In this sense, the bond is the evidence that the obligee wants to see that this separate contract exists. The surety bond proper is a legal instrument that results from a separate contract between the surety and the principal, in which the surety agrees, for a price (the premium), to guarantee the principal’s performance with respect to some obligation to the obligee that the principal has assumed. These other considerations are explained in this section. In part, the surety is operating on an actuarial basis, but additional considerations lie behind the willingness of the surety to assume the liability involved. The potential liability assumed by a surety greatly exceeds the premium charged for underwriting the performance of the principal. In other words, the surety makes sure that it is indemnified by the entity “where the money is” and from which the assets cannot be transferred by accounting manipulations in the face of an impending claim against the bond. This concept of personal indemnification is the origin of the oft-repeated expression “going on the line.” If the principal is a subsidiary company of some other entity, the surety generally wants indemnification from the parent company as well as from the subsidiary. A surety often also requires personal indemnification from the officers or owners of the entity that is the principal. lndemnitorĪn indemnitor is a person or entity who promises to pay the surety back for any cost that the surety incurs if called upon to make good the guarantee. Bond premiums have escalated, then stabilized somewhat, since that time. The cost of the same bond package in the small contract market was between 1 1⁄2 and 2% of the construction contract price. Before 1985, bond premiums on large contracts for well-established contractors ranged from 1⁄2 to 3⁄4% of the total contract price for a package consisting of the bid, performance, and labor and materials payment bonds. The premium is the fee that the principal pays to the surety in exchange for providing the guarantee to the obligee. The penal sum is the upper limit of the surety’s potential financial liability to the obligee. For example, the penal sum of one type of surety bond, called a bid bond, is usually 10% of the amount of the bid, whereas the penal sum of performance bonds and labor and material payment bonds is usually 100% of the contract price. The amount of the penal sum is stated in different ways, depending on the type of bond. Penal SumĪlthough the surety guarantees the performance of the principal, there is a monetary limit to the guarantee called the penal sum of the bond. Essentially, the guarantee is a case of the surety underwriting the performance of the principal. This concept is different from that of an insurance policy where the insurer agrees to pay for a loss resulting from some unexpected catastrophe or from claims made by third parties to the construction contract. The exact nature of the guarantee varies, depending on the type of surety bond involved. The guarantee is a promise made by the surety to the obligee that, if the principal should fail to carry out fully and faithfully whatever particular duty to the obligee is stated in the bond, the surety steps in and either performs that duty or causes it to be performed by others.
When performance bonds are furnished by a subcontractor, the prime contractor is the obligee. In some jurisdictions, the subcontractors and material suppliers themselves are considered to be the obligees. In the case of labor and material payment bonds furnished by the prime contractor, the owner is usually the obligee for the use and benefit of subcontractors and material suppliers. In the case of bid bonds and performance bonds furnished by the prime construction contractor, the owner of the project being constructed is the obligee. The guarantee promised by the bond is made to an entity called the obligee. The surety is the entity that furnishes the guarantee that the bond promises. The entity that actually furnishes the bond is called the principal. Sureties will be required to furnish convincing evidence of their financial strength and are often required by the terms of prime construction contracts to be registered as approved sureties and to appear as such on a published list maintained by the U.S. The surety (sometimes called the obligor or the bonding company) is a financial institution possessing great wealth and stability. To understand the purpose and operation of the various construction industry surety bonds, you should become familiar with the following commonly used terms:
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