What Is a Surety?
A surety is a promise or agreement made by one party that debts and financial obligations will be paid. In effect, a surety acts as a guarantee that a person or an organization assumes responsibility for fulfilling financial obligations in the event that the debtor defaults and is unable to make payments. The party that guarantees the debt is referred to as the surety or the guarantor. Sureties can be made by issuing surety bonds, which are legal contracts obligating one party to pay if the other fails to live up to the agreement.
Key Takeaways
- A surety is a promise that financial obligations will be met if one party defaults.
- A surety is made by a person or party that takes responsibility for the debt, default, or other financial responsibilities of another party.
- Sureties are used in contracts in which one party’s financial holdings or well-being are in question and the other party wants a guarantor.
- Surety bonds tie the principal, the obligee (often a government entity), and the surety.
How Sureties Work
As noted above, a surety is a guarantee or promise that assures payment through a legally binding contract. Under the agreement, one party promises to fulfill the financial obligations if the second party (the debtor) fails to pay the third party (the creditor).
The surety is the company that provides a line of credit to guarantee payment of any claim. They provide a financial guarantee to the obligee that the principal will fulfill their obligations. A principal’s obligations could mean complying with state laws and regulations pertaining to a specific business license or meeting the terms of a construction contract. An example of such a contract would be when a surety company vets and hires an administrator to handle a will or estate.
If the principal fails to deliver on the terms of the contract entered into with the obligee, then the obligee has the right to file a claim against the bond to recover any damages or losses incurred. If the claim is valid, the surety company will pay reparation that cannot exceed the bond amount. The underwriters will then expect the principal to reimburse them for any claims paid.
A surety is most common in contracts in which one party questions whether the counterparty in the contract will be able to fulfill all requirements. The party may require the counterparty to come forward with a guarantor to reduce risk, with the guarantor entering into a contract of suretyship. This is intended to lower risk to the lender, which might, in turn, lower interest rates for the borrower. A surety can be in the form of a surety bond.
The claim amount in a surety is still retrieved from the principal, either through collateral posted by the principal or through other means.
Special Considerations
A surety is not a bank guarantee. Similarly, it is not an insurance policy. Where the surety is liable for any performance risk posed by the principal, the bank guarantee is liable for the financial risk of the contracted project.
The payment made to the surety company is paying for the bond, but the principal is still liable for the debt. The surety is only required to relieve the obligee of the time and resources that will be used to recover any loss or damage from a principal.
Surety Bonds
A surety bond is a legally binding contract. It is used as an assurance that the issuer will pay any debts if the other party fails to do so. Surety bonds are entered into by three parties:
- The Principal: This party is responsible for obtaining the bond and fulfilling the obligation.
- The Obligee: This party is the one who needs the guarantee by the principal. This can be a company, a government agency, or an individual.
- The Surety: The guarantor of the bond. This party ensures that the principal makes payment.
Here's how it works. The principal is responsible for securing the surety bond, which must abide by certain conditions, including the total amount owed. If the principal defaults or breaks the contract, the obligee, who is owed the money, can file a claim seeking restitution. The surety (or the party issuing the bond) can review the claim and decide. If the claim is paid, the surety can then seek financial compensation from the principal. This includes interest and fees on top of the principal balance.
Types of Surety Bonds
Surety bonds can be used in a number of different circ*mstances. The table below outlines some of the most common types of surety bonds:
| Types of Surety Bonds | |
|---|---|
| Commercial Surety | Commercial sureties are needed by licensed businesses. Governments issue these sureties to make sure business owners follow codes and regulations. |
| Contract Surety | This type of surety ensures that contractual agreements are met. Contract sureties are commonly used for construction projects. |
| CourtSurety | Commonly used in civil cases, these sureties provide a form of protection against court losses. |
| Fidelity Surety | This type of surety is used by companies to protect against theft and employee misconduct. Fidelity bonds aren't mandatory for business but are used as risk management tools. |
Surety Bond vs. Insurance
There's some important distinctions between a surety bond and insurance that are worth calling out. A surety bond is a three-party agreement that guarantees the performance of an obligation, while insurance is a two-party agreement that provides financial protection against specific risks.
One of the key differences between surety bonds and insurance lies in how claims are handled. When an insurance claim is made, the insurer compensates the insured for covered losses according to the policy terms. This compensation is typically final, and the insured does not have to repay the insurer.
When a claim is made against a surety bond, the surety may pay the obligee to cover the costs of the principal's failure to meet their obligations. However, unlike insurance, the principal is legally obligated to repay the surety for any claims paid out. This reimbursem*nt clause ensures that the principal bears the ultimate financial responsibility, making surety bonds more like a form of credit than traditional insurance.
The purpose behind obtaining a surety bond versus insurance also differs. Surety bonds are primarily used to ensure that contractual obligations are met, often in the context of construction, environmental projects, or other business agreements. They assure the obligee that the principal will fulfill their commitments or face financial consequences. Insurance, on the other hand, is designed to protect the insured from unforeseen risks, such as accidents, natural disasters, or health issues.
Example of Surety Bond
Imagine a real estate developer planning to build a new residential community on a large tract of land. The local government mandates that the developer complete extensive landscaping and environmental restoration as part of the project. This work includes planting trees, creating green spaces, and restoring disturbed wetlands.
To ensure the developer meets these commitments, the government requires the developer to obtain a surety bond specifically for the landscaping and environmental tasks. In this scenario, the developer approaches a surety bond company to secure the required bond. The obligee is the local government which wants to guarantee that the developer will fulfill the obligations. The surety bond ensures that if the developer fails to complete the landscaping or properly restore the environment, the local government can claim the bond.
The surety, having issued the bond, would then be responsible for either hiring another contractor to finish the work or compensating the government for the costs associated with completing the tasks. This arrangement protects the government and the community from bearing the financial burden of unfinished environmental work, while also holding the developer accountable for meeting their environmental responsibilities.
What Is the Purpose of a Surety?
A surety is the guarantee of the debts of one party by another. This is intended to lower risk to the lender, which might, in turn, lower interest rates for the borrower.
What Is a Surety Limit?
A surety bond protects an obligee against losses, up to the limit of the bond. The bond amount is the monetary limit up to which the obligee requires the bond to be issued.
What Are the Benefits Available to a Surety?
Surety bonds provide a defense against false claims and act as clear-cut representation when claims occur. Because surety bonds also lower risk for lenders, they can reduce interest rates for borrowers.
The Bottom Line
A surety is a person or party that takes responsibility for the debt, default, or other financial responsibilities of another party. A surety is often used in contracts in which one party’s financial holdings or well-being are in question and the other party wants a guarantor.
Surety bonds are financial instruments that tie the principal, the obligee—often a government entity—and the surety. In the case of surety bonds, the surety is providing a line of credit to the principal so as to reassure the obligee that the principal will fulfill their side of the agreement.
