Surety Bond Definition

Surety bonds are often mistake for insurance.  However, surety bonds are different from insurance by the way they work and how they are underwritten.  So, what is a surety bond?  Learn what is a surety bond, and the surety bond definition from the information below.

In very simply terms, a surety bond is a guarantee.  What the bond is specifically guaranteeing is determined by the bond language.  It is important to know that surety bonds differ from insurance and that there are three parties involved.

 The first party is known as the principal.  The principal is the party that needs to be bonded.  The second party is known as the oblige.  The oblige is the party requiring the bond principal to guarantee something.  Usually the oblige is a department within the government.  The third party is known as the bonding company or surety.   The surety is the party that will be providing the financial backing to make good on any claims that might arise.  

A license and permit bond is a common type, which will serve as a good example. Let’s say the state of Florida is requiring a bond of an auto dealer in order to become license and operate within the state. The Florida department of motor vehicles is the oblige. Remember the oblige is the second party. The principal in this example is the auto dealer. The auto dealer must obtain a surety bond from an approved bonding company. In this example, the bonding company will be making a written guarantee to the state of Florida that the auto dealer will operate per the licensing terms. Should the auto dealer break the state of Florida regulations, the Florida department of motor vehicles can place a claim against the bond.

In the event that a claim is paid out by the surety they will go after the auto dealer for all cost associated with the claim. This will also include legal fees. For some this comes as a surprise, but remember bonds are not insurance. Surety bonds are more like a form of credit than insurance.

The answer becomes clear when you look at the most common accepted alternative to surety bonds – Letter of Credit. Surety bonds are typically about 1-3% of the bond amount. A letter of credit usually requires a 1% fee. However, surety bonds normally do not require the principal to put up collateral. Whereas a letter of credit always requires collateral. At first glance it appears that surety bonds are more expensive. However, the principal could invest the liquid cash of 3% and earn interest. Using this method could cover the bond premium making it less expensive then the letter of credit.

If a claim does arise, bonding companies have claim professionals that will investigate the claim. This ensured that all claims against the principal are valid. With a letter of credit you do not get the professional claim investigators. This is another reason surety bonds are preferred over letters of credit.

The last reason surety bonds are preferred over letters of credit is – surety bonds don’t affect your credit scores. Whereas a letter of credit does.

• A Surety Bond is the guarantee of something
• There are 3 parties

1. Principal
2. Oblige
3. Surety

• Surety bonds are not the same as insurance
• Surety bonds are a form of credit
• Surety bonds are preferred over letters of credit