The easiest way to think about surety bonds is as a tool for risk management with some similarities to both insurance and credit. Surety bonds exist to ensure that businesses complete their work in accordance with the law and under the terms of their contractual agreements. Surety bonds accomplish this by involving a third party who will compensate customers for a business’s failures to meet their obligations and recover damages from that business later.

Say Business A agrees to perform work for Business B. Business B wants the certainty that either Business A will complete the work they agreed to—as promised and within the legal standards for their industry—or, if Business A is unable to do so, that Business B will not suffer a financial loss or other risk as a result. To help guarantee this, Business A may be required—by law or by Business B—to obtain a surety bond from a third party. The bond is a promise that Business A will meet its obligations to Business B or, if they do not, that Business B will be compensated for Business A’s failure. Meanwhile, the third party charges Business A for taking on financial risk in the transaction and will seek to recover the costs of the claim from Business A later.

Surety bonds can be somewhat complicated to understand, as many purposes and applications exist across different types of businesses and industries. However, most surety bonds include some similar components and features, regardless of the specific terms or use case. To understand how surety bonds work, it is essential to first know who is involved in a surety bond agreement and then understand the elements of each bond.

Surety bonds are an agreement between three different parties: a principal, an obligee, and a surety.

✅Principal: The principal is the individual or business that obtains a bond from a surety to guarantee their ability to fulfill obligations to another party, the obligee.

✅Obligee: The obligee is the entity that requires the bond from the principal. Obligees require bonds to minimize their risk and financial loss if a principal cannot meet its obligations. Obligees receive compensation from the surety in the event of a claim against the principal.

✅Surety: The surety is the company that underwrites the bond to back the principal financially. If the principal is unable to meet its obligations and the obligee makes a claim, the surety will pay out the claim.

Each bond agreement looks a little bit different, but principals and sureties will usually need to work out a few particular elements or criteria as part of the agreement. These include the bonded amount, the principal’s working capital, the bonding capacity, the bond premium, and the bond term.

✅Bonding capacity: Bonding capacity is the maximum amount of coverage a principal can obtain from a surety, usually based on the principal’s finances, track record, and reputation. Businesses that sureties determine to be more reliable will likely be able to obtain a higher capacity. Capacity can be set for individual jobs or as an aggregate limit across all of a principal’s projects.

✅Working capital: Working capital is a factor that surety companies will evaluate before underwriting a bond, calculated as the difference between a company’s current assets and current liabilities. Because sureties will require reimbursement from a principal in the event of a claim, they want to know what sort of financial cushion a business has to repay its debts.

✅Premium: Surety bond premiums are calculated as a percentage of the bond amount. The rate is set based on factors like your or your business’s credit history, the likelihood of loss or other risks, and your business’s financial statements, like your balance sheet.

✅Term: The surety bond’s term is how long the bond remains in effect. If the term ends, the principal will no longer pay a premium, and the surety will no longer hold the bond risk.

Insurance and surety bonds are both common forms of risk management in business, and a company may require both to operate. And they share one important attribute in common: both insurance policies and surety bonds help compensate one party in the event that something goes wrong. The key difference is in the parties involved—and specifically, which parties carry risk in the agreement.

Under an insurance policy, a policyholder pays their insurance provider a regular premium in exchange for the insurer accepting the financial risk to pay for certain losses. For many types of coverage (e.g., under property insurance), an insurer will reimburse the policyholder in the event of a loss. If someone brings a successful claim against the policyholder (e.g., in a liability claim), the insurer will pay out the cost to whoever brought the claim, and the policyholder will not have to contribute financially beyond their premiums and deductible.

Under a surety bond, financial risk ultimately remains with the individual or business that obtained the bond. The surety bond represents a promise that the principal will fulfill their commitments to the obligee; the surety guarantees that the obligee will receive compensation if the principal cannot cover a payment if they fail to meet their legal or contractual obligations. Ultimately, however, the principal must repay the surety in the event of a claim, which means that the financial risk of the agreement always remains with the principal.

