Summary of Surety Bond Principles

Common Elements for Surety Bond Transactions

All surety bonds have three parties. The principal/obligor/contractor performs the work. The surety guarantees the work. The obligee/owner is the entity that expects that the work will be completed successfully and according to contract terms. The principal and surety are discharged from further liability after the work is completed. The principal that defaults or fails to perform triggers a demand from the obligee to pay some, if not all, of the bond amount penalty. This penalty is also called a penal sum.

Example of the responsibility of surety bond parties

The contractor is J & J Construction, the owner is Kerry County Developers, and the surety is ABC Surety Company. Kerry County Developers is developing a shopping center. If J & J does not perform its obligations properly, ABC Surety is obligated to Kerry County Developers for the bond amount.

Principal/contractor and surety are jointly and severally liable to the obligee/owner. If the principal/contractor fails to perform, the surety must fulfill the obligation in place of the principal/contractor.

Example – Bond Obligator

 J & J Construction declares bankruptcy and cannot complete the shopping center. ABC Surety is liable to Kerry County Developers for the bond amount.

Except for most license and permit bonds, the surety does not have the option of canceling its obligation before the principal completes the project.

Example – Indemnitors

ABC Surety realizes that the J & J Construction has financial problems but it cannot cancel the bond.

A surety can reduce its exposure by requiring support of personal, partnership, or corporate indemnity on behalf of the principal. In this way, the surety can look to the indemnitors if the principal defaults.

Note: A word of caution is in order here. It is often said that indemnity is a good crutch to lean on, but not to lean on it too heavily. Like a bank guarantor, a surety indemnitor is not jointly and severally liable with the principal/borrower. The surety/bank must make every effort to fully recover its loss from the principal/borrower. Any recovery should include application of credits, salvage in surety cases, unearned interest on bank loans, and collateral (if any) before a demand can be made on the indemnitor/guarantor to recover any remaining loss.

Example: ABC Surety first looks to J & J Construction for restitution but then looks to Mark Johnson and Jerry Johnson personally because they are surety indemnitors.

Once the surety sustains a loss on behalf of a defaulting principal, the obligee’s rights of recovery against the principal are subrogated to the surety. The same rights pass to loan guarantors against the makers or borrowers once they have to make good on a loan default.

Example: Once ABC Surety pays Kerry County Developers, ABC Surety takes over Kerry County Developers’ rights to pursue J & J Construction.

Surety Premiums versus Insurance Premiums

The law of large numbers is a key integral component to most primary insurance lines of coverage. This law anticipates collecting sufficient premium from all policyholders to cover the losses of the few. Pooling premiums to respond to injury or damage sustained by certain members of that pool is how insurance works.

However, that approach does not necessarily apply to corporate suretyship. The premium for any type of surety bond is not treated as an amount that can be held in reserve to make payments. On the contrary, it should be considered as a fee for the bond. When losses occur, they are paid out of the surety’s assets, surplus investment income, and contingency reserve. After the surety fulfills its obligation, it assumes the principal’s rights, because it has already handled the principal’s financial responsibilities. Once an obligee receives a surety bond, that bond is valid, even if the principal never pays for it. The surety bond does not have any cancellation provisions for nonpayment of premium. In addition, the rights of the obligee cannot be invalidated unless the bond has an express provision that permits it.

 

Surety Bond Underwriting Overview

The surety underwrites the risk based on the three C’s: Capital, Character, and Capacity. Most grantors of surety credit, commercial bank loan providers, and many other firms that extend credit as a normal business risk use these credit evaluation standards.

Many grantors of credit use a fourth C, Collateral, to support unusually hazardous surety obligations. Collateral is also routinely used with the extension of many commercial bank loans. The additional support collateral for a credit risk does not necessarily challenge the creditworthiness of the bond principal or the party that seeks a loan. However, under contract suretyship, the requirement for collateral by standard surety markets (defined as conventional underwriters usually affiliated as members of or subscribers to the Surety and Fidelity Association of America) is highly unusual. One situation when such requests are made is when a contractor previously defaulted in performing bonded work.

Surety obligations (and contract bonds in particular) frequently depend on the officers and directors of a corporation to personally indemnify the surety against any loss it may sustain by reason of executing the bonds on behalf of a corporate principal.

