety provides the assurance under a bond, while companies provide guarantees
- Employment bond – this is a type of fidelity bond that is used by many sureties
- How do bonds work – a bond is a three party agreement. A surety provides assurance to the Obligee that the Obligor will perform according to the terms of the contract
- Contract of suretyship – this is the agreement witht the bond company
- What is an underwriter insurance – underwriter insurance is another name for a bond that is used in specific industries, such as mortgage firms
- Legal bond – a legal bond is used mainly for other types of industries, like notaries
- Surety contract – a surety contract is used to assure that a surety can recover from the Obligor
- Construction guarantee – this is another name for a performance bond
- co surety
- What is a bond in business – a bond in business is used to provide assurance to a party that another party will perform
- Obligee bond – the Obligee bond is provided to make sure that the party that is being protected is actually being protected
- Bonded employee – a specific employee can be bonded (called a fidelity bond)
- Surety agreement – the surety agreement is the actual form used to provide assurance
- Bond underwriter – this is the individual at the surety company that determines the risk and pricing of any performance bond
- Performance guarantee contract – this is another name for a performance bond contract
- difference between insured and bonded – being insured is the ability to share risk with a pool of other people. Bonded is more like a guarantee, where the risk is not being shared, but instead falls on another party. If bonds were priced like insurance, they would be prohibitively expensive.
- can surety
- collateral bond – a collateral bond is a bond where the surety does not provide the underlying bond without some sort of other collateral. The collateral is usually preferred to be liquid, such as an irrevocable letter of credit, but some sureties will also take other pieces of collateral, such as certain equipment or even real property.
- the guarantee insurance – sometimes a surety bond will be called guarantee insurance, although as you’ve seen above, a performance surety agreement is not insurance. Instead, it’s a three party agreement to guarantee the performance of an underlying contract.
- what is bond rate – the cost of the bond can depend on several factors. The first, of course, is the type of a bond. For a performance bond, the general starting rate is three percent (3%) of the contract. This amount will go lower as the contract size grows. For other bonds, the price is typically lower. For a probate bond, the standard price is around 1% Notary bonds are usually priced using a fixed fee price for several years.
- bond business – the business of providing bonds are usually left to professional surety companies. However, this wasn’t always the case. In the old days, surety was providing by individuals on behalf of other individuals. You can sometimes see this, but it is more common now for companies to provide surety business on behalf of another business, such as a general contractor being the surety for one of its subcontractors.
- surety business – surety business is the some thing as bond business. It’s where one company provides surety on behalf of another company.
- being bonded and insured – some companies are both boned and insured. In these cases, the bond protects against a specific job or task, while insurance spreads risk across a pool of similarly situated companies.
- bond obligee – the bond obligee is the party that gets the benefit of the performance bond, payment bond or underlying surety bond. Thus, if the Obligor defaults on its obligations, then the obligee will look to the surety to make it whole pursuant to the terms of the surety agreement.
- surety company definition – the definition of a surety company is a company that provides surety on behalf of someone else. In most cases, a surety company is a division of a large insurance company, but as we discussed above, it can be another private company.
- performance bank guarantee – a performance bank guarantee is also called a performance bond. However, unlike a performance bond, the performance bank guarantee does not have to make a claim for any payout to be given. Instead, the payout is given upon demand of the Obligee. Obviously, these are much harder to get than a normal performance bond.
- security bond definition – the definition of a security bond is a bond that provides surety pursuant to the terms of another agreement. In the U.S., these are usually referred to as performance bonds.
- assurance bond definition – an assurance bond is a bond that provides a guaranty, or other surety assurance, based upon an underlying agreement. In the states, these are more typically called contract or performance bonds.
- cost bond – the cost of a bond depends on the size and type of the bond. For most contract bonds, the price starts at three percent (3%) and then goes down based upon the size of the bond and the creditworthiness of the Obligor. The price can increase if the bond or Obligor is deemed risky. For notary bonds, these are super cheap while court bonds range from 0.5% to 2% of the assets.
- what is a bonding company – a bonding company is a surety company. Most surety companies are divisions of a larger insurance company.
- surety deposit – some bonding companies require a deposit when getting the surety bond in order to defray the cost a bit.
