A surety bond is a legal contract that guarantees the fulfillment of one’s duty or a number of duties. In legal term, duty refers to a legally enforceable promise. When a bond is furnished, all the duties or obligations that one party needs to fulfill must be listed in writing.
There is a common misconception that a surety bond is synonymous to insurance. It’s not. While it’s true that insurance companies are the primary issuers of a surety bond and that both are risk-transfer mechanisms, a surety bond is not the same as an insurance policy.
To begin with, surety bond has three parties (Principal, Obligee, and Surety), while an insurance contract only has two. Insurance has only one source of fund that separates it from having a loss, while a surety bond has two sources of funds, namely:
- The principal’s assets
- The premium charged for the credit risk
Who Are The Three Parties That Are Involved In A Surety Bond?
The principal is the person who will purchase the bond and the person who is required to fulfill the duties that are stipulated on the bond. The principal’s credentials will be assessed before a surety bond is issued.
An obligee, on the other hand, is the party who requires the surety bond from the principal. The obligee will dictate the terms of the bond, which in most cases is derived from a statute, ordinance, or regulation. If the principal fails to perform the duties required, it is the obligee who will be eligible to file a claim against the surety bond in order to recover the result of losing business.
The surety is the party who will serve as the principal’s backer. The surety will guarantee the faithful performance of the principal to the obligee. But if the principal fails to perform the bond’s obligations, the surety is required to step into the shoes of the principal in order to complete the performance of the contract, meaning the surety will be responsible for the consequences along with the principal.
What Are The Credentials That Will Be Assessed When Obtaining A Surety Bond?
These credentials are also known as the three C’s of underwriting. According to Surety Bond Authority’s website, the Chartered Property Casualty Underwriter (CPCU) is an expert when it comes to property-casualty insurance. The underwriter will evaluate these three C’s thoroughly before a bond is issued.
Is the principal honest? Is the principal a person of integrity? Will he be able to meet his obligations no matter what happens? These are just some of the things that an underwriter will look at when assessing a principal’s character. Some might misperceive that character is not as significant as the principal’s financial strength when it comes to underwriting. In reality, character plays a lead role in underwriting. As history reveals, downplaying character in favor of financial capacity has resulted in many surety losses.
An important example of this was the fall of Enron back in 2001. By overlooking the importance of character, the surety bond industry was not able to safeguard its credit exposure to Enron. As a result, the industry took a heavy blow by paying billions of dollars in settlement.
Capacity is the ability of the principal to meet the obligations and to conserve his capital in order to finish the said obligations. The principal must have the established and protected intellectual property to complete the job. There are several factors in which capacity is measured. These are the following:
- Experience of the principal
- Expertise of the principal
- Business facilities
- Personnel management
- The industry’s stability
- Principal’s credit history
The principal should have sufficient funds to successfully complete the project or to fully perform the tasks stated on the contract. A principal’s financial strength is relevant to the level of credit risk. As a rule, the higher the credit risk, the higher the bond penalty will be. In addition, the length of obligation will be considered as well.
In order to assess the principal’s capital, the underwriter will require the principal to submit the latest financial statement among others. Corporate financial statements will have to be prepared by a certified public accountant and must cover the last three fiscal year-end periods, at the very least.
How Long Will A Surety Bond Be Processed?
It depends on the type of surety bond and how fast the principal submits the necessary requirements. However, the turnaround time is not that long for most bonds. In fact, you may be able to get your bond in as little as 1-3 days.
It will take more than the aforementioned days to issue bonds that have higher risks. Riskier bonds goes through a more complex form of underwriting process resulting in longer turnaround time.