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Surety Bonds

Sureties are used wherever there is a need for assurance of performance under the contract. A Surety Guarantee is a three-party agreement between the principal, the obligee and the surety. The surety undertakes to indemnify the obligee from loss arising from the principal's contractual default. Once the guarantee has been invoked and the surety having paid out to the obligee, recovers from the defaulting contractor.

It is an alternative to bank guarantees which is obtained by the principal, favoring the beneficiary/obligee, undertaking to compensate for the loss suffered by the obligee in the event of a default by the contractor. Some examples -

  • The obligations of a contractor to carry out a construction contract.
  • A dealer's obligations to the manufacturer
  • A franchisee's payment obligations to its franchiser
  • A tenant's monthly lease payments to its landlord
  • A borrower's loan payments to its lender

Surety vs. Insurance

Sureties are not the same as insurance. Traditional insurance protects the policyholder from losses due to accidents, natural events, or medical events. Surety bonds are different, as they are bought by the contractor but protect the project owner or obligee. Unlike traditional insurance, in which the insurer anticipates at least some claims, surety is underwritten with the expectation that a claim is highly unlikely.

Why Sureties

The current performance security system does not differentiate between high-performing and marginal contractors. If two companies have the same level of financial assets, they have the same ability to furnish performance bonds. Sureties on the other hand, help prequalify a contractor based on their capability to efficiently deliver on the implementation of the contract.
The following is the result of a study based on case studies in five State Departments of Transportation of the USA: Iowa, Oklahoma, Utah, Virginia, and Washington. Structured interviews were conducted with members of the construction contracting sector and the surety industry. The paper finds that while average default were less than 1.0% and a performance bond adds an average of 1.5% to the cost of every construction project, both DOTs and contractors were be reluctant to eliminate performance bonds from the industry. Therein, lays the paradox: Construction project owners were willing to pay an additional 1.5% to protect itself from an event that happens less that 1.0% of the time.
The study had bought out that the quantitative benefits of the surety bonding system do not exceed the costs and that both owners and industry see value in the financial discipline the system imposes on contractors who want to compete for and build public highway projects. The relationship between the Surety and the contractor emerged as the central factor of the risk mitigation.

Prime Benefits of Using Surety Bonds

  1. Improves businesses liquidity by freeing up bank lines for working capital needs.
  2. A Guarantee provider doing the holistic assessment of the company - performance and financial as a domain expert adds to the credibility of the work and not just the financial underwriting.
  3. Restricting contractor failures - According the Canadian Centre for Economic Analysis, a non-bonded construction enterprise is 10 times more likely to become insolvent than bonded companies
  4. Viable alternative to bank guarantees / letters of credit.
  5. Wider distribution of credit risk amongst specialists in underwriting guarantees
  6. Bonding capacity can increase a contractor's or subcontractor's project opportunities