- bond claim – a bond claim is where one party (such as the Obligee, a subcontractor or material vendor) makes a claim upon the job bond. The claim is then processed by the surety to see if the claim was timely made and that the dispute is valid. If the claim is valid, the surety will then pay, or get another contractor to finish the job, and then look to the Obligor for recompense.
- bank guarantee cost – the cost of a bank guarantee is typically three percent (3%) of the underlying job. However, these bonds are very difficult to get as the surety will require collateral in the amount of the bond being written.
- benefits of bonds – the biggest benefits of a bond is to the Obligee. The Obligee is assured that the Obligor will not mess up, and if the Obligor does have a mistake, then it will be taken care of. This helps facilitate commerce. For many Obligors, the benefit of getting a bond is the ability to get a job that they otherwise would not qualify for.
- licensed insured bonded – the trinity or holy grail of all contractors is to have all three of these. A contractor wants to be licensed, as well as insured. Being bonded, along with being licensed and insured, means that they can bid on any job they want as well as tell their customers that they are a “safe” company to do business with.
- contract surety – a surety can write a bond for many reasons, but one of the biggest reasons is to provide assurance based on an underlying contract. So, they become the contract surety on behalf of the Obligor.
- getting bonded for small business – when a small business gets a bond, they can then go out and bid on more jobs. Further, there is a marketing benefit to being bonded as well as the small business can now assure its customers that it is a stable company that is able to complete jobs.
- surety bond obligee – the Obligee to any surety bond is the party that receives the benefit of the bond. In a contractual situation, this is the owner of a project. Thus, if the general contractor is unable to perform, then the Obligee can look to the surety to make it whole.
- bonds fidelity – a fidelity bond is one that does not provide assurance based on an underlying contract, but instead provides surety based upon the character of an individual. These bonds are written for public servants, as well as certain employees that have jobs where they have the opportunity for bad acts, such as a bank teller.
- bond risk – the risk underlying most bonds is not the risk that you associate with insurance. Instead, bonds are written assuming no loss. However, there is always risk assumed as there can be outside events that can cause a bond claim, such as unforeseen economic changes, etc.
- who is a surety – well, anybody can be a surety. All you need is for a someone to be willing to act on behalf of another. In the older days, sureties were typically individuals, as a wealthy individual would provide surety on behalf of another. That then evolved into companies providing surety to other companies. Finally, in the modern age, most sureties are large insurance companies, such as AIG or Zurich.
- bonding a company – the company that provides the bond is the surety and the company receiving the bond is the Obligor. So, when the surety is bonding a company, they look at the Obligor to make sure that there will not be any default under the bond to cause a claim and, if there is a claim, that the surety will not have to pay anything or can receive reimbursement from the Obligor.
- company guarantee bond – a company guarantee bond is the same thing as a performance or payment bond. The surety bond is guaranteeing performance on behalf of one company.
- performance warranty bond – a performance warranty bond is also known as a maintenance bond. This bond is usually attached to a standard performance bond. The maintenance bond provides that the finished product will continue to perform as expected for a specified period of time, such as one year following completion of the job.
- life assurance bond – the life assurance bond is a surety that provides that a particular person will continue to be the main point of contact for a specified period of time.
- on demand bond – an on demand bond is quite different than a typical performance bond. In a normal performance scenario, any bond claim must first go through a verification process. This verification process will make sure that the claim is valid before the surety will pay. In an on demand bond, the surety pays immediately. Then, after that immediate payment, the surety will look to the company regarding recompense. As you can imagine, these are very, very hard to get.
- surety guarantee difference – there is a big difference between surety and a guarantee. A surety bond is a three party agreement. Thus, any dispute is directly between all three parties. In a guarantee agreement, the dispute is between two parties. Upon the resolution of that dispute, then the guarantor is required to pay. It’s a two step process instead of a single step process like in the surety context.
- risk of insurance – the risk of insurance is the pooling of risk across a similarly situated group of people. This is different than in the surety space where bonds are written assuming no losses.
- the business of insurance – the business of insurance is to provide a risk-spreading among the parties, which is different than surety where the parties are not wanting any losses.
- fully bonded and insured – most owners want their licensed contractors to be both fully bonded and insured. The insurance provides protection against normal business losses, while the bond is specific to the job at hand.
- guarantee bond – a guarantee bond is another name for a surety bond. This guarantees the performance of a party.
