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Surety Bonds: What You Need To Know

  • December 10, 2021

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one dollar bills wrapped up in a pile - surety bonds

Looking for information about surety bonds? Here's what you need to know to get started.

Surety Bonds: A Brief Introduction

Business owners and entrepreneurs who work in certain types of professions have to deal with many different tasks. They must choose their legal entity structures, create business plans, secure business insurance, and handle many other duties needed to operate their businesses. An additional requirement for certain types of businesses and licensed professionals is a surety bond. In some industries, people are required to secure surety bonds to obtain the licenses they need to operate their companies. In this article, you'll learn what surety bonds are, what they involve, who needs them, how much they cost, and how to acquire them.

What Are Surety Bonds?

Surety bonds are binding legal agreements involving three parties, including the principal or obligor who seeks the bond, the obligee or party that requires the principal to purchase a surety bond, and the surety company that issues the bond. A surety bond guarantees that the principal will perform its contractual obligations, engage in ethical conduct, and comply with the laws and regulations that apply to the industry in which the principal works.

In many cases, the obligee is the state or federal government. However, some private contracts also require contractors to secure surety bonds and maintain them while their projects are ongoing. In exchange for the surety company issuing the bond, the principal must pay a premium up-front to the surety. The amount of this premium will depend on the factors considered by the surety during the underwriting process.

For example, a salvage vehicle dealer who is selling a vehicle with a lost title can get a bonded title. This is a surety bond that is used to establish the ownership of the vehicle and allows the dealer to sell it. If the dealer cannot obtain a surety bond because of the factors considering during underwriting, they will not be able to secure a dealer's license or sell the vehicle.

Is a Surety Bond a Type of Insurance?

A surety bond is not the same as an insurance policy. When business owners purchase business insurance, they do so to protect themselves when claims are filed. Purchasing a surety bond does not protect the principal, however. Instead, it works as a guarantee that the principal will perform its obligations under the contract and will abide by the law.

Surety bonds protect the public and the obligee. Consumers or the obligee can file claims against a principal's surety if the principal fails to perform as contracted or violates the law. If a valid claim is filed, the principal will be required to pay it. The surety company will only step in as a secondary party to pay a valid claim when the principal fails to do so, and the surety will then be legally entitled to go after the principal for reimbursement.

Are Surety Bonds Permanent?

Surety bonds are not permanent. They normally last for terms that range from one to four years. However, they are renewable as long as the principal has established a good history with the surety company and has avoided claims. Since surety bonds are required for many different types of businesses before they can secure licenses, being unable to secure a new surety bond could force a company out of business because it will lose its license. Also, surety bonds are not automatically issued. Instead, the principal's application for a surety bond will have to go through underwriting so that the surety can assess the risks involved with issuing the bond.

Factors Surety Companies Consider During Surety Bond Underwriting

There are numerous factors that surety companies consider during underwriting when a principal submits an application for a surety bond. Some of the most important ones are:

• Available working capital: A principal will need to have sufficient working capital available to cover any potential claims that might be filed.
• Creditworthiness: The surety will want to see that the principal has established a good credit history.
• Experience: Having experience with the same type of project in the past is desirable for surety companies because it shows that the business is capable of handling the current project.
• Reputation and character: The principal's reputation and character are important. A principal with a history of unpaid claims or criminal convictions will have a difficult time securing a surety bond.

Industries Required to Obtain Surety Bonds

Many industries need to be bonded. You can contact the Secretary of State's office in your state to find out whether you will need to get a surety bond to obtain a license and legally operate your business. Industries and individuals that require surety bonds include:

• Notaries public
• Auto dealers
• Auto dealerships
• Mortgage brokers
• Contractors who work on public projects
• Medical device providers who contract with Medicare
• Construction companies
• Travel agencies
• Health clubs

How to Obtain a Surety Bond

If you need to get a surety bond, you can apply through a surety company. Prepare to bring documents demonstrating your company's financial status. Documents you might need to make available include:

• An organizational chart for your company
• A copy of your business plan
• Financial statements demonstrating your available working capital and your company's profitability
• References from past projects
• A detailed resume
• Balance sheets and income statements

It's a good idea to ask about the documents the surety company requires ahead of time so that you will be well prepared.

Cost of a Surety Bond

If the surety decides to approve your application for a surety bond after going through the underwriting process, you will be charged a premium up-front. This premium will be a percentage of the total bond amount. Your premium amount will depend on the risk the surety company will assume by issuing you a surety bond. In general, people who have good credit histories, relevant experience, good moral character, and strong financials can expect to pay around 1% of the required bond amount as a premium. People with problematic credit and histories of filed claims will likely have to pay much more to secure surety bonds or potentially be denied for them. The premium percentage for surety bonds can range anywhere from 1% to as high as 15% for principals that pose a high degree of risk.

While surety bonds do not protect your company against claims, they are a necessary part of operating many different types of businesses. Once you purchase a surety bond and obtain your license, it is critical to always follow the law and build good relationships with your customers, suppliers, and subcontractors. By operating your company ethically and meeting your contractual obligations, you can both build a good business reputation and avoid claims against your surety.

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