A suretyship is created by a contract. If a person is a surety, they have made an express promise to be responsible for a debtor’s debts or some other legal obligation. Creditors can directly collect from the surety.
A surety bond represents a pledge or promise by a surety to fulfill obligations of a principal. The obligation could be repayment of a debt or fulfillment of some other obligation. A surety is often used in contracts where one party’s financial assets or well-being are questionable or uncertain, and the other party requires a guarantor of their performance.
Surety bonds are financial instruments that tie three parties: the principal, who owes the obligation, the obligee, who is to receive the performance of the obligation, e.g. repayment of a loan, and the surety, the entity that guarantees the performance of the principal. Surety bonds are often used in connection with construction projects to guarantee the performance of building contractors and subcontractors.
It is commonly assumed that the price a principal pays for a surety bond is the bond amount, which would be a very high cost. However, this is not the case. The actual cost of a bond, the bond premium, is usually only a small percentage of the bond amount.
In the case of surety bonds, the surety is providing a kind of line of credit to the principal, so as to assure the obligee that the principal fulfills their side of an agreement. An example is a motor vehicle dealer bond. Every state requires car dealers to be bonded as a condition of obtaining a license to do business as a car dealer. The goal is to protect the public from financial loss caused by a dealer’s misconduct, e.g. the dealer selling a customer a car that is a lemon.
If the vehicle dealer violates the terms of the bond, the person who suffers a loss as a result can file a claim against the surety bond. The company that issued the surety bond would pay the claim. The dealer would then be legally obligated to pay back the surety company for the paid claim.
If the principal fails to deliver a performance as promised by the terms of the contract to which the principal and the obligee are parties, then the obligee has the right to file a claim against the surety bond to recover any damages or losses incurred. If the claim is valid, the surety company that issued the bond must pay damages to the obligee. The amount cannot be greater than the bond amount. The underwriters of the surety bond would then expect the principal to reimburse them for any claims paid.
It is important to note that a surety bond is not an insurance policy. The payment made to the surety company that issues the bond is payment for the bond, but the principal remains liable for the debt if the surety has to pay it on behalf of the principal. The amount of any claim that the obligee has can be recovered from the principal through other means.
For example, the obligee might foreclose on collateral posted by the principal or even sue the principal. If the obligee turns to the surety bond for payment, the surety also may recover the amount of the bond that it pays to the obligee from the principal by filing a lawsuit.
With an insurance policy, the insured is never liable to pay the insurance company for any amount of money that the insurance company pays on behalf of the insured. So, for example, an insured person might pay an annual premium of $750 for auto insurance. After the first few months of coverage, the insured could get into an accident that is the fault of the insured and causes $300,000 of damage to the other driver..
The insurance company, which has received only $750 from their insured, would have to pay the policy limits of $300,000 to the victim of the accident. The insurance company would not then be able to look to their insured to recover the $299,250 that it never received from their insured. The insurance company accepted the risk of providing insurance to their insured driver and is liable for paying the policy limits. It has no recourse to any other entity. It might react by canceling the policy after it has paid out the policy limits, but it is not entitled to recover the amount it pays out.