What are surety bonds?
A surety bond is a contract between three parties: the principal (the company or individual who is purchasing the bond), the surety (the insurance company that issues the bond), and the obligee (the entity that requires the bond).
The surety in exchange for a premium, assumes financial obligations of the principal towards the obligee, in case the principal defaults. Thus anchoring trust between the principal & the obligee to work together.
What are major types of surety bonds ?
There are many different surety bonds and they are used in a variety of industries. These surety bonds can be grouped into two major types of surety bonds, which are:
Type I : Contract Bonds
Contract Bonds make sure that parties to a contract fulfill their obligations as binded by the contract. It is primarily used in construction industry, but same concept is used wherever a contract is involved.
In Construction Industry, they provide assurance to the public entity, developers, subcontractors and suppliers that the contractor will fulfil its contractual obligation. Contract bonds include: Performance Bonds, Bid Bonds, Advance Payment Bonds and Retention Bond.
Type II : Customs and Court Bond
In Customs & Court Bond the obligee (party asking for surety bond) is a public office. It is tax office, customs administration or the court. The Bond guarantees the payment incurred from opening a court case,clearing goods from customs or losses due to incorrect customs procedures.
Various Contract Bonds Explained
Contract bonds include: Performance Bonds, Bid Bonds, Advance Payment Bonds and Retention Bond. Let us go about them one by one.
Performance Bond guarantee that a contractor will complete a project according to the terms of their contract. If the obligee (govt. authority) declares the principal or contractor as being in default and terminates the contract, it can call on the Surety (insurance company) to meet the financial obligations under the bond.
They ensure that the bidder will, if awarded the contract, furnish the prescribed performance bond and enter into contract within a specified period of time. Bid Bond provides financial protection to the obligee if the bidder does not follow through if awarded the contract pursuant to the bid documents.
Advance payment bond
Advance Payment Bond secures the advance payment made by obligee to the principal to procure service or supply to initiate , work on or conclude the project. It is a promise by the Surety provider to pay the outstanding balance of the advance payment in case the contractor fails to complete the contract as per specifications or fails to adhere to the scope of the contract.
It relates to retention. Retention is financial security (also called cash retention or withheld cash) held by the lead contractor to ensure that its subcontractors adequately fulfill the obligations required of them under the contract. It is also used as a safeguard against defects in case a subcontractor fails to correct them. In the Retention bond agreement, the Surety will act as guarantor between the two parties.
To conclude, the surety bonds are quite a flexible financial tool that can be applied in a variety of situations. They provide financial protection to the obligee & frees up working capital of the principal (surety bond buyer). Since they do not require collateral ; being a win – win situation for both of them.
Freeing up capital further tends to reduce typical completion time of the project, if reinvested in that project. This will develop India at a faster pace.
This is in contrast to line of credits or Bank Guarantees requiring collateral. LCs & BGs were the only way to ensure such agreements in the past.