The surety’s and lender’s respective means of recourse against default is similar. An unsecured lender has essentially the same legal remedies available to it against its defaulting borrower in civil proceedings as the surety does against its defaulting principal. In the surety business, this is known as the right of equitable subrogation. If the lender had a guarantor or co-maker supporting the borrower on its security instruments, these third parties are the equivalent to the surety as the guarantor to the obligee on a bond.

Understanding License and Permit Bonds

There are hundreds of License and Permit Bonds. They are individually listed and rated in the bond manual. The number of these bonds increases on a regular basis because new forms are developed after nearly every meeting of state legislatures and other legislative and regulatory bodies. License and Permit bonds fall into three general categories.

 

 

1. Code Observance and Good Behavior Bonds

This category of bonds applies to businesses such as plumbers, electricians, sewer installers, and retail liquor establishments. These bonds guarantee that the principal will comply with applicable health or safety laws or regulations. They are the most freely written and least hazardous because their primary purpose is not to guarantee the payment of money.

2. Tax or Money Remittance Bonds

Examples of this category include gasoline tax bonds; most federal liquor, beer, and wine bonds; milk dealer bonds; and commission merchant bonds. These bonds guarantee that the principal will pay money due to others and are considered financial guarantees. Coverage is underwritten carefully because of the financial guarantee. Most sureties want to write only experienced and financially responsible applicants.

3. Property Damage and Personal Injury Bonds

Examples in this category are blasting bonds, permit bonds for hauling or storing explosives, fireworks display bonds, and certain motor vehicle bonds. Most sureties require that the applicant be experienced and financially responsible. In many cases, they require underlying and excess liability insurance coverage as a safeguard.

General Characteristics of Licenses or Permit Bonds

A striking characteristic of modern business is its virtually unlimited variety, ranging from simple and basic business enterprises to huge multinational corporations. Despite the many differences among the various types of businesses, each must meet two underlying requirements in order to operate:

• A license or a permit from a federal, state, county, or municipal governmental entity issues in order to conduct operations in general and/or to exercise a special privilege
• A corporate Surety bond to support the license or permit

Licenses or permits are interchangeable terms. They are required when the public interest demands the regulation of certain types of business in order to protect its citizens and/or public and private property. A license or permit that is issued is considered a special privilege. The licensee must justify the privilege by complying with the terms of codes or standards of conduct outlined by law, ordinance, or regulation. The codes and standards are usually designed to prevent abuse of the privilege to the detriment of others.

The licensee’s agreement to comply with the law, ordinance, or regulation requires a guarantee in the form of a Surety bond that all levels of government recognize as indispensable to enforcement.

Purpose of securing a bond

The reasons why License bonds are required are so varied that classifying them is not practical. A representative listing of sample License bonds is included at the end of this analysis. It illustrates the wide range of businesses and applications to which they respond and apply. In general, License bonds:

• Indemnify governmental entities for loss or damage to their property. In certain cases, the bonds indemnify private parties and their property. When the appropriate provision is part of the license, the bond also protects governmental revenues by guaranteeing that taxes are paid.
• Save the time, expense, and personnel required to exhaustively investigate a prospective licensee’s financial and moral qualifications.
• Allow licensees to guarantee that they comply with the law without requiring a money deposit. This enables the licensee to use capital in its operations instead of tying it up in a deposit.
• Relieve the governmental entity or public official from having to maintain a special bank account to hold cash deposits and from the responsibility of returning those funds when the license expires.

License bonds never have to be returned. They may be held to protect a governmental entity and/or other parties that sustain or claim losses that may arise after the license ends.

Many types of License bonds must be filed annually. Others are issued for shorter periods in connection with a special privilege. In most communities, electricians, plumbers, and similar businesses file bonds annually. In addition to filing the customary Performance and Payment bonds, building and road contractors must frequently file License bonds for special types of work, such as street obstruction, blasting operations, opening sewers, and similar work subject to regulation. Many business concerns must obtain License bonds in order to hang or maintain signs, canopies, or awnings; for area-ways and vaults; for underground storage tanks, and similar exposures.

