Surety bonds explained: a beginner's guide

A surety bond looks like an insurance policy, is sold by insurance agents and is often listed on the same page as the general liability certificate, and it is not insurance. An insurance policy transfers risk from you to a carrier in exchange for a premium, and the carrier expects to pay claims. A surety bond is a guarantee, made by a surety company to a third party, that you will do what you promised: finish the job, pay your suppliers, follow the licensing rules, show up in court. If you do not and the surety pays, it comes to you for the money. The premium buys the surety's signature, not its willingness to absorb a loss.

This guide explains the three-party structure, walks through the kinds of bond a small business in Arizona, Nevada, Utah or Idaho is actually asked for, describes what a surety looks at before it signs, and reads the indemnity agreement that makes the owner personally liable for whatever the surety pays. It also covers what happens when a claim is made against a bond, which is where the difference from insurance becomes concrete.

Three parties, one promise

Every bond has a principal, the person or business whose performance is being promised; an obligee, the party who required the bond and who benefits from it; and a surety, the company that guarantees the principal's performance to the obligee. The bond form states the obligation, the penal sum, which is the maximum the surety will pay, and the conditions under which the obligee may claim. A contractor is the principal on a performance bond, the project owner is the obligee, and the surety is the company whose name is on the form.

The surety's promise runs to the obligee, not to the principal. That is the whole difference. If the obligee suffers a loss because the principal failed, the surety pays the obligee up to the penal sum, then recovers every dollar from the principal and from anyone who signed the indemnity agreement. A bond claim is therefore never a covered loss from the principal's point of view; it is a loan the principal did not ask for, at the surety's terms.

Licence and permit bonds

These are the bonds a state or a city requires as a condition of a licence. A contractor's licence bond guarantees that the contractor will comply with the licensing statute and pays a consumer or a subcontractor who is harmed by a violation. Motor vehicle dealers, mortgage brokers, collection agencies, notaries, auctioneers, private investigators and many other regulated trades carry a similar bond, each with a penal sum set by the licensing statute or the agency. The amount is the state's figure, not yours, and the analysis simply confirms it against the board's current requirement rather than treating it as a coverage decision.

Licence bonds are written on the principal's credit. For a small penal sum, a clean personal credit report is usually enough for the surety to issue at a standard rate; a poor credit history moves the bond to a higher-rate market or requires collateral. The bond renews annually with the licence, and a lapse in the bond typically suspends the licence, so the renewal date is one to keep with the licence itself.

Contract bonds: bid, performance and payment

Construction owners, and public owners in particular, require a set of bonds on larger projects. Each guarantees a different stage.

• A bid bond guarantees that if the contractor is awarded the job at the price bid, they will sign the contract and provide the performance and payment bonds. If they walk away, the surety pays the owner the difference between the bid and the next one, up to the bid bond's penal sum.
• A performance bond guarantees that the contractor will complete the work according to the contract. If the contractor defaults, the surety may finance the contractor to finish, hire a replacement contractor, or pay the owner the cost to complete, up to the penal sum, which is usually the full contract price.
• A payment bond guarantees that subcontractors and suppliers will be paid. It exists because a supplier cannot lien a public project, so the bond stands in for the lien right. On private work it protects the owner from liens filed by unpaid subs.
• A maintenance or warranty bond guarantees that defects appearing within a stated period after completion will be corrected.
• A subdivision bond guarantees to a city or county that a developer will build the public improvements, streets, sewers, sidewalks, that the plat requires.

What the surety underwrites

Contract bond underwriting is closer to bank lending than to insurance rating. The surety reads the business's financial statements, prepared by a CPA for larger programmes, and looks at working capital, net worth, debt, and the trend over several years. It reads the work in progress schedule to see whether current jobs are on budget. It reviews the owner's personal financial statement and credit, because the owner will be indemnifying. It looks at the business's experience with jobs of the size being bonded, its equipment, its key people and its bank line. From that it sets a single limit, the largest job it will bond, and an aggregate limit, the total of bonded work in progress it will support at once. A contractor grows into larger bonds by building the balance sheet, not by shopping the premium.

Suppose a Utah concrete contractor with $400,000 of working capital and $900,000 of net worth asks for its first performance bond on a $1,500,000 municipal job. A surety might approve a single job at that size and an aggregate programme of $4,000,000, on the strength of the statements, a clean credit file and completed jobs of half that size. It would not approve a $6,000,000 single job at any premium, because the working capital could not absorb a problem on it. The numbers are invented; the shape, in which capacity follows capital, is exactly how the market works.

The indemnity agreement

Before issuing any bond of substance, the surety requires the principal and its owners, and usually their spouses, to sign a general indemnity agreement. It says that if the surety pays anything on any bond, or incurs any expense investigating a claim, the indemnitors will repay it on demand, with interest and legal fees, and that the surety may settle claims as it sees fit. It usually gives the surety the right to demand collateral the moment a claim is threatened and to take over contract funds. Owners sign it once, at the start of the relationship, and it covers every bond issued afterwards. It is the document that makes a bond claim a personal debt, and it is the reason a bond is not insurance. Read it, and if a spouse's signature is required, understand that the spouse's assets are behind the promise too.

What happens on a claim

When an obligee claims against a bond, the surety investigates whether the principal actually defaulted. It is entitled to do so, and the principal is expected to cooperate and to cure the default if it can. If the claim is valid, the surety pays the obligee or arranges completion, then turns to the indemnitors. If the claim is not valid, the surety defends the principal, and the cost of that is also charged to the indemnitors under most agreements. A single paid claim will usually end the surety relationship and make the next bond expensive or unavailable in the standard market, which is why a contractor with a dispute on a bonded job should call the agent before the obligee calls the surety.

Court, fiduciary and miscellaneous bonds

Courts require bonds from parties in litigation and from people appointed to handle someone else's property. An appeal bond guarantees that a judgement will be paid if the appeal fails. An attachment or injunction bond protects a party against a wrongful court order. A probate or fiduciary bond guarantees that an executor, guardian or trustee will manage the estate honestly, and is required by many probate courts in the region unless the will waives it. A public official bond covers a treasurer or a clerk who handles public money. These are written on the applicant's credit and the size of the estate or judgement, and some are difficult to obtain without collateral. The agent's job on a court bond is largely speed, because the court's deadline does not move for underwriting.

Regional notes and how to use this

Each of the four states licenses contractors through a state board and requires a licence bond at a penal sum the board sets by classification, with the figures in each state's statute; Nevada additionally ties the bond to the licensee's monetary limit on contract size, so a growing Nevada contractor raises the bond and the limit together. Public works above a stated contract value require performance and payment bonds under each state's little Miller Act equivalent, and cities and counties in the growth corridors around Phoenix, Las Vegas, Salt Lake City and Boise routinely require subdivision bonds from developers. Idaho and Utah probate courts commonly require fiduciary bonds on estates administered without a waiver in the will.

For a licence bond, the request is simple: tell us the licence type, the state and the board's required amount, and the bond can usually be issued on credit within a day or two. For a contract bond programme, bring two or three years of financial statements, the current work-in-progress schedule, a personal financial statement for each owner, and the bid or contract you are pursuing; from that we can say what single and aggregate limits a surety is likely to support and what the balance sheet needs to look like to grow them. Where the statements will not yet support the job, we say so early, because the answer changes with capital, not with time.