In the world of projects, especially construction or procurement, there is always a risk of contractors failing to complete the work. To minimize these risks, guarantees are usually applied to provide security for project owners. One such guarantee is a surety bond.
A surety bond is a credit guarantee in the form of a written commitment from an insurance company (surety) to the obligee (creditor/project owner) that ensures claims will be paid if the principal (debtor/contractor) fails to fulfill their obligations.
This guarantee is commonly used in construction or procurement projects as protection against risks that may hinder the progress of the work.
With a surety bond in place, potential losses can be minimized and project continuity better secured. To understand the principles and types of surety bonds, let’s take a closer look below.
What is a Surety Bond?
A surety bond is a three-party agreement involving the obligee (project owner), the principal (the party being guaranteed, such as a contractor), and the surety (the guarantor, usually an insurance company).
This guarantee ensures that the principal fulfills their obligations to complete the project as agreed.
If the principal fails to perform the work or make payments under the contract, the surety will compensate the obligee up to the amount stated in the policy.
Surety bonds can only be issued by insurance companies that provide such services. Their primary function is to reduce risks such as delays, work failures, or other defaults in construction and procurement projects.
This aligns with Article 1820 of the Indonesian Civil Code (KUH Perdata) on suretyship, which states that a third party is obliged to fulfill the debtor’s obligations if the debtor fails to do so.
Principles of a Surety Bond
The implementation of a surety bond follows several key principles:
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The contract agreement must be formalized and agreed upon by all parties before the bond is issued.
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The principal must comply with all terms of the contract.
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The surety supports the principal in fulfilling obligations and executing the contract.
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The insurance company (surety) has the right to seek reimbursement from the principal for any payments made to the obligee.
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Surety bond agreements are absolute and cannot be canceled.
Types of Surety Bonds
Surety bonds come in several types, tailored to project needs and stages. The most common types include:
1. Bid Bond
A bid bond guarantees the principal’s bid in a project tender.
It ensures that contractors participating in a bid meet the obligee’s requirements and are capable of signing a work contract.
If the winning contractor withdraws, the surety must pay damages equal to the difference between the lowest bid and the next lowest bidder, up to the bond’s value.
2. Performance Bond
A performance bond guarantees the principal’s performance in executing a contract.
If the principal fails, the surety provides compensation up to the bond’s value, typically 5–10% of the project cost. This bond may be extended if the contractor still has obligations after the initial term expires.
3. Advance Payment Bond
An advance payment bond guarantees the repayment of advance funds provided by the obligee to the principal.
This usually covers about 20% of the project value and can be repaid gradually to the obligee in line with contract terms.
4. Maintenance Bond
A maintenance bond guarantees the contractor’s responsibility for post-project maintenance or repairs.
If the contractor fails to carry out required maintenance, the surety (insurance company) will cover the repair costs up to the bond’s value.
5. Payment Bond
A payment bond guarantees that the principal will fulfill payment obligations stated in the contract or purchase order.
Examples include cargo agency guarantees, which ensure that freight agents pay shipping fees to logistics companies, as well as other forms of payment guarantees.
6. Appeal Bond
An appeal bond guarantees that the principal will formally submit an appeal regarding a tender decision announced by the obligee.
Difference Between a Surety Bond and a Bank Guarantee
While both serve as project guarantees, surety bonds and bank guarantees differ in who provides the guarantee.
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A surety bond is issued by an insurance company. If the contractor fails, the insurance company compensates the project owner.
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A bank guarantee is issued by a bank. If the contractor defaults, the bank assumes responsibility for the loss.
In short, the key distinction is: surety bonds are backed by insurance companies, while bank guarantees are backed by banks.
That’s an overview of surety bonds, covering their definition, principles, and types. By understanding this financial instrument, you can better anticipate project risks and ensure smooth execution.
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