It is a promise by a surety or guarantor to pay one party a certain amount if the second party fails to meet the obligation, such as fulfilling the terms of contract. The Surety Bond protects the obligee against losses resulting from the principal’s failure to meet the obligation.
A surety bond is most commonly thought as a way to transfer risks. Surety bonds are designed to protect public or private interests from the actions of a third party. You can think of Surety Bond as an insurance for the benefit of one party, paid for by a second party and financed by a third party.
For example, when a general contractor works on a commercial construction project with a project owner, he’ll typically be required to purchase a contract Bond. This Surety Bond protects the project owner from the General Contractor’s potential failure to complete the contract a specified.
If this failure occurs, the project owner can file a claim against the Surety Bond. A Surety Bond company will pay for the financial damages on behalf of the general contractor. After damages are paid, the general contractor is required to repay the Surety Bond Company. This means that there are three parties involved with all Surety Bonds.
The principal will pay a premium (usually annually) in exchange for the bonding company’s financial strength to extend surety credit. In the event of a claim, the surety will investigate it. If it turns out to be a valid claim, the surety will pay and then turn to the principal for reimbursement of the amount paid on the claim and any legal fees incurred. In some cases, the principal has a cause of action against another party for the principal’s loss, and the surety will have a right of subrogation “step into the shoes of” the principal and recover damages to make up for the payment to the principal.
If the principal defaults and the surety turns out to be insolvent, the purpose of the bond is rendered nugatory. Thus, the surety on a bond is usually an insurance company whose solvency is verified by private audit, governmental regulation, or both.
A key term in nearly every surety bond is the penal sum. This is a specified amount of money which is the maximum amount that the surety will be required to pay in the event of the principal’s default. This allows the surety to assess the risk involved in giving the bond; the premium charged is determined accordingly.
Surety bonds also occur in other situations, for example, to secure the proper performance of fiduciary duties by persons in positions of private or public trust.