In the world of projects, particularly in construction or procurement, the risk of contractor failure to complete the work is always present. To minimize this risk, collateral is often used to provide a sense of security for the project owner. One form of such collateral is a surety bond.
A surety bond is a written credit guarantee from an insurance company (surety) to the recipient of the guarantee (obligee/creditor) to pay claims if the guaranteed party (principal/debtor) fails to fulfill its obligations.
This guarantee is commonly used in construction or procurement projects as a form of protection against risks that could hinder the progress of the work.
With a surety bond, potential losses can be mitigated and the smooth running of the project can be better maintained. To further understand the principles and types of surety bonds, see the explanation in this article.
What is a Surety Bond?
A surety bond is a three-party agreement involving the obligee (the recipient of the guarantee/project owner), the principal or debtor (the guaranteed party, such as the contractor), and the surety (the guarantor, usually an insurance company).
This guarantee ensures the principal fulfills its obligations to complete the project as agreed.
If the principal fails to perform the work or make payments as agreed, the surety will cover the obligee's losses up to the limit stated in the policy.
This guarantee can only be issued by insurance companies that provide surety bond services. In principle, a surety bond serves to reduce risks, such as delays, work failures, or other defaults in construction or procurement projects.
This aligns with Article 1820 of the Civil Code concerning guarantees, which stipulate that a third party is obligated to fulfill the debtor's obligations if the debtor fails to do so.
Principles of Surety Bond Implementation
The principles of surety bond implementation include several key provisions, including:
- The contract agreement must be formally drawn up and agreed to by all parties before the surety bond document is issued.
- The Principal is obliged to comply with all provisions of the contract.
- The Surety supports the Principal in fulfilling its obligations and carrying out work as per the contract.
- The insurance company, acting as Surety, has the right to claim compensation from the Principal for any payments made to the Obligee.
- The surety bond agreement is absolute and irrevocable.
Also read: 8 Types of Credit Guarantees for Your Loan
Types of Surety Bonds
Surety bonds come in several types, tailored to the needs and stage of project implementation. The following are the most commonly used types of surety bonds:
1. Bid Bond
A bid bond is a bond issued by a guarantor at the request of a principal to guarantee the principal's bid on a project or work performed by an obligee.
This type guarantees that the contractor participating in the tender meets the obligee's standards and is capable of signing the work contract.
If the selected contractor withdraws, the surety is required to pay damages equal to the difference between the lowest contractor's bid and the next lowest bidder, up to a maximum of the value of the guarantee.
2. Performance Bond
A performance bond is a surety bond issued by a guarantor at the request of a principal to guarantee the principal's performance in carrying out a contract or agreement with the obligee.
If the surety fails to fulfill the contract, the surety will provide compensation up to the value of the guarantee, usually 5–10% of the project value. This agreement can be extended if the contractor still has outstanding liabilities after the surety bond expires.
3. Advance Payment Bond
An advance payment bond is a surety bond issued by a guarantor at the request of the principal to guarantee the return of the advance payment received by the principal from the obligee according to the contract value and terms.
This repayment amount is typically 20% of the project contract, and payments can be made in installments to the obligee.
4. Maintenance Bond
A maintenance bond is a surety bond issued by a guarantor at the request of the principal to guarantee the principal's performance of the work to the obligee in accordance with the contract.
This surety guarantees the contractor's willingness to repair any damage to the work after the project is completed. If the contractor is deemed insolvent, the insurance company will reimburse the repair costs up to the value of the guarantee.
Also read: Collateral: Definition, Function, Types, and Examples
5. Payment Bond
A payment bond is a surety bond issued by a guarantor to an obligee if the principal fails to make payment according to the value and time specified in the contract or purchase order (PO).
The types include cargo agency guarantees, which are guarantees to the transportation service company for the cargo agent's obligation to pay the freight costs, as well as other payment guarantees outside of the cargo agency guarantee.
6. Appeal Rebuttal Bond
A surety bond is a guarantee issued by a guarantor to an obligee to ensure the principal files an appeal against the auction announcement issued by the obligee.
Differences Between Surety Bonds and Bank Guarantees
Although they both serve as collateral for a project, surety bonds and bank guarantees are actually different. Many people often think they are similar, but the difference lies in who provides the guarantee.
In a surety bond, the guarantor is an insurance company. This means that if the contractor fails to fulfill its obligations, the insurance company will cover the project owner's losses.
Meanwhile, a bank guarantee involves a bank as the guarantor. Therefore, if the contractor does not complete the work as agreed, the bank will cover the project owner's losses.
In short, the main difference lies in the guarantor: a surety bond is guaranteed by an insurance company, while a bank guarantee is guaranteed by a bank.
That concludes our discussion of surety bonds, from their definition, principles, and types. By understanding this guarantee instrument, you can be better prepared to face project risks and ensure its continuity professionally.
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