Surety bonds are a form of three-party bond contract used to guarantee performance or fulfillment of certain conditions. The three parties represented in the bond contract are the surety, the principal and the obligee.
In a surety bond contract, the principal has a performance obligation to the obligee. For example, the principal may be a construction contractor who's agreed to undertake and complete a project for the obligee by a certain date. In this case, the surety bond company would pay the obligee back in the event that the contractor defaulted on the terms of his performance. Such a scenario might result if, for example, the obligee felt the contractor did not meet agreed-upon performance standards.
Continuing with the example given above, the surety bond would be used to ensure the contractor couldn't just walk away with the obligee's money after failing to live up to his obligations.
In "legalese," surety bonds are used as a "written promise, under seal, which commits its issuer to pay a named beneficiary a stipulated amount, subject to the proviso that the obligation of the issuer will cease if certain specified conditions are met."
There are specific types of surety bonds available for just about any type of commercial contract imaginable. However, some are more common than others; for example, the bond that releases someone charged with an offence from pre-trial custody (i.e., "released on bond") is a form of surety bond, as is an employee bond (i.e., "bondable").
Performance bonds and bid bonds are also frequently used. The above example regarding the construction contractor is a type of performance bond. A bid bond is used during the contract bidding process, and it promises that the party winning the bid will enter into the performance contract under the terms of its bid.
Note that surety bonds are not a form of insurance, even though insurance companies commonly issue them. Insurance contracts are designed to anticipate an eventual financial outlay, offset by the collection of a regular premium from the client. Surety bonds are issued on the assumption that there will be no loss to cover; in other words, the issuing company expects that the principal will fulfill his obligations to the obligee. Thus, while you'll likely hear the term "insurance surety bond" used, it's something of a misnomer, as there's no actual insurance involved.
If you're entering into a commercial contract as an obligee and there's any degree of performance risk, consider taking out a surety bond. It will protect you from financial loss in the event that the other party fails to meet contractual obligations.