- surety insurance definition – surety is different than insurance in that it does not pool risk to be shared, but instead is written on a specific basis.
- what is a bid bond and a performance bond – a bid bond is a bond that is written to provide assurance that a contractor will take a job if they are awarded a job. Thus, the owner of the project gets some assurance that they won’t have to start the process over with another company. The performance bond is the bond that protects the owner from any default in the actual performance of the job. Normally, in bid situations, the bid bond is done at the beginning and then the performance bond is written once the contract is signed.
- surety underwriting – surety underwriting is done assuming no losses in the job or other surety. That is, the surety underwriter does not assume that a certain percentage of companies or people will default, but instead writes the bond assuming a no loss scenario.
- surety fee – the typical fee for a contract bond is approximately three percent (3%) of the contract price. This can go up based on the risk of the situation, but can also be decreased as the job size increases.
- commercial surety – in the modern age, most sureties are now commercial arms of large insurance companies. Thus, a commercial surety will write the bond based on their experience across multiple industries and using historical data.
- surety underwriter – the surety underwriter is the individual at the surety that is in charge of writing the bond on behalf of the surety. The underwriter analyzes the risk of the company that is wanting to be bonded and also the risk of the job at hand.
What is a surety company?
A surety company is typically a company that provides surety bonds. That is, a guarantee on behalf of a contractor or other Obligor. In the modern U.S., most surety companies are subsidiaries of insurance companies. The surety company will underwrite a contractor and then provide the surety guarantee to the owner of the project. Some of the things that a surety company will look at are:
- surety bond service – a good surety bond service is one that can provide a bond that meets your particular needs. So, what you need to look for in a surety bond service is one that provides a wide variety of offerings through a variety of sureties.
- licensed bonded insured – this is the goal for every great construction company. Once they are licensed bonded and insured, they are able to bid on all jobs and provide great security/assurance to the owners that they can complete the jobs per the job requirements. That is why all contractors want to become bonded licensed and insured.
- premium in insurance – a premium in insurance is the cost for the insurance. It is the same thing in the surety world. A premium is paid for the cost of the bond being acquired. The insurance premium is based on the pooling of the risk across similarly situated entities.
- surety guarantee – a surety guarantee is the underlying basis for providing any sort of payment or performance bonding. This surety guarantee is something that the owner of the project can rely upon in the job.
- bond prices – the bond prices for any contractor are based on the underwriter’s assumed risk of the project and the contractor that is getting the guarantee.
- bonding cost – the bonding cost of a job is based on the type of bond being written. So, the job is the largest factor. Additional factors are the perceived risk of the contractor that is asking to be bonded.
- bond of indemnity – a bond of indemnity is one where an entity is required to provide the bond. However, the bond can be called at any time, which makes it very difficult to get.
- insurance guarantee – an insurance guarantee is sometimes called a performance bond. The insurance guarantee can also refer to the fact that the insurance is a “wrap” around a specific transaction or job. There are also instances where someone could get an insurance wrap, but could also get a performance bond to replace that wrapper.
- cost of bond – the cost of a bond is depending on the type of bond that is being acquired. For most P&P bonds, the bond cost is around 3% for bonds up to $400,000. Above that, the bond percentage tends to decrease as the contract amount increases.
- about bonds – It is good to know about bonds. Knowing about bonds can help you determine which bond is right for your business and also how to get the lowest cost performance bond possible.
- construction surety – In construction, a surety will want to know about the type of bond that is being required as well as the underlying terms of the contract and the reputation and financial viability of the contractor. The construction surety will review all of those terms to determine the lowest performance bond cost to cover the surety’s risk.
- bond protection – the bond protection that a Obligee receives is based on the financial security of the surety. Most sureties are large insurance companies, so the bond protection is significant. In addition, the bond protection is based on the terms of the bond itself. An owner of a company needs to make sure that they read all of the terms and exclusions of the bond itself. Otherwise, there could be claims that are not covered and the bond protection is only an illusion.
- contractor cost – the contractor cost will include the surety bond. Thus, the cost of the performance bond or payment bond (or P&P bond) will be built into the bid cost of the contractor.
- corporate surety – in the U.S., almost all sureties are a corporate surety. This is different than in history, which had most sureties being individuals.
How do I get a bond?
