Obtaining surety bonds or insurance for a business can be confusing. Surety bonds are often mistaken for insurance because they are a form of 'insurance against loss. Different businesses and scenarios require different types of financial guarantee For instance, auto dealers need a surety bond in order to get a dealer license but they may not need insurance. Sometimes, both are necessary. For example, licensed contractors need both a surety bond for licensing and liability insurance for potential losses.
While surety bonds and insurance sound similar and serve somewhat similar functions, there are a few key differences between the two. In this article, we’ll explore the differences between surety and insurance and point out common misconceptions people may have about the two.
Surety bonds are financial guarantees or promises made by one party (typically a surety company) to ensure that another party (the principal) fulfills a specific obligation to a third party (the obligee). If the principal fails to meet their responsibilities, the surety compensates the obligee financially and seeks repayment from the principal afterward.
An insurance policy is a contract between two parties: the insurer and the policyholder. This contract outlines the specific terms of coverage — what is covered by the insurer and what is not. The policyholder will make an initial payment or premium, and in return, the insurer is contractually obligated to pay for any losses detailed in the policy.
One main distinction between surety and insurance is the question of where the money comes from to fund claims. With a surety bond, it is ultimately the party that takes out the bond, or the principal, that is liable for any financial losses incurred. Typically, a surety company will first make payment to ensure the obligee is financially secure, then seek repayment from the principal. If the principal cannot repay the surety, then the surety company writes down the loss in their books. In the case of an insurance policy, however, the insurance company is the one who is paying for losses in a claim.
Surety bonds
Insurance
General differences
3-party contract: A surety bond is a contract between three parties: the surety, the principal, and the obligee. The surety is the party that receives the premium paid by the principal. This premium is required by the obligee such that the principal will fulfill its obligations to the obligee. In return for this premium, the surety provides a financial guarantee to the obligee that the principal will fulfill their obligations.
2-party contract: In contrast, insurance is a two party agreement between the insurer and the insured (policyholder). The insured pays a premium to the insurance company. In return, the insurance company will be financially responsible for paying out any losses that occur, as long as they are covered within the scope of the insurance policy.
Protects obligee: Surety bonds will protect the obligee (often the government or the general public) who contracted with the principal. Important to note here that the obligee was not the bond purchaser. If the principal fails to meet certain obligations, a surety bond reimburses the obligee when a claim occurs.
Protects policy holder: In contrast, an insurance policy protects the policyholder (eg. business owner, homeowner, or any other insured party) that has purchased the insurance policy. The policyholder receives financial protection if an unforeseen event or occurrence is covered by the policy.
Reactive: Surety bonds are not typically sought out voluntarily without prompting. Instead, they are reactionarily obtained as a result of some requirement encountered during the licensing or permit process.
Proactive: Insurance policies serve a preventative purpose and are acquired to protect a policyholder from certain kinds of loss. Different from a surety bond, people seeking an insurance policy will proactively seek a policy to avoid future loss.
Quotes based primarily on credit score: While many surety companies require documents and information outside of one’s credit score, the quoted premium rate for surety bonds are based primarily on the principal’s credit score.
If your credit score is lower than average, you may have a harder time obtaining a surety bond, but there are some companies that work specifically with bond-seekers with lower credit scores!
Quotes based on more varied factors: Insurance premiums are based on more than just the credit score. Depending on the type of insurance you’re looking for, insurance companies have many criteria for determining the price you’ll pay.
For example, you can get cheaper insurance by installing a driving app and letting the insurance company track things like how hard you brake and how quickly you accelerate. This additional information will be used to determine your quote.
Selective underwriting: The underwriting (or approval) process for an entity to obtain a surety bond is relatively selective compared to insurance. Most surety companies will often reject applicants with low credit scores, but there are specialized surety companies that focus on applicants with low credit scores.
Less selective underwriting: On the other hand, insurance companies have a far less selective underwriting process. Insurance companies will rarely reject an applicant. Instead, they will simply assign higher premiums to risky customers.
Compulsory: Most surety bonds are purchased to satisfy requirements to get a license or permit, to begin a project, or to complete a contract.
For example, in the case of a contractor, some states require contractors to be licensed to operate legally.; As part of the licensing process, contractors are required to purchase a surety bond. Without purchasing this bond, the person or business cannot legally become licensed as a contractor.
Nonmandatory: Insurance policies are often not mandatory, unless there is a mortgage or loan involved.
One example of a nonmandatory type of insurance is life insurance. A person can get a life insurance policy to insure themselves against their own death. In the event of their death (barring certain circumstances such as suicide), a sum of money is paid out to their beneficiaries, usually a family member or next of kin. This kind of insurance, while very common (around 52% of Americans have a life insurance policy), is not required.
Surety lends credibility: The reason why surety bonds are important (its value proposition) is because they lend credibility to a principal. When a principal obtains a surety bond, it is a guarantee to the obligee that the principal will follow through with their obligations, which lends credibility to the principal.
Insurance shares risk: The value of insurance policies is to spread risk among multiple parties, namely the insured and the insurer. Thus the main value proposition of insurance companies is the company’s ability to pay for part of the losses, allowing the customer to avoid shouldering the entire cost of any circumstances that arise.
What happens when a claim is filed?
Claims not expected: Because the underwriting process for surety bonds is more stringent, risky, or unqualified applicants are often rejected by underwriters. Therefore, the quality of principals who are granted bonds is higher, and claims are much less prevalent.
Claims expected: Insurance companies take on more risk than surety companies due to their less selective underwