What is a Surety Bond?

Understanding what surety bonds are helps you to be better prepared when you need one. It’s vital to recognize that a surety bond is not a form of insurance. 

What is a Bond?

A bond is a contract between three parties, where one party promises to pay a loss caused by a second party. The second party is usually performing an act or service for the third party. 

How Do Surety Bonds Work?

Take a small business such as a used car dealer, for example. The state may ask for a surety bond to guarantee that the used car dealer’s transactions are handled in a certain way. In this scenario, the small business is party one, the insurance company is party two, and the state is the third party. 

The small business, or the principal party, is required to pay back the insurance company, otherwise known as the surety, if a loss occurs. 

Because the insurance company has to pay the state when the bond contract is triggered, they will be looking for reimbursement from the small business for the money paid out on their behalf. 

It’s important to recognize that the bond is just a guarantee of payment, not a form of insurance. This guarantee of payment exists because losses on bonds are completely avoidable. 

Surety bonds serve as financial guarantees that an entity is going to perform an action in a way that they’ve contractually agreed to. As long as the small business handles their transactions in a certain way, they will be able to avoid a loss. 

While insurance provides coverage for unpredictable losses, surety bonds provide coverage for predictable ones. 

What to Know Before Buying a Surety Bond

If you understand that the money associated with the surety bond must be paid back, you’ll know why credit is such a big part of buying a bond. 

Insurance companies look at the ability of the small business to pay a bond back. However, this ability is not solely based on your credit score, which illustrates your ability to pay debts back over time. Insurance companies are looking for your ability to pay the bond back in a lump sum or a short period of time. 

When setting up your business, it’s important to understand the creditworthiness of business owners, partners, and even their spouses. Some insurance companies require a personal guarantee of indemnification, which means that you’ll be required to pay the bond back as an individual even if your business fails.

Understanding the role of credit in this process, as well as making the differentiation between bonds and insurance, will help you to make better decisions for your business. 

Not all insurance or bonds are created equal. See your insurance policy or bond contract for exact terms, or talk to a trusted insurance advisor about any concerns you may have.