Bonds which act as a way to transfer risk are most commonly known as surety bonds. In simple words, one can think of them as insurance that’s for the benefit of one party, paid by a second party, financed by a third party. These bonds are underwritten by insurance companies and offered either directly by insurance companies or by surety bond brokers.
For instance, when an employee joins an organization then the management will require him to purchase a security bond. This surety bond will protect the organization from the new employee from potential failure to complete the specific work required by the firm.
Three parties which are involved are as follows:
- The Principal: The person who must live up to the expectations for the bond.
- The Obligee: The person who needs a guarantee that the principal will perform according to the requirement.
- The Surety: The issuer of the surety bond guaranteeing that the principal will meet its obligation.
How does the surety bond transaction work?
A surety bond requires the surety to pay a set amount of money to the obligee if a principal fails to perform a contractual obligation. It also helps principals, typically small contractors, compete for contracts by reassuring customers that they will receive the product or service promised. To obtain a surety bond, the principal pays a premium to the surety, typically an insurance company.
Obligees are frequently government agencies, but commercial and professional parties also use surety bonds. The surety bond requires the principal to sign an indemnity agreement that pledges company and personal assets to reimburse the surety if a claim occurs. If these assets are insufficient or uncollectable, the surety pays its own money to satisfy the claim.
Types of Surety Bonds
There are various types of surety bonds, each serves different purpose. However, few of them have similar features.
- Bonded Amount: Sureties typically cap the bonded amount at 10 to 15 times the principal’s business equity, which is the amount invested in the company plus retained earnings. Sureties generally have an absolute cap on the bonded amount.
- Working Capital: Sureties usually require principals to have an amount of working capital—that is, current assets minus current liabilities—equal to at least 10% of the total bonded amount.
- Bonding Capacity: The maximum bonded amount a principal can obtain. It is a function of business equity and working capital.
- Bond Premium: A fee of 1% to 15% of the bonded amount charged by the surety and paid by the principal annually.
- Bond Term: A surety bond usually has a term of one to four years. Some are perpetual, with no expiration date.