Saturday, April 25, 2015

Surety Contracts

Surety bonds

This is a contract that has three parties.  Instead of a typical contract with two parties, there is a third party that guarantees the performance of another party.  The party that is doing the guaranteeing is the surety.  The party being guaranteed is the principal, also known as the obligor.  The party being indemnified is the oblige.

Surety Insurance
Surety Insurance

Why are surety bond contracts used?

They are really a way to avoid risk in the marketplace.  Instead of placing all of the risk on one party (the owner or oblige), the contract instead provides that there is a guarantor.  This takes the risk away from a party that has very little ability to actually understand the risk.  Further, that party really also cannot afford to have any losses one these types of contracts.  Owners of a project are typically very much at the end of their financing – as they have expended most of their funds for the purchase of the property, design elements, etc.  Thus, they cannot simply just take a huge hit by a party not performing to the terms of the agreement. 
surety bond insurance

Another place that they are used is in federal government work.  This is due to the Miller Act, which requires a surety bond on any project greater than $200,000.  Unlike a private owner of a piece of property with a development on it, the government can actually afford a loss like this.  However, the government is completely unable to accurately assess and mitigate risk in these situations.  So, instead of having the government assess risk, a surety bond is used to transfer that risk to another party.
The surety company itself can be any type of entity – from a private corporation to a public entity to an individual.  However, in modern society, the most typical type of surety is a corporation.  Even more than that, there are not a lot of private companies that serve as sureties.  Instead, most surety companies are large insurance companies, like AIG, Zurich, Liberty, Philadelphia, etc.  These large insurance companies have a branch that deals solely with surety bonds.  The branch division is usually well capitalized and has a long history with loss runs in the industries that they underwrite.  Although bonds are written on a zero-loss basis (that is, they assume that the company will perform and, if they don’t perform, have enough collateral to cover the loss), losses can still occur.
surety insurance companies
  They use this historical loss amounts to understand the inherent risks and then work to mitigate those risks. Since the dollar amounts on large construction projects can be very large, it usually takes a large corporation to cover the inherent risks on these type projects.
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