Statutes and ordinances on License bonds vary among states and cities. There are thousands of types of businesses that must furnish License bonds annually. When these numbers are multiplied by the 50,000 or more governmental entities throughout the United States that require their use, it is clear that License bonds effectively support a vast complex of federal, state, and local governments as they regulate business.

Example: All plumbers must be licensed. If the local building department handled their security deposits, it would have to increase staff in many areas. It would need staff to collect the deposits and place them in a special account in order to prevent commingling them with funds from other accounts. This fund would have to be audited periodically. In addition, the building department would need a group of inspectors to review and ensure that the jobs were completed successfully and professionally before it released any funds. It would also need additional staff to oversee the refunding of deposits. The final step would involve auditing the refund process to verify safeguards and accuracy in handling the refunds.

On the other hand, Surety bonds may be used in place of security deposits. In that case, the only staffing required is that needed to verify the surety and to be able to contact the surety in case of a complaint.

The same basic principles generally apply to electricians, street openers, and the laying of drains and pipelines, tapping sewers, and other similar activities that are subject to local licensing.

Example: License bonds are usually required of real estate brokers. The primary reason is to guarantee protection against fraudulent real estate transactions, as well as to properly account for all proceeds of such transactions. This presents a rather broad fidelity exposure and License bonds protect the rights of interested parties to these transactions.

Procedure for applying for a bond

The applicant files a bond with the supervising authority before the license is issued or the permit is granted. As a result, the surety performs an important function in enforcing laws, ordinances, and regulations because it does not execute a binding agreement until it is satisfied with the applicant’s character and ability.

License and Permit bonds are divided into two broad categories. The first guarantees payment to the governmental entity in case of default. The second guarantees payment directly to third parties.

The first category guarantees payment to the governmental entity if the bonded party fails to comply with the law, pay fees or taxes, or otherwise meet its obligations to the entity.

In cases where licenses or permits are required, bonds for each type of undertaking must utilize standard forms that the issuing authority previously approved.

Most License bond forms are written in clear general terms. The principal and the surety firms are bound to the governmental entity for a specified sum.

Conditions of the obligation include a statement that the government entity will issue a license to the applicant for a stated term to perform a specified business according to the governmental entity’s ordinances and regulations.

The bond states that the obligation is void if the principal faithfully discharges the duties outlined in applicable ordinances, rules, and regulations and pays the owner of any property for a loss that arises from any work done that violates any ordinance. Otherwise, the surety is required to pay the bond penalty amount.

The applicant receives complete information regarding the regulations that apply to its business when the license is issued. Surety companies have complete records of (or access to) all applicable laws, regulations, and ordinances.

The second category includes bonds extended to give third parties a right of action in their own names. These bonds guarantee recovery by members of the public for losses or damages that result from the principal’s breaching of its obligations. Such obligations arise from the law, ordinance, or regulation that requires the bond.

Third-party bonds usually are not required. An example of one that might be required is when a contractor’s work involves tearing up public streets and highways. However, they are not a substitute for liability insurance. If the surety is obligated to pay a third party, it will later recover from the principal. As a result, principals should carry liability insurance for their own protection. In fact, sureties usually require that applicants have such coverage in force and confirm in writing or in the application that it exists before they extend a bond to apply to third persons.

Bond Categories

Most bonds fall into one of the following categories.

Regulatory

These bonds are required to regulate, limit, or guarantee that the business will be conducted or the privilege exercised according to governing laws. They usually have a small penalty ($1,000 or less) and are usually written freely for well-known applicants that are highly respected and recommended by insurance agents in their local communities. Typical examples are florists, ministers, and billiard or bowling alley operators.

Public Safety

These bonds usually involve an element of liability. Their purpose is to protect the general public against physical damage. Examples include hanging signs and canopies, street obstructions, building demolition, house moving, transporting explosives, and similar hazardous activities.

Public Protection

These bonds are also for the benefit of the general public. They are intended to protect against fraud, unfair dealing, and misrepresentation. Used car dealers, livestock sales groups, employment agencies, insurance agents, real estate brokers, collection agents, auctioneers, ticket agencies, grain or other commodity warehouses, moneylenders, and related businesses are required to secure bonds in this category.

