Bonds 101

In the contemporary global business environment, suretyship is a dynamic financial management tool. Surety bonds offer all types and sizes of businesses increased financial flexibility and greater potential for business growth by providing off balance sheet credit with more favorable terms and conditions than other financial instruments like letters of credit. Today's innovative risk and financial managers know that surety bonds are an important tool in meeting strategic business goals and improving competitive positions, not merely an indemnified assurance of performance.
Corporate Suretyship is closely associated with insurance as most sureties are property and casualty insurance companies. However, a Surety's method of operation involves principles, which more closely resemble banking than insurance. Insurance is a contract between two parties, the insured and the insurer. Suretyship is an obligation between three parties: the Principal, Surety and Obligee. The Surety agrees to be jointly bound with the Principal for the obligation of the Principal to the Obligee. Simply stated, a surety bond is an instrument under which one party guarantees to another that a third party will perform its obligation.
Surety Bonds once written are very broad documents. The bond guarantees that promises made will be kept. If the principal defaults, the Surety must meet the guarantee and then subrogate against the principal through the indemnity agreement. Unlike insurance where losses are anticipated, in theory there should be no losses under surety bonds.
The majority of Surety bonds are required by law or regulations of any of the political divisions of the government system, The other bonds often encountered arise out of the need to secure or guarantee contractual obligations from one private entity to another. There are a number of broad classifications of surety bonds with the major groups being:
  • Contract
  • License
  • Judicial
  • Public Official
  • U.S Government
  • Miscellaneous
  • Guarantees of Financial Performance
Contract bonds
Contract Bonds make up the largest group of surety bond writings. They guarantee that the Principal will carry out the terms and conditions of a contract, generally of a construction nature. Contract bonds can be required on public works or private projects. The role of the Surety in this process is provide assurance that the project will be completed according to the specifications, time and cost provisions contained in the underlying contract. Bid, Performance and Payment, Subdivision, Completion, Design & Build, Supply, and Maintenance bonds are the primary types of contract bonds encountered.
License and Permit Bonds
License and Permit Bonds generally are required to protect the public welfare; Government organizations of many types and levels require these bonds either by law or regulation. These license bonds generally guarantee that the Principal will comply with the rules governing their activities. They can protect the public from fraud, incompetence, bodily or property damage or credit losses. Examples of these bonds are:
  • Contractors License bonds - Incompetence
  • Insurance Agents Bond - Fraudulent policy or promises
  • Easement or Blasting Permit bonds - Bodily or property damage
  • Public Official
  • Mortgage broker bonds - credit losses
Judicial Bonds
Judicial bonds provide a guarantee on the part of a Principal that is involved in a court action. All court bonds are non-cancelable in nature. They can guarantee costs, damages, actions or faithful performance of an obligation overseen or directed by the court. Some common court bonds are:
  • Attachments bond - guarantee that the Principal will pay damages if property is later determined to have been wrongfully attached on their behalf through a court action.
  • Replevin Bonds - guarantee that property that was in the possession of the Obligee and has been taken by the Principal pursuant to a court order, will be returned to the Obligee should it later be instructed to do so. It also guarantees that the Principal will pay any costs and damages that accrue as a result of having replevied the property.
  • Injunction or Restraining Order Bonds - guarantee that if it is later adjudged that an injunction or restraining order had wrongfully been place on the Obligee, that the Principal will pay for and costs or damages that result from these actions having occurred.
  • Appeal, Supersedeas or Stay of Execution Bonds - guarantee that the Principal will pay to the Obligee the amount of any Judgment plus costs and interest owed by the Principal as a result of a verdict from a lower court while the Principal pursues an appeal of the verdict through the judicial system. Should the verdict be overturned and vacated the bonds is exonerated. In addition to securing the judgment the bond also effectively stays the Obligee's ability to pursue other legal remedies such as attachment or replevin of the Principal assets, in order to realize the proceeds of the judgment.
  • Fiduciary Bonds - guarantee the faithful performance of an individual appointed by the court to administer the affairs of another individual or firm. Such as the administrator of a deceased's estate that is lacking a will, a guardian or conservator, or a trustee appointed to oversee the reorganization or and administration of a business or individual subject to bankruptcy proceedings. These bonds are filed court as the named Obligee, but generally run for the benefit of anyone with an interest in the assets of the entities being administered.
U.S. Government Bonds
U.S. Government bonds as the name implies guarantee the obligations to the federal government with the two main types being:
  • Customs Bonds - guarantee the payment of custom duties on goods by the responsible parties.
  • Excise Tax Bonds - guarantee that the dealers and manufacturers of products such as alcohol, and cigarette will pay the federal taxes that accrue on these items.
Miscellaneous Bonds
Miscellaneous Bonds generally are described as any private or public bond not readily classified under the other bond types. These bonds are vast in their scope and are often broad coverages whose risk factors and obligations are only defined and ascertained within the underlying obligation being bonded. Quite often, the real obligation being bonded is the compliance to the underlying agreement and in the event of failure to comply, the payment of money to compensate for recouping of losses, or as a penalty for default. These financial guarantee obligations often contain some of the most onerous hazardous and long-term risk factors within the surety industry. Some common Miscellaneous bonds are:
  • Utility Payment Bonds - guarantee the payment of charges owed by the Principal to a Gas, Electric or Water Utility.
  • Lost Instrument Bonds - In exchange for re-issuance of a duplicate replacement of a lost or destroyed financial security, document or check, the Principal and Surety guaranty that the Obligee as the re-issuer and/or any other potential injured third party, such as a holder in due course, will be held harmless as a result of the re-issuance of this replacement security. Many of these types of bonds are open penalty obligations, structured in that manner to account for the potential increases in the value of missing instrument.
  • Workers Compensation Self Insurance Bonds - required by the various state Insurance departments for business that have a self insured portion of their Workers Compensation Insurance programs. These bonds are generally large in size and are subject to strict regulation as to their scope and structure. The risk factors contained in these exposures vary from state to state dependent on the regulations imposed. Many state regulations are structured in such a manner that the Surety exposure under the bond can remain for decades after the termination of the actual bond, due to long term benefit exposures or the states aggregation of any and all security posted under a firms self insurance program.
Public Official Bonds
These bonds are required in many of the public offices held and state county and local levels. If the position is one in which handling of public funds is involved a bond of this type is normally required. These bonds generally guarantee the faithful performance of the duties of the position. These bonds for tax collectors, supervisors and treasurers can be very large in size and may according to the governing regulation require various standards and aspects of performance for similar positions in different jurisdictions. A key aspect to undertaking these risks is the understanding of the financial controls in place for these positions.