Introduction to Surety

By Briana Louis & George W. Thompson   •   11/15/2021

What is surety and how does it work?

Despite being the lifeblood of numerous industries in the United States, surety bonds remain as one of the most widely misunderstood financial tools. Perhaps the most important thing to understand about surety bonds is that they are not insurance. A surety bond is an agreement between three parties: a principal, an obligee, and the surety provider. Unlike insurance, the principal pays a premium for the bond to the surety company, and the obligee derives the direct financial benefit should the principal fail to perform. The surety provider promises the obligee that the outlined and agreed-upon responsibilities of the principal will be fulfilled, assuming full responsibility for the performance of the principal and agreeing to absorb any loss, costs, or expenses incurred to satisfy the principal’s contractual or statutory requirements if they are unable to perform. The obligee is typically the entity requiring the surety bond by either statute or contract. Additionally, the obligee is the only party within the agreement with the power to release (terminate) the bond, which is another feature of surety that distinguishes it from insurance.

Surety is undeniably a credit business. There are great risks associated with the surety provider’s role as a performance guarantor and, because of this, they carefully evaluate the principal before issuing a surety bond. The principal’s credibility, past performance standards, strategic planning, profitability, and financial profile are all considered by the surety provider to assess projected future performance. In the extractive industry, bond providers are also concerned with the type of mining that is being performed and its sustainability; they consider commodity market trends and projections. A strong principal will have the resources and equipment necessary to complete the proposed project in addition to a reputation of professionalism, reliability, and regulatory compliance. The surety underwriter will also obtain a complete understanding of the principal’s ownership continuation and/or perpetuation plans given the long-term, noncancelable nature of certain surety obligations.

Legislation

As briefly mentioned above, surety bonds are either required by a contract, court order, or statute. As an example, the Surface Mining Control and Reclamation Act of 1977 (SMCRA) is the primary Federal legislation that regulates the mining of coal and coal equivalents in the United States. The Federal Office of Surface Mining Reclamation and Enforcement (OSMRE), U.S. Department of the Interior, is empowered under SMCRA to enforce the SMCRA requirements. OSMRE has two distinct responsibilities: one that manages active mines and the other that is focused on the reclamation of abandoned mine lands. Mining activities that are not encompassed in the coal regulations of SMCRA are typically regulated at the State, county, and/or city levels under separate statutes.  

Treasury limits

Surety companies are regulated by the U.S. Treasury Department to the extent that the Department assigns a maximum amount each surety can issue in a single bond. This amount is called a Treasury limit (T-limit) and is unique to each surety. Each year, the Treasury Department reviews the financial standings of each surety company, including their capital and surplus; this information is used to calculate the surety’s T-limit. Every year on July 1, the Treasury Department issues their Department Circular 570 that lists all licensed surety companies with their individual bond limits for the fiscal year. In addition, sureties are required to be licensed in the States in which they are issuing bonds and, in most States, they must be in compliance with United States T-limits. For this reason, it is essential that the bond providers and principals have a thorough understanding of Federal and State statutes for the jurisdiction(s) in which they are operating.

Bond amount

The domestic surety industry in the United States generates about $6 billion in surety premiums annually. While the largest share of the domestic surety premiums is attributed to construction projects, reclamation bonds in the aggregate make up some of the largest bond penal sum exposures to the surety industry.  

The bond amount, also known as the penal sum, is determined by the obligee upon analyzing the costs and risks associated with the proposed project or mining activity. In the event of the principal’s default on a reclamation obligation, the surety has two options. The surety can either forfeit (pay) the full penal sum of the bond to the obligee or choose to complete the reclamation or project themselves if they find after analysis that they can complete the bond obligations for less than the penal sum. The surety is only responsible up to the penal sum of the bond; should the cost exceed the penal sum, the obligee absorbs the excess cost to reclaim.