Tax Bonds

These bonds guarantee payment of taxes levied under laws or ordinances that require such bonds. Examples are Cigarette Tax bonds, Gasoline Tax bonds, and Sales Tax bonds. Because such tax collections are usually commingled with the proceeds of sales, they lose their identity as trust funds. As a result, the bonds become liable for successful operations of the business and must be written as credit or financial guarantees. Sureties usually require that the principal’s reputation and moral status be above reproach and that his or her financial standing be sufficiently strong, as determined from a verified statement and bank and trade investigation.

These undertakings are federal, state, or local guarantees.

Example: Livestock dealers must carry a federal tax bond. These bonds come under the Federal Packers and Stockyards Act. State agencies require similar bonds. Federal law requires that a commission firm or one that engages in auction market buying or selling livestock on commission file a bond in an amount based on its volume of business. This assures farmers and ranchers that they will receive the net proceeds for the livestock the marketing agency sells. It also assures that others will receive proper value for funds entrusted to the commission firm to purchase livestock. Under the Act, the bond covers all sales in interstate commerce.

Many states and cities impose taxes on merchandise sold within their boundaries. Manufacturers, wholesalers, and retailers collect these taxes from the purchasers and bonds are usually required to guarantee that the revenues are remitted. There are obvious advantages to such Tax bonds. Without them, conducting expensive and time-consuming interim audits would be necessary to be certain that the tax collections were remitted when due and that the licensee did not use the money to finance its own business operations.

A final way to categorize License and Permits bonds is as credit guarantees, financial guarantees, and indemnity bonds.

Obtaining License and Permit Bonds 

License and Permit bonds are issued only after submission and approval of carefully completed applications furnished by the surety. Short-form applications are used for most bonds. However, longer and more detailed applications are required for bonds that give a third party the right to sue the surety.

License or Permit bonds require the providing of certain basic information. This includes the applicant’s name, address, type of license applied for, amount and date of the bond, the party that receives the bond, the length of time the party has engaged in the business subject to the license, and net worth over and above all liabilities.

Complete information regarding the applicant’s liability insurance must be provided when a bond extends to include the right of a third party to sue the surety. Required information includes the type of coverage provided, name of the insurance company, policy number, and policy term. Special forms are used for certain License and Permit bonds and for permits for unusual or dangerous activities, such as blasting and other hazardous contracting operations.

Bond Coverage Analysis 

Most License bonds are quite simple. The principal or licensee and the surety are “held and firmly bound” to the municipality or other governmental entity as obligee for a specified amount. The obligation identifies the type of license that will be issued to the applicant and states that the privilege granted must be exercised according to the provisions of the obligee’s ordinances or applicable regulations.

Most License bonds indemnify only against the actual damages the obligee or third-party claimant sustains. However, a few include forfeiture clauses. In those cases, it is assumed that forfeiting the bond penalty enables the governmental entity to more effectively enforce the law that the licensee violated, such as a liquor retailer selling to minors.

The term for a License or Permit bond is the same as the period of the license or permit granted by the governmental entity. In most communities, electricians, plumbers, and others file bonds annually. Building and road contractors frequently file license bonds for special types of work, such as street obstruction and blasting operations. State laws specify the period during which a claim may be filed for a loss that occurred during the term of the bond after it terminates.

The bond obligation becomes void if the principal faithfully discharges its responsibilities as outlined in the law. Otherwise, it continues in force to indemnify for any default on the principal’s part.

The surety may terminate a License bond if the law, ordinance, or regulation under which the bond is required permits it or if the bond’s terms permit it.

Standard bond forms do not include cancellation rules. Whether the surety may terminate a License or Permit bond depends on the law, ordinance, or regulation that requires the bond.

A bond’s premium is fully earned if it is canceled and there is no successory bond. Pro rata return of premium is allowed when a bond is terminated after six months and there is a successory bond. A return premium equal to 50% of the annual premium is allowed between three and six months. A return premium of 75% of the annual premium is allowed for termination within three months of a bond if there is a successory bond.

If you have questions or need help securing a Surety Bond call us at 800-392-6532.

Business Insurance for Contractors in the Lake Sunapee, and Upper Valley of New Hampshire and Vermont. 
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