Well, you should call us. Right now. The general process works like this: we will have you fill out a bond application and see if we can get you approved quickly. For larger bonds (think over $400,000), we ask for company financials and some other information to get the bond price lower. We can usually get smaller bonds approved in a day or two and larger bonds take just a bit longer.
What is a contract bond?
A contract bond is a specific type of surety bond that has a contract as the underlying agreement that forms the basis for the bond. The most common types of these bonds are performance bonds and bid bonds. What happens is that a company, like a contractor, bids on a contract and if they get the contract then they will perform according to the terms of that contract. Thus, the performance and payment bond is assurance from a surety that the company will actually perform per the terms of the underlying contract.
What is surety insurance?
Surety insurance is another name for a surety bond. These bonds can guarantee a variety of things. In the construction context most of these are contract bonds, which means that the bonds guarantee the performance of an underlying contract. Some related things are:
- P&P bonds – a P&P bond is another name for a performance and payment bond. In the industry lexicon it is abbreviated to P&P bonds. This can also be abbreviated as a p&p bond or p & p bond.
Performance Bond in Construction
In the construction industry, a performance bond is usually required by the client who wants the intended work to be covered by an insurance policy. When a contract is awarded to a particular contractor, the owner may require the winning contractor to post a specific bond to ensure performance or completion of the project, and that the owner will be properly reimbursed for any losses that may be incurred in relation to the project.
In case the contractor defaults, the owner may file a claim to recover the damages amounting to the total cost of the job. A performance bond is a common fixture for public works contracts.
Before a bond is acquired, both parties must first be amenable to the terms of the bond. The full scope of the required work, the time frame for completion, and the estimated value of the work must first be determined before the bond is issued. The issuer usually defines the terms of the performance bond, including the claims and payment.
The cost for this type of bond is paid for by the contractor; and this is typically included in the cost of their bid for the particular project. The cost of the bond depends on various factors, and these include the type of construction being done, and the full cost of the required work. It ranges from 1 to 5% of the total estimated construction cost. If the issuer finds the contractor to be a risky investment, higher upfront bonding costs, including interest, may be imposed.
This type of insurance or bond is basically a policy for the owner. A contractor must first be qualified in order to be bonded, so its ability to acquire a bond is in itself an assurance to the owner that the said contractor is likely to complete the job, and that it is financially stable.
A performance bond likewise gives the assurance that in case the contractor defaults on its obligations to deliver or takes a longer time to comply than what is agreed upon, the owner will be compensated for the losses accordingly. In any case, the owner is shielded from any possible financial damage or loss arising from the project.
The required bond to ensure performance places smaller general contractors at a distinct disadvantage in securing projects as they may not be able to at least qualify or afford to be bonded. There are also some contractors who may not be willing to spend upfront for bonding requirements or undertake the additional work required just to secure a performance bond, and this could result to fewer bidders.
Less competition provides a good opportunity for the remaining bidders (usually larger contractors) to place higher bids. In any case, the bid costs may be higher because contractors will definitely include the bond cost in their project cost estimates that will ultimately be passed on to the owner.
Modern History of Surety Bonds
Modern History of Surety Bonds
Where it all started – London
The beginnings of the surety business started in London in 1720. The London Daily Post announced:
Unfortunately, this venture was still ahead of its time. It wasn’t until 1840 that the Guarantee Society of London was created. Its sole purpose was the writing of fidelity insurance. However, at the time, many people objected to this organization.
These objections largely centered around morals, which largely went like this “why would you hire someone that you don’t trust; you’d be hiring a morally bankrupt person that is backed by an organization?” This “moral argument” has been disproved by history as surety insurance has continued unabated since then. It appears that many people have understood the concept of unforeseen risk. More importantly, the “moral argument” is really about good intentions. And the road to purgatory is paved with good intentions.
Where it all started – United States
It took until the mid-19th century for the concept of surety insurance to really take hold (who knows why; maybe it was our more puritanical sense of morals). In 1853, the New York legislature finally enacted a law authorizing the formation of corporations that could offer surety insurance. What’s ironic, however, is that no company utilized this ability until 1875 when the Fidelity and Casual Company was organized. It began operating three years after that is the first US company to issue surety bonds.
