How Is a Surety Bond Underwritten?
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Introduction
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A surety bond is designed to transfer financial risk. In some ways, it resembles an insurance policy, except that the beneficiary of the bond, called the Obligee, is a third party. A surety bond underwriter, called the Surety, is usually a subsidiary of a larger insurance company specializing in such instruments. In this three-party agreement, the Principal promises to perform certain work, and pays a premium to a Surety, who will then pay out a settlement to the Obligee if the work is not performed to specifications. Surety bonds can be issued to guarantee that a bid represents a Good Faith intent of the bidder to perform work as described. That work will actually be performed as agreed, or that payment will be made on work performed as stipulated. The Surety also gets an indemnity agreement from the Principal for any expenses incurred through a claim on the bond.
Applying for a Surety Bond
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The most common use of surety bonds is to guarantee the work of a contractor or subcontractor. The entity who contracts to perform certain work may be required to obtain a surety bond that will pay out in case they are unable to meet their obligations. The contractor who applies for a surety bond is called the Principal. Upon their application for a bond, the Surety or a surety broker will assess the work that is expected to be performed and the likely ability of the contractor to successfully perform such work. Some factors that are considered are the reputation and track record of the contractor, their financial strength and their other obligations. To obtain the bond, the Principal may need to produce letters of recommendation, evidence of lines of credit, resumes of key employees, a detailed plan of the work to be performed and financial statements for at least three years. Depending on these factors and other actuarial calculations, the bond usually costs the Principal between 0.5% and 3% of the contract price.
Claims on a Surety Bond
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If a claim is made on a surety bond, it becomes the responsibility of the underwriter, the Surety, to investigate the claim and determine liability. The nature of construction projects is that a delay in one aspect of the job, even a small piece, can set back the entire effort. The existence of the surety bond transfers the responsibility of collection in the case of a breach of contract from the Obligee to the Surety, allowing the construction to continue unimpeded. Surety bond underwriters conduct speedy investigations and pay out quickly so the Obligee is financially able to hire another contractor or make any necessary repairs. According to the terms of the indemnity agreement, the Principal of the surety bond will then have to compensate the Surety for its expenses regarding the claim.
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