Surety bonds are one of the most important financial instruments in our financial system. In this article, we shall understand how does a surety bond work, and what is the surety bond cost.
A surety bond is nothing but a financial guarantee for protecting business enterprises from losses due to defaulted contracts. Having surety bond insurance has become absolutely essential in today’s uncertain corporate world. A surety bond is a way of dealing with risks in signing contractual agreements with businesses and people. In the signing of a bond, the following three parties are actively involved:
- Principal
- Surety
- Obligee
In the agreement, the principal is the company which performs the contractual obligation whereas the Obligee is the organization which accepts the obligation. The role of the surety is to assure that the principal will complete his stipulated task. In many cases, banks act as the surety. When such institutions issue surety bonds, it is known as the ‘bank guarantees’.
Function
The surety bond contract begins with the principal paying a percentage of the bond amount. This amount is known as the ‘bond premium’. Once this is done, the financial institution acting as surety will extend a surety credit for completion of the bond formalities. In this contract, principal has to meet with the obligations of the contract and pay amount to the obligee. In case the principal fails to honor the contract, then compensation is received by the obligee from the surety and this is phenomenon known as the ‘penal sum’ in the business world.
Before the penal sum is paid, the surety will first investigate the authenticity of the claim and take decision regarding paying the obligee only if it finds the claim to be valid. The surety later demands the compensation paid by him to the obligee from the principal. The surety will also recover the legal expenses from the principal which it has incurred for completing this entire process. Most of the time, financial institutions and banks act as surety and they receive a premium from the principal. The value of this premium depends on the total amount of the ‘penal sum’.
Solvency of the Surety
The surety bond process can function smoothly only if the surety is able to discharge its functions professionally and perfectly. If it happens that the principal defaults on payments and the surety too is unable to pay up, then it would be a great loss for the obligee. So, the solvency and financial strength of the surety has to be ensured before the bond is signed. The government finance authorities thoroughly scrutinize the balance sheet and other financial statements of the surety before permitting them to sign surety bonds. Most of the time, large insurance giants and banks act as surety because of their stable businesses and high cash in the balance sheet.
Applications
There are various types of surety bonds which have been listed below:
- Contract bond: A contract bond can be a performance bond, maintenance bond or payment bond
- Permit bond: Permit bonds are required by government laws and regulations
- Commercial Bond: Commercial bonds help in providing credibility to businesses
- Bail bond: This bond is useful to get bail for an offender until his trial begins
The cost of a surety bond can be around one to four percent of the total cost of the bond. However in case of high risk bond, the cost can be as high as ten to fifteen percent of the total bond amount.
Securing a company’s interests is the responsibility of its senior officials and hence taking help of surety bonds is an excellent way to render this duty. It is better to take suggestions from a legal expert before signing these bonds with the other party.