Surety

A surety, surety bond, or guaranty is a financial agreement where one party promises to take over a borrower’s debt if that borrower fails to pay. In practice, a surety bond involves a person or company (the surety or guarantor) agreeing to pay a set amount to another party (the obligee) if a third party (the principal) does not meet a specific obligation, like completing a contract. This bond shields the obligee from losses caused by the principal’s default.

The arrangement is a contract among three parties: the obligee, who is owed the obligation; the principal, who is supposed to fulfill it; and the surety, who assures the obligee that the principal can do the job. In Europe, banks and surety companies can issue these bonds. When issued by banks, they are called bank guarantees in English and *cautions* in French; when issued by surety companies, they are simply called surety bonds. In case of default, the surety pays cash up to the guarantee limit, based solely on the obligee’s verified claim, without needing to consult the principal.

Through a surety bond, the surety agrees to back the principal’s contractual promises for the obligee’s benefit if the principal fails. This contract encourages the obligee to work with the principal by proving the principal’s credibility and guaranteeing performance. The principal pays a premium, usually annually, for the bonding company’s financial backing. If a claim arises, the surety investigates; if valid, the surety pays and then seeks reimbursement from the principal, plus legal costs. In some cases, the principal can sue another party for losses, and the surety gains a right of subrogation to recover those damages.

If the principal defaults and the surety is insolvent, the bond becomes worthless. So, the surety is typically an insurance company whose solvency is checked by private audits, government regulation, or both. Nearly every surety bond includes a penal sum—the maximum amount the surety must pay if the principal defaults. This sum lets the surety assess risk and set the premium. Surety bonds also secure fiduciary duties for people in private or public trust.

Historically, individual surety bonds are the original form. The earliest known record is a Mesopotamian tablet from around 2750 BC. Evidence appears in the Code of Hammurabi (written around 1790 BC, which provides the earliest surviving legal mention of suretyship) and in Babylon, Persia, Assyria, Rome, Carthage, among ancient Hebrews, and later in England. Suretyship wasn’t always done with bonds; Frankpledge, a medieval English system of joint suretyship, didn’t use them. The first corporate surety, the Guarantee Society of London (later merged into Aviva), started in 1840. In 1865, the Fidelity Insurance Company became the first US corporate surety but soon failed. In 1894, the US Congress passed the Heard Act, requiring surety bonds on all federally funded projects. In 1896, the US Supreme Court ruled in *Prairie State Bank v. United States* that a surety’s claim to retained payments had priority over a lender’s claim. In 1908, the Surety Association of America (now the Surety & Fidelity Association of America, or SFAA) formed to regulate the industry, promote public understanding, and discuss common issues. The SFAA is a licensed rating organization in all states and a statistical agent for reporting fidelity and surety experience; its member companies write most US surety and fidelity bonds. In 1935, the Miller Act replaced the Heard Act, becoming the current federal law mandating surety bonds on federally funded projects.

A guarantor is typically needed when the principal’s ability to perform is in doubt or when public or private interest requires protection from default. In most common law jurisdictions, a suretyship contract falls under the Statute of Frauds and is unenforceable unless written and signed by both the surety and the principal.

In the US, the SFAA published preliminary H1 2022 results: direct written premium totaled $8.6 billion, with a direct loss ratio of 14.5%, showing strong profitability. The industry remains highly fragmented.