Surprisingly, the Guarantee Company of North America was organized in Canada in 1872. It then expanded to the United States in 1881. In 1884, the American Surety Company organized, followed by the Fidelity Deposit Company in 1890, the United States Fidelity and Guaranty Company in 1896, and the National Surety Company in 1897.
CurrentState of Affairs – United States
There currently exists over 200 Certified Companies, found here (as listed by the Financial Management Service, a bureau of the United States Department of the Treasury), plus several reinsurers, and regional insurance companies as well as multiple captive insurance companies, etc. Life has certainly changed.
An Overview of Bonds
There are three parties to every bond, surety bond (said in a cool English accent).
- The Principal – this is the person who is the primary payer on the bond. That is, the Principal is the one that everyone will want to pay FIRST. In a major construction project the General Contractor is the Principal on a large surety bond.
- The Surety – this person is also known as the obligor. The Surety provides a guarantee that the Principal will not default on the bond; that is, that they will perform the job per the contract requirements. The Surety is generally a large insurance company. They have spent lots of time and resources through their underwriting department (more on that below) to verify that the Principal can perform. But if the Principal can not perform, then the Surety will make good.
- The Beneficiary – this person is also known as the obligee. This is the person that wants a surety bond. In a major construction project this is the owner – or an agent of the owner (possibly, the developer). The Beneficiary requires that there is a surety bond for several reasons, including the transfer of risk (despite some increased cost), the protection against unforeseen risk (such as against Black Swan events; see Nassim Taleb’s book here), as well as their general lack of underwriting capability (a transfer of specialization in an industrialized society).
What is the difference between surety bonds and insurance?
One of the great questions is the difference between a surety bond and insurance. Many insurance agents do not understand the difference. That’s unfortunate, as the differences are immense.
The underwriters for surety bonds and those that underwrite insurance have completely models about risk that they use. When it comes to regular insurance, the underwriter assumes that there will be losses and that this is a part of the risk of writing insurance. However, when it comes to writing a surety bond, the insuring bond company does not want to take any risk whatsoever.
This is one reason why each and every insurance company wants to have a surety bond division. That is, they should be able to offset losses in their regular insurance division with the profits generated by their surety bond division. The simply reason for this is that there is a party standing between them and any loss (the Principal). In addition to the Principal, many surety bond companies require additional collateral to protect their surety bond, such as cash collateral (savings bond; accounts receivable, personal guarantee by the Principal’s shareholders, etc.). Finally, there are substantial assets in the construction industry, where the majority of surety bonds are issued. In the case of a total meltdown by a Principal, there always remain some accounts receivable that haven’t been collected or equipment that can be sold. Thus, even if there’s a loss, it generally isn’t a complete loss.
The rationale behind writing a bond where there is no assumed loss has simply to do with cost. The typical cost of a surety bond is around 1% (give or take) of the total contract value. However, if they were written like regular insurance, the cost would skyrocket to many multiple percent (estimates range from 15-75%). How would you like to pay 15% of the total cost of a contract to insure against the risk of non-completion? Neither would anybody else.
Curiously, the premiums of a surety bond are not really “premiums” in the general sense of the term. Instead, they are really service fees, which are charged for underwriting the bond. The general contractor needs credit in the eyes of the owner, and a surety company, if property secured, will provide this credit, lending to the contractor the responsibility of its seal, in return for a minor service fee.
There is a small exception to this rule when it applies to license bonds. These bonds are written on an “insurance basis” and, therefore, are more akin to standard insurance. Thus, the underwriters expect to pay losses from a reserve fund generated from premiums paid instead of through the Principal.
What is the Difference between a Fidelity Bond and a Surety Bond?
Ok, so you may have heard about a Fidelity Bond (and noticed that the name of many of the early companies were called Fidelity Insurance). So what’s the difference between a fidelity bond and a surety bond? First, every fidelity bond is a type of surety bond. But not every surety bond is a fidelity bond. That is, surety bonds are a very wide category while fidelity bonds are a smaller subset within that category. In the picture below, fidelity bonds are circle A while surety bonds are circle B.
Any written agreement executed with certain formalities where one party becomes a guarantor for another party is a surety bond. Sometimes the instrument makes the surety guarantee the fidelity of a person, which is where it becomes a fidelity bond. The guarantee can be one of fidelity only, but also a much broader guarantee, while still including fidelity. Sometimes, the surety bond has little or nothing to do with fidelity, but guarantees that the person will perform a certain contract or will pay a stated amount in the event of a given event.
