What Are Surety Bonds and How Do I Explain Them to My Customers?
As an insurance agent, you spend the majority of your time matching insurance policies to customers. And it’s likely that your customers are already familiar with the framework upon which most insurance policies are built (i.e. an insured and insurer enter into a contract where one or more payments are made in exchange for financial protection or reimbursement against losses). So when the need for a surety bond arises, it’s probably tempting for your customers (and some insurance agents too) to apply this same framework. After all, surety bonds are a form of insurance issued by insurance companies that insure against unmet obligations. But there are some big differences between insurance policies and surety bonds. Notably, it’s your customer who is on the hook—not only to pay for the bond, but to back it as well!
Surety Bonds Defined
BusinessDictionary.com defines a surety bond as a “Formal, legally enforceable contract between a first party (the principal or obligor), a second party (the customer or obligee), and a third party (the surety, such as a bank, bonding company, or insurance company) whereby the surety guarantees payment of a specified maximum sum, or to otherwise compensate (indemnify), the obligee against damage or loss caused by the actions (or a failure to perform) of the obligor.” Clear as mud, right? Let’s break down this definition by taking a closer look at the role played by each of the three parties involved in a surety bond:- This is the party that is obtaining the bond (i.e. your customer). For example, contractors are often required to obtain performance bonds in order to guarantee satisfactory completion of a project. The principal not only purchases the bond, but is also responsible for any claims made against the bond in the case of failure to meet obligations.
- Obligee. This is the party that is requiring the bond, often a government entity. If the principal does not meet its obligations, it is the obligee that is the beneficiary of any claims filed.
- This is the party that guarantees the principal can fulfill the obligations set forth in the bond. Although it’s the principal who is legally responsible for reimbursing the surety for any claims made against the bond, the surety is ultimately responsible for paying the obligee for valid claims. For this reason, it’s in the surety’s best interest to carefully assess not only the likelihood of the principal to incur claims (e.g. does the principal have a good performance track record?), but also the ability of the principal to cover claims (e.g. are they financially sound?).
“Aha!”
Your customers may be wondering what the point of a bond is if they are ultimately responsible for all claims payments. In other words, what’s in it for them? To help you answer this question, here are a couple of additional angles from which you can attack the topic of surety bonds and hopefully spark that “aha!” moment of understanding:- Bonds aren’t designed to protect the principal. Unlike a standard insurance policy which is a win-win for both the insured and insurer, bonds have no real upside for the principal (i.e. your customer). They exist as a mechanism to protect the obligee from risk. If your customer wants to do business within a certain industry—or with certain government entities—then the question of “what’s in it for me?” is largely a moot one as your customer really has no choice but to obtain the bond being requested of them.
- Think of the surety bond as a form of credit. If surety bonds didn’t exist, how would your customer guarantee that they could fulfill their bond obligation? They’d need to post 100% collateral in the form of cash. Depending on the bond amount required, this could significantly decrease working capital and liquidity. A surety (or bonding company) provides, in essence, a line of credit to your customer. For a small percentage of the bond amount, the obligee’s need to transfer risk is met, and so is your customer’s need to hold onto liquid cash.