Getting Back to the Basics: Part 2 A Layman’s Introduction to surety bonds

By Tymothy Parmenter

Surety contract bonds are being required more and more these days and having a basic understanding of what they are and how they work is crucial for any growing business. In part one of this series we touched on the different parties in the surety bond which include the principal, the obligee and the surety. We discussed the most common types of bonds, bid and the performance bond, and we also dove quickly into the differences between insurance and surety bonds.

               In part two we will discuss a few other contract bonds that are often required. These include the material and payment bond, the maintenance bond and the subdivision bond. We will also discuss the indemnity agreement, what it is and how it works. These items are all vital to understanding contract bonds as a whole. Once we understand these concepts we can then discuss the basic underlying principles of the underwriting process that goes into determining the qualifications that are necessary to qualify for a bond.

The material and payment bond is also referred to as a payment bond. This bond often goes hand in hand with the performance bond. Where the performance bond guarantees the contract, the payment bond guarantees that the principal will pay subcontractors, laborers, and material suppliers associated with the project. Because this bond will often times go hand in hand with the performance bond there are no additional underwriting requirements and there is no additional premium. This bond again works on that three party notion of the obligee, principal and surety. Any claim on this bond will be directed to the Surety Company which protects the obligee from liens against their projects.

The maintenance bond guarantees against defective workmanship of materials for a specific period of time. The period of time that this bond is required is usually one or two years after the job is completed but it can be longer. The longer the maintenance period the more likely a surety will shy away from taking on this obligation. The simple fact is that the longer maintenance period increases the chances of there being a claim on the bond. Again this bond is designed to protect the obligee should the workmanship or materials on this specific project be unsatisfactory. This bond can be purchased as a standalone bond. That means that the performance and payment bonds may not have to be required in order for this bond to be requested.

Subdivision bonds are bonds that are often required for site improvement projects. Projects where a contractor needs to install infrastructure such as roads, sidewalks, curbs, gutters and utilities. These bonds are often required by a municipality guaranteeing that the contractor will fulfill their obligation to that municipality.

The indemnity agreement is a key part of contract bonds. The indemnity states the terms of the bond agreement. Although each surety has a version of their own indemnity agreement and they basically state the same provisions. That is, any claims paid out by the surety will be paid back by the principal out of their corporate assets and their personal assets. That being said, the indemnitor is the principal, and the indemnitee is the surety. The indemnity agreement will be required to be signed by all business owners and their spouses. Any other businesses owned or partly by any of the owners would have to be added to the indemnity agreement as well. This guarantees that the surety will have a greater ability to reclaim their assets in case of a claim.

In summation, we discussed material and payment bonds, maintenance bonds and subdivision bonds. Again all of these bonds are designed to protect the obligee from any losses. We also spoke briefly about the indemnity agreement, what it is and how it works. In this case the indemnity agreement is designed to protect the surety from losses and guarantees that they will recoup any claims paid out from the assets of the principal. Most principals don’t understand this concept and will often confuse bonds with insurance.

               In part three of this series we will discuss the underwriting principles and how they are the key to getting bonded. The basic idea is that nobody in a surety relationship wants to incur losses which is the major reason underwriting is so important. If the underwriting is done properly and the principal has been vetted and determined that they are a qualified contractor to do the job, the chance of a loss is greatly reduced. Though no system is perfect and things happen, taking the right precautions by all parties will leave everyone satisfied with the final outcome. The obligee will receive a completed project, the principal will get paid for a job well done and the surety has paid no claims.