Definition of Fidelity: the strict observance of promises.
Fidelity bonds are an important part of the business that is written by insurance companies, but surety bonds are more numerous, can be more difficult to underwrite and are much more common. Surety bonds can be nearly infinite in their variety. They can be very broad or extremely specialized, which would allow an otherwise very difficult and slow negotiation to conclude quickly, easily and relatively inexpensively.
Definition of Indemnitor: one who executes an indemnity agreement on behalf of another where he agrees to reimburse the surety company for any loss sustained by the bond.
An indemnitor is more easily thought of as a guarantor. That is, someone who guarantees the payment to the bond company.
When a principal is unable to get a bond on their own merits, many bond companies will still offer a bond if they get a good indemnitor to sign for the bond. There are some surety companies that will issue bonds based solely on the merits of the indemnitor. Some companies won’t, however. That’s because history has shown us that, during times of trouble, the indemnitor frequently tries to get out of payment of the bond; whether due to their lack of desire to pay or, many times, changes in their own circumstances that require them to seek to not pay the bond.
A good underwriter will, however, look at the merits of the indemnitor for those cases that seem to straddle the border. In the current climate, many contractors are in this exact situation. Their businesses are good, but not stellar. An indemnitor that has some connection with the construction site is viewed as especially valuable, as they have an incentive to see the principal/contractor finish the job. In many circumstances, a contractor will be in the middle of underwriting and need an indemnitor. The indemnitor could be a supplier, such as the concrete supplier. The concrete supplier would have a very large incentive to oversee the project (especially for a high-rise) and make sure that the contractor fulfills on their promises. The concrete supplier also stands to gain a very nice piece of business as well.
One of the types of companies that have a tendency to need an indemnitor is a small contractor. Although these businesses are typically profitable, and they are seen as having a high reputation, they still need an indemnitor. That’s because their size is unable to stand large economic shifts and unforeseen events. However, they rarely default, which is why people are willing to indemnify them.
I have had several attorneys and underwriters express concerns about how to get a corporation to sign a valid indemnity. In many cases, a vice president of sales wants to sign these things. However, it’s better to get a board authorization or at least an executive to sign off. Surety companies can get burned by trying to enforce an indemnity on a corporation when the company defends by saying that the signing party did not have authority. Surety companies then have to spend time, effort and lots of legal fees arguing about apparent authority (instead of actual authority). Even if they win, it’s still expensive and takes a lot of time and energy.
There are a lot of cases where a surety company will still want some sort of additional guarantee before writing a surety bond. In some cases, the surety company does not want an indemnitor (or, as is more likely, the Principal cannot find a satisfactory indemnitor). In those cases, they ask for some sort of collateral security.
Definition of collateral security: Property that a surety can sell to repay the bond if the Principal defaults and the bond is paid.
What’s odd about the requirement for collateral security is that the requirements vary widely among the surety bond companies. Further, the title to the security is of paramount value; surety underwriters place little to no value on having a second position behind someone else. This is, of course, very important when the collateral has a lot of value and there is a significant amount of equity above the first lien holder’s position.
The other problem with certain collateral is the ability to liquidate or liquidate in a non-readily apparent marketplace. If it can only be redeemed by a limited number of investors (say a buyout in real property) or if the amount realized can vary widely or can be limited (see auction rate securities), then the value taken into account by an underwriter could be close to zero. Many times, you have to search for the right underwriter to get value out of those pieces of collateral.
Types of collateral
A surety bond underwriter typically looks at very liquid investments, such as cash, savings bonds, treasury bonds, certificates of deposit, or securities listed on an exchange (although stocks can be heavily discounted due to the wide swings that they incur).
Sidenote: here’s an interesting story about security. I knew of a company that had an outstanding line of credit of $800,000, which they typically had $500-600,000 out at any time in working capital. That’s pretty standard for a construction company. However, their banker required them to post a certificate of deposit – held by that bank – in the amount of $800,000. Thus, they were “self-funding” their own working capital. They were paying around $40,000 in fees on the Line of Credit and only getting around $8,000 on the certificate of deposit. They “liked” their banker and said he was really responsive. Of course he was. He was making $32,000 in fees each year off of this arrangement. Crazy.