What is a Surety Bond and How Does it Differ From Insurance?
Most consumers and business owners have heard of insurance in one form or another over their lifetime, but surety bonds are not nearly as well-known. Surety bonds are typically brought up in scenarios where a contractor or business states they are bonded and insured, although there are some circumstances where individuals may have a need for a surety bond as well. Regardless of the type of surety bond in question, there are key differences between surety bonds and insurance that can be a little confusing at first. However, understanding what makes a surety bond stand out as different from insurance is helpful in determining which type of protection, if any, is the right fit for business or personal needs.
Here’s what you need to know about how surety bonds differ from insurance based on the parties involved, how they work, and how they are priced.
Parties to Surety Bonds and Insurance Policies
The biggest differentiator between surety bonds and conventional insurance is the number and role of parties involved in either contract. A surety bond is an agreement between three parties, including:
The Obligee – this is the person, company, or municipality requiring the protection of a surety bond
The Principal – this is the person required to take out a surety bond to protect the obligee
The Surety – this is the company offering the surety bond to the principal
With an insurance policy, there are only two parties involved. The insurance company offers coverage to an individual or business requesting the insurance in exchange for a premium.
How Surety Bonds and Insurance Work
Individuals or businesses getting a surety bond do not do so to protect themselves from financial loss, and this differentiates bonds from insurance policies. Instead, the surety company guarantees payment to the obligee should the principal fail to meet certain requirements. For instance, a surety bond for a construction contractor gives the job owner peace of mind that if the contractor fails to meet the requirements of the job, the surety company will pay a claim up to the full amount of the bond in place.
For individuals, a surety bond may be used instead of insurance for auto coverage, and it works similarly. Surety bondholders are not off the hook when a claim is made, but instead, they are obligated to repay the claim amount back to the surety company. You can think of a surety bond as a form of credit that ensures the obligee will be paid regardless of the financial capability of the principal.
Insurance policies work differently because they transfer the risk of financial loss onto the shoulders of the insurance company, away from the policyholder. For example, an individual with a car insurance policy who is in an accident files a claim with his insurance company. The insurer then pays out the amount of damage or injury up to the limits of the policy, without putting an additional financial obligation on the driver. When claims are paid, there are no requirements that a policyholder of an insurance contract repay the insurance company, unlike a surety bond agreement.
The Cost of Insurance vs. Surety Bonds
Another key difference between insurance policies and surety bonds is how they are priced. With a surety bond, the principal is evaluated based on his or her financial track record, including personal and business credit history. The surety company wants to know two critical things: that the individual requesting a surety bond has the means to repay should a claim be made, and that there is no significant history of claims against another surety bond in the past.
Surety bonds are priced as a percentage of the total bond amount, making them more affordable in some cases. However, an individual with a poor credit history may pay a higher percentage than someone with a stellar financial track record.
Insurance policies, on the other hand, are not a form of credit and therefore do not require a credit check. Instead, depending on the type of insurance, companies evaluate the level of risk of financial loss from each applicant. For example, an individual who has several car accidents or speeding tickets may have a higher cost of insurance than someone who has a clean driving record. The same may be true for a homeowner with numerous claims against an insurance policy compared to someone who has none. Premiums for insurance are not priced as a percentage of coverage but instead a fixed amount based on the risk factors of the individual or business.
Both insurance coverage and surety bonds can be helpful financial tools for individuals and business owners, but there are distinct differences between the two. Understanding how surety bonds and insurance work, who is involved in the process, and how they are priced helps in determining which type of protection is best fit for your needs.