A surety bond is a contract involving three parties: the surety, the principal, and the obligee. In the contract, the surety guarantees the principal’s performance to the obligee. If the principal fails to perform according to the agreed-upon terms, the surety will pay for the failure. Surety bonds are typically required for any company working on government contracts. Private contracts in sectors like construction, agriculture, and transportation also often require bonds.

While a surety bond is sometimes referred to as “bond insurance,” there are several significant differences between bonds and insurance. Getting a surety bond is more like securing bank credit than buying insurance.

Here are some of the main differences:

• Approach to losses: Surety bond providers use prequalification to try to prevent losses. Insurance policies spread losses among a group of similar risks.
• Limits: The amount a surety will cover depends largely on your company’s financials. Conversely, the details of your insurance policy are determined by your risk profile.
• Coverage: Bonds cover 100% of the contract price, while insurance only covers up to a policy limit. Bond coverage is project-specific, while insurance coverage is term-specific.
• Liability: If a surety pays out on a claim, the principal remains liable and must repay the surety. By contrast, an insured business does not pay back the insurance carrier for a claim.

In short, when a surety bond pays out, it’s more like a loan than an insurance claim. The purpose of a surety bond is to protect the obligee. Most often, this means ensuring that laborers and suppliers are paid for work and materials. If a claim is filed, the principal is still on the hook for financial losses – the surety just pays the obligee up front.

Bonding capacity is the maximum amount a surety will cover. Underwriters use financial signs like revenue, net worth, liquidity, and debt levels to determine a principal’s bonding capacity. There are two types of capacity, known as the single-job limit and the aggregate limit. The single-job limit is the largest amount the surety will guarantee on one project. The aggregate limit is the total amount of work, across projects, that the surety will back at one time.

A variety of construction projects might require a contract bond. They’re required by federal, state, and local governments for construction contracts valued over certain amounts. The Miller Act specifies federal requirements, and each state has a “Little Miller Act” governing state contracts. While not mandated, private owners and general contractors may also choose to require surety bonds. This helps them ensure the contract will be completed, and suppliers and subcontractors will be paid.

The best way to increase your surety capacity is to provide timely, accurate financial information to your underwriter. Leaving your surety carrier guessing does not build confidence. Provide frequent updates to show that your company is organized, transparent, and on a positive trajectory.

The cost of a bond is a percentage of the final contract price. The percentage is based on rates filed with the state insurance department, usually ranging from around 1-4%. Your financial standing, credit score, and other factors determine your bond rate. Because the cost of a project usually fluctuates, your bond premium will be adjusted based on the final contract price.

The principal pays the premium for a surety bond. The premium is due upon the execution of the bond and underlying contract. If a claim occurs, the surety pays up front for the project costs up to the contracted amount. Then, the principal must reimburse the surety for those costs.