A surety bond is a three-party agreement whereby the surety assures the project owner (obligee) that the contractor (principal) will perform a contract in accordance with the contract documents. When a contractor requires its subcontractors to obtain bonds, the contractor is the obligee and the subcontractor is the principal.

Most surety companies are subsidiaries or divisions of insurance companies, and both surety bonds and traditional insurance policies are risk transfer mechanisms regulated by state insurance departments. However, traditional insurance is designed to compensate the insured against unforeseen adverse events. The policy premium is actuarily determined based on aggregate premiums earned versus expected losses. Surety companies operate on a different business model. Surety is designed to prevent a loss. The surety prequalifies the contractor based on financial strength and construction expertise. Since the bond is underwritten with little expectation of loss, the premium is primarily a fee for prequalification services.

There are three basic types of contract surety bonds.

• The bid bond assures that the bid is submitted in good faith and that the contractor will enter into the contract at the price bid and provide the required performance and payment bonds.
• The performance bond protects the owner from financial loss should the contractor fail to perform the contract in accordance with its terms and conditions.
• The payment bond assures that the contractor will pay specified subcontractors, laborers, and materials suppliers associated with the project.

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