One day, an up and coming contractor with a passion for restoration is alerted to his dream job. A federally funded restoration of a historic landmark is up for bid, and he knows this is more than a dream, it’s a career making move. With a background that has him well prepared and a workforce he’s confident in, he starts the bidding process only to find out that, because it’s a federal contract, he needs a surety bond if he wants this job.
What is a surety bond and why does he need one? If you’re asking these questions, you’re not alone. Surety bonds have been around for thousands of years and are fairly common, but unless you’ve already purchased one, the concept can be a bit mystifying.
A surety bond is a legal agreement between three parties: the Principal, the Obligee and the Surety. In the aforementioned situation, the contractor would be the principal or the business owners responsible for doing the work. The Obligee would be the one requiring the bond, in this case, the government sect responsible for overseeing the restoration of the building. Finally, the Surety would be the bond company one providing the insurance or line of credit.
The circumstances may change, but the three parties involved will always be the same.
This a surety bond is a type of business insurance that acts to protect the Obligee from fraud or incomplete work by guaranteeing the amount they paid to the Principal. If our restoration contractor considers his obligations a thing of the past, then the surety bond he was required to get will prevent the Obligee from losing the money initially paid to get the job done. It will also hold the Principal legally responsible if a claim is filed against him.
To help answer some of the most frequently asked questions about surety bonds, we called in our friends from SuretyBonds.com to provide their expert opinions:
What type of businesses/situations typically require surety bonds?
If you’re an auto dealer, notary public, contractor, freight broker, or mortgage broker, you’ll be required to buy surety bonds. However, there are other businesses in which surety bonds are useful to the business owner.
According to the authorities over at SuretyBonds.com, some businesses like “cleaning services, pet sitting companies, or house painting companies” choose to purchase business insurance or surety bonds(in this case, fidelity bonds) because it can help instill trust in customers. In these situation, a bond can translate into assurance against theft or material damages in their client’s home.
How much does a surety bond cost?
This is a tough question, and there is no one-size-fits-all answer. For starters, the price of a bond can change depending on its type and purpose. A bond for a notary can hover between $50 and $150 while a bond for a construction contract or an auto dealership can extend well over $5,000.
The price of your bond may be determined by:
- The type of bond
- The amount of the bond
- The risk associated with the industry
- The risk associated with the Principal (poor credit, new business, etc)
Again, generally speaking, a small business owner can assume the bond premium can range from 1% to 15%, of the total bond value. The higher the overall bond value, the more the business owner will be required to pay. If our contractor above won the bid, the job cost $500,000, and the premium was 1%, he would need to pay $5,000 for the bond.
The best way to determine the price of your bond is to discuss it with a qualified surety bond or business insurance specialist. Of course, don’t rely on one interaction. Do your homework and determine the average premium for your industry and type of bond.
Does my credit affect my premium?
We have some good news and some bad news here. In some industries, like notaries, you may just be able to purchase a flat rate bond regardless of your credit. However, more often than not, if you need a surety bond for your business, your credit is going to come into play, and much like business loans, poor credit is often associated with a higher premium. Your business credit may come into question as well.
However, the folks at Suretybonds.com assured us that you shouldn’t let bad credit act as a deterrent from your business goals. In fact, many companies are willing to offer business owners the opportunity to pay their bonds in installments.
What happens if I default on my bond?
It shouldn’t be surprising that defaulting on your bond is a violation of terms — i.e., not a good thing. However, it does happen. If you default on your bond, or in surety bond terms, a claim is filed against your bond, an investigation will be conducted by the Surety’s claims department.
If the dispute is found to be legitimate, then Principal will have the opportunity to take action and satisfy the original claim and the items agreed upon in the indemnity agreement. If the principal is still not able to live up to the initial agreement, the Obligee will receive a settlement from the Surety and the Principal will face collections proceedings.
Melanie was able to give us these great tips to avoid a claim in the first place:
- Read both the bond form and the accompanying laws.
- Know exactly what is expected or you run the risk of having claims filed against your bond.
- Before purchasing and signing the bond, ensure that you can adhere to its conditions.
She adds that “if you default on your bond, take necessary steps to correct whatever led to the default. Then, take responsibility for the incident by promptly reimbursing the surety company.”
How do I choose a surety bond company?
Much like lending opportunities, you may want to shop around for your surety bond. Some surety companies cater to different industries, while others may not consider high-risk bonds associated with certain industries (construction) or for businesses with poor credit.
When we asked Melanie Baravik, author for Surety Bond Insider, for tips on choosing a surety bond company, she advised us to “be prepared when you’re shopping: know your credit score, know your industry laws, and know how much surety bond coverage you need.”
She also was kind enough to offer some sage advice in the form of a red flag: “Some surety companies might tell you not to shop around for a bond quote – that’s bad advice” she said. “You should determine which companies offer the bond you need, verify their reputability, and get quotes from several different providers.”
It’s also worth noting that small businesses could benefit from working with the SBA and their Prior Approval, or SBG, Program and the Preferred, or PSB, Program. Though these bonds are obtained through a surety company, they are guaranteed by the SBA and are often a great option for new business with no previous business experience or a small business that may not have the best track record.
When is a surety bond not the right answer?
Surety bonds are a form of business insurance for the Obligee. They may help the small business owner get the job or win the bid, but the bonds aren’t there to protect the Principal. If you’re a small business owner in search of business insurance to protect your assets, a surety bond is not the right answer.
Surety Tips & Resources
Now that we’ve covered some of the most popular surety bond questions, here are some quick tips to make sure you find the best bond company.
- Always research the surety bond company and the agent selling you the bond.
- Check the U.S. Department of the Treasury to companies that are approved to issue bonds for federal projects.
- Consult A.M. Best, a global insurance credit ratings and information service, when researching surety bond companies.
- Avoid companies that want payment up front, don’t need underwriting information, or try to persuade you not to look elsewhere.
Surety bonds may seem confusing, but understanding the answers to these commonly asked questions can help you navigate a seemingly complex business essential.
This article was originally written on January 20, 2017 and updated on December 14, 2021.