A surety bond is a promise to be liable for the debt, default or failure of another. It is a three-party contract by which one party (the surety) guarantees the performance or obligations of a second party (the principal) to a third party (the obligee). In the event the principal (e.g. a contractor) fails to perform its obligations the surety will make payment to the obligee up to the limit of the bond.
The surety company stands behind the bonded principal and guarantees the completion of the bonded work. In this way, the surety bond is a risk transfer technique similar to, but different than, insurance. A bond differs from insurance in two fundamental ways: 1) the number of parties to the agreement, and 2) the surety’s right of indemnity from the principal if they fail.
Insurance has two parties to the insuring agreement: the insurer and the insured (the policyholder). A bond, however, has three parties to the surety agreement: the bonding company (surety), the entity being bonded (principal) and the entity who benefits in the event of a bonded default (the obligee).
In addition, the surety company has the right of indemnity from the principal. If a surety is called upon to make a payment on a bond because the principal failed to meet a bonded obligation to the obligee, the surety may recover the amount of loss from the principal. In this way, the bonded contractor has a punitive incentive through the legal constraints of the bond to complete the work expected by the obligee. This right of subrogation may exist even in the absence of an express agreement to that effect between the surety and the principal.
Further, surety companies carefully underwrite applicants for bonds by examining the principal's managerial and financial ability to undertake and complete a job. Thus, the requirement for surety bonds also serves to eliminate truly unqualified principals from the bid process.
Although bonds are most often used in construction projects, there are other specific agreements where performance bonds may be used. Purchase agreements for software development or other products specifically engineered by the vendor may incorporate language requiring a performance/material bond.
Contract bonds are used heavily in the construction industry by general contractors to protect the project’s owner. Losses arise when contractors do not complete their contracts, which often arise when the contractor goes out of business. Unfortunately, contractors often do go out of business and the industry has a higher failure rate than other industries.
There is a wide variety of bonds used for many different purposes. Require a bond when the risk of loss is sufficiently high to warrant their use. If the contracting party balks at the requirement it might be a good time to reconsider whether you are dealing with the correct principal.