Because of the differences between surety bonds and insurance described above, it can also be helpful to think about surety bonds as a form of credit, in which principals pay a premium to a surety to borrow money if needed for compensation to the obligee.

Letters of credit perform a similar function. A letter of credit is an agreement between a customer (the same as a principal), a beneficiary (the same as an obligee), and an issuer, traditionally a bank. Under a letter of credit, the issuer promises to advance compensation for a claim to the obligee, but the bank customer is ultimately responsible for repaying the claim cost.

Letters of credit differ from surety bonds in a couple of important ways that may make them less desirable to the business seeking out the LOC. The first is that a letter of credit requires a collateral deposit from the business in the amount of credit in the LOC, which the company cannot touch while the letter of credit is outstanding. This means that in contrast to surety bonds, which only require principals to pay a premium, a letter of credit limits the cash available to a business. The second difference is that unlike surety bonds, which allow the surety to evaluate the claim, banks must pay on the letter of credit regardless of whether the beneficiary has proven a breach of contract or some other harm.

With a firm understanding of what surety bonds are and how they work, it’s time to review the three broad categories that most surety bonds fall into.

Contract Bonds

Contract bonds are bonds that guarantee that the terms of a contract will be carried out. The terms to be fulfilled may fall in multiple dimensions, such as a business’s obligations to perform the work that they say they will complete or their obligations to pay suppliers or subcontractors for their work on a project. Many obligees—especially government clients—require a contract bond to be filed before a business is allowed to bid on a project or enter a contract. On the front end, this helps hone in on only those businesses that can fulfill the contract terms. During the project, contract bonds minimize the financial risks associated with project failure.

Commercial Bonds

Commercial bonds are usually a legal requirement for a business to be licensed to operate, enacted by a federal, state, or local law. The purpose of these bonds is to protect the public: if a business acts illegally or in a manner that harms a customer or member of the public, the surety bond will compensate someone who brings a successful claim against that business, and the surety will seek to recover the cost from the business. Commercial bonds can be used in any number of industries to make sure companies meet their obligations under the law and to their customers, from auto dealers to warehouses to notaries to alcohol manufacturers and distributors.

Court Bonds

A court bond is a surety bond that one would need to secure when acting as part of the court system. Such bonds may be required to reduce the risks of financial loss or to ensure that someone tasked with a specific responsibility by a court of law completes that task. For example, if a court makes a monetary judgment and one party appeals, the court may require a bond to be put in place to ensure that the party who wins the judgment receives payment if the appeal fails. Another example is a bond put in place for a particular individual appointed as a guardian or custodian for minors to ensure that the individual acts in the minor’s best interest. Similarly, a bond might be put in place for the executor of a will to ensure that the executor distributes the estate’s assets appropriately.

There are thousands of different types of surety bonds. Accordingly, surety bond requirements differ substantially depending on the industry in which a business operates and the federal, state, and local laws to which a business is subject. Additionally, statutory requirements may outline how much coverage a business needs to obtain. To be certain of whether your business is required to have a surety bond—and what type of bond(s) you need if you do—it is best to consult directly with a risk management professional or a surety with expertise in your industry and jurisdictions.

Generally, however, surety bonds are required in the following cases:

• As a requirement of licensure or permitting – If you work in a business where you must meet certain licensing standards to legally operate, the government may require a surety bond, depending on the laws governing your industry in your location. These bonds essentially guarantee that you will follow all of your profession’s laws, rules, and standards. All states have websites listing specific industry bonding requirements, like the CSLB in California.
• When entering into certain government contracts – To protect public resources, many federal, state, or local governments will require some contractors or vendors to have surety bonds. For instance, the federal government and many state and local governments require a surety bond for any construction contract valued over $150,000.
• Under certain court proceedings – Sometimes, a court bond will be required of one party in a legal case to protect another party from financial loss or to ensure that an individual or entity carries out tasks required of them by the courts.

The common thread in these situations is some involvement of a government actor with an interest in protecting the public or public resources. In most cases with private parties, any requirement for a surety bond will be at the discretion of the entity you contract with.

