(February 2023)
Surety bonding has much more in common with commercial lending than it does with insurance. Unlike insurance coverage and fidelity bonding, surety bonding is essentially a three-party obligation. It consists of the following:
This is the first party. It is the party to whom the indemnity is provided.
Note: American Institute of Architects (AIA) construction bonds use the term Owner in place of Obligee.
This is the second party. It performs or complies with contractual or statutory obligations for the obligee.
Note: AIA construction bonds use the term Contractor in place of Obligor or Principal.
This is the third party. It guarantees that the principal will perform or comply with the contractual or statutory obligation.
The surety bond is a joint and several financial undertaking of the principal and surety. The principal bears full responsibility to perform the obligation.
Unlike most insurance coverage forms and policies that consist of many pages, the surety bond rarely exceeds one page. The format of all bonds (as well as their eighteenth-century language) is nearly identical. In most cases, the entire obligation consists of only three clauses. These are illustrated in abbreviated form as follows:
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Examples:
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Examples:
Each of the above ends with “then this obligation shall be void; otherwise, it is in full force and effect.” |
Note: The 2010 AIA Construction Bonds significantly changed the language described above.
Related Article: Construction Contract Bonds
The surety underwrites the risk based on the three Cs: Capital, Character, and Capacity. Most grantors of surety credit, commercial bank loan providers, and many other firms that extend credit as a normal business risk use these credit evaluation standards.
Many grantors of credit use a fourth C, Collateral, to support unusually hazardous surety obligations. Collateral is also routinely used in extending many commercial bank loans. The additional support that collateral provides for a credit risk does not necessarily challenge the creditworthiness of the bond principal or the party that seeks a loan. However, under contract suretyship, the requirement for collateral by standard surety markets (defined as conventional underwriters usually affiliated as members of or subscribers to the Surety and Fidelity Association of America) is highly unusual. One situation when such requests are made is when a contractor previously defaulted in performing bonded work.
Surety obligations (and contract bonds in particular) frequently depend on the officers and directors of a corporation to personally indemnify the surety against any loss it may sustain by reason of executing the bonds on behalf of a corporate principal.
The surety’s and lender’s respective means of recourse against default is similar. An unsecured lender has essentially the same legal remedies available to it against its defaulting borrower in civil proceedings as the surety does against its defaulting principal. In the surety business, this is known as the right of equitable subrogation. If the lender had a guarantor or co-maker supporting the borrower on its security instruments, these third parties are the equivalent to the surety’s part as the guarantor to the obligee on a bond.
The following elements are common to all surety transactions:
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Example: The contractor is J & J Construction, the owner is Kerry County Developers, and the surety is ABC Surety Company. Kerry County Developers is developing a shopping center. If J & J does not perform its obligations properly, ABC Surety is obligated to Kerry County Developers for the bond amount. |
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Example: J & J Construction declares bankruptcy and cannot complete the shopping center. ABC Surety is liable to Kerry County Developers for the bond amount. |
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Example: ABC Surety realizes that J & J Construction has financial problems, but it cannot cancel the bond. |
Note:
A word of caution is in order here. It is often said that indemnity is a
good crutch to lean on, but not to lean on it too heavily. Like a bank
guarantor, a surety indemnitor is not
jointly and severally liable to the principal/borrower. The surety/bank must
make every effort to fully recover its loss from the principal/borrower. Any
recovery should include the application
of credits, salvage in surety cases, unearned interest on bank loans, and
collateral (if any) before a demand can be made on the indemnitor/guarantor to recover any remaining loss.
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Example: ABC Surety first looks to J & J Construction for restitution but then looks to Mark Johnson and Jerry Johnson personally because they are surety indemnitors. |
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Example: Once ABC Surety pays Kerry County Developers, ABC Surety takes over Kerry County Developers' rights to pursue J & J Construction. |
The law of large numbers is a key integral component of most primary insurance lines of coverage. This law anticipates collecting adequate premiums from all policyholders to cover the losses of the few. Pooling premiums to respond to injury or damage sustained by certain members of that pool is how insurance works.
However, that approach does not necessarily apply to corporate suretyship. The premium for any type of surety bond is not treated as an amount that can be held in reserve to make payments. On the contrary, it should be considered as a fee for the bond. When losses occur, they are paid out of the surety's assets, surplus investment income, and contingency reserve. After the surety fulfills its obligation, it assumes the principal's rights, because it has already handled the principal's financial responsibilities. Once an obligee receives a surety bond, it is valid, even if the principal never pays for it. The surety bond does not have any cancellation provisions for non-payment of premium. In addition, the rights of the obligee cannot be invalidated unless the bond has an express provision that permits it.
Related Article: Compare: Surety to Insurance