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.
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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.
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.