The cost you pay for surety bonds is usually calculated as a percentage of the overall bond amount. In the majority of cases, the percentage rate is set between around 1% and 5%, based on the principal’s finances and credit history, the nature of the job, and other factors. However, rates can sometimes be as low as .5% or as high as 20%.

Principals who are considered by the surety to be more likely to fulfill their obligations will pay a lower rate, while those who are seen as less reliable will pay a higher rate. Say two companies each need a bond for a construction project worth $500,000. The first company has a good credit history, strong financial position, and a track record of completing similar jobs to clients’ satisfaction. This company might receive a rate of 1% from the surety, which means they would only pay $5,000 for coverage. The second company has limited working capital and has a reputation for not completing jobs on time and producing lower quality work. This company might receive a rate of 6%, which means they would pay $30,000 for the same bond.

Each surety looks at a variety of factors to evaluate the risk level of a bond when setting rates, and no one surety will weigh each factor equally. In general, however, rates are a reflection of the type and amount of the bond, your personal and business credit and finances, your business’s track record, and several other variables. Specific factors that a surety may consider are explained below.

Bond Type

Different types of bonds have different risk levels and obligee expectations, and sureties set rates accordingly. For instance, court bonds like a probate bond or commercial bonds like a notary bond are considered low risk and may have rates of 1% or less. In contrast, something like a contract performance bond for a construction project may be considered riskier, especially if the job requires specialized knowledge or expertise to complete. In such a case, the construction company may need to pay a higher rate to obtain the bond.

Bond Amount

Bond amount could also impact your rates, as sureties want to account for the possibility that they could end up paying a large sum for any claims and having to collect that amount from the principal. All else being equal, a principal may be considered safer to cover—and therefore pay lower rates—on a $30,000 bond than a $300,000 bond because the financial risk to the surety is lower and the principal will have an easier time repaying if needed.

Credit

When setting rates for a surety bond, the credit history for businesses and certain individuals (usually those with a significant ownership stake in the business) will be one of the most important factors the surety considers. Like with any loan, credit history will be taken as an indication of your willingness, ability, and commitment to paying off any debts. If the surety considers you less likely to repay them if they pay out a claim, you will likely encounter a higher rate on the bond. You can get a copy of your business’s credit report from companies like Experian or D&B.

Financial Statements

Because surety bonds can put a significant amount of money at stake, sureties want to know that principals have the financial wherewithal to pay the bond amount if needed. One of the most important factors the surety will look at is working capital, or the principal’s assets minus their short term liabilities. This measure gives the surety a quick indication of the principal’s liquidity and ability to meet short-term financial obligations. Companies in a strong financial position will usually pay lower rates.

Industry Experience

For contract bonds, the surety will be interested in the principal’s capacity to meet the terms of the contract. This may involve looking at the firm’s human and financial resources, technical expertise, and other projects currently underway. But even if a company currently appears capable of completing the work as agreed, one of the best reassurances for sureties is a track record of having successfully completed similar work in the past. Companies without that track record in the industry may be considered riskier and pay more for surety bonds as a result.

Claims History

If clients, subcontractors, or other individuals have filed many claims against you in the past, the surety might take it as a sign that your work is not of high quality or that you are unreliable in meeting your obligations. These attributes would seem to increase the likelihood that more claims will occur in the future. However, the number of claims may be related to the type of bonds you have or the industry you work in, and sureties should consider that context. Regardless, surety companies will evaluate your claims history and will prefer to offer lower rates for those who have avoided claims in the past.

Reputation & Character

Sureties want to deal with trustworthy principals because those businesses or individuals are more likely to act responsibly, meet their obligations, avoid claims, and pay what they owe if there is a claim. And while sureties can get a sense of a business’s trustworthiness from their credit, claims history, or industry experience, they may also look for other, more intangible signs of a business’s reputation and character. Factors like communicating well, having long-tenured management, or paying subcontractors in a timely manner can all indicate that a business is reliable and worthy of paying a lower rate.