Even though many business owners that sell products are required to purchase surety bonds before they can open a business, they often don’t understand how they work or why they need them. The general idea behind surety bonds is to keep companies from misusing their power and taking advantage of consumers. But how do surety bonds do this?

1) Surety bonds hold businesses to higher standards.

Because surety bonds are required before many business owners can get a license, the process keeps unqualified individuals from gaining access to certain professions. These surety bond types are often called license and permit bonds. The surety bond process requires business owners to meet certain qualifications that vary depending on the profession. Surety providers typically evaluate applicants’ financial records and work histories. This helps them determine the inherent risk associated with an applicant’s ability to manage a business appropriately.

When surety providers find that applicants don’t meet the qualifications, they deny the request. Without the necessary surety bond, entrepreneurs cannot get a business license and thus will not be allowed to start a business. Because some bonding requirements can be hard to qualify for, the process naturally reduces the competition in certain industries.

2) Surety bonds eliminate fraud.

Government agencies typically require businesses or professionals to be bonded when they provide certain services to consumers. Oftentimes bonds are used to regulate markets with histories of fraud, such as the auto, mortgage and telemarketing industries. Surety providers use a great deal of discretion when issuing bonds for such risky industries as they intend to avoid any possibility for financial loss. As such, once a claim has been made on a professional’s bond, he or she will have trouble getting bonded again in the future.

For example, say an auto dealer used fraudulent selling tactics and a claim was made on the bond. Since surety providers can choose not to bond risky applicants, this infraction could keep the auto dealer from getting a new bond. Without a bond, the auto dealer cannot get a license and thus cannot operate a business. This, in turn, keeps other consumers from having to work with the fraudulent auto dealer in the future.

3) Surety bonds protect consumers from financial loss.

Although many professionals assume surety bonds work like other insurance products, these risk mitigation tools actually work quite differently. Unlike most insurance products that provide financial protection for business owners, surety bond insurance actually functions as a line of credit that protects consumers.

In underwriting a bond, the surety producer provides a line of credit that guarantees a harmed party can collect reparation if the principal should fail to meet the bond’s terms. Should the bond’s obligee makes a valid claim, the surety will reimburse the obligee using the bond’s penal sum. Most bonds have an indemnification clause that then requires the principal to repay the surety. Of course, principals cannot always do so, which leaves surety providers eating the cost to ensure the consumer does not incur financial loss.

With a basic understanding of how surety bonds work and why they’re required, business owners can better understand how bonding benefits their businesses, their customers and their industries.

Danielle Rodabaugh is the chief editor of SuretyBonds.com, a nationwide surety producer. As a member of the company’s educational outreach team, Danielle writes informational articles to help business owners better understand the legal intricacies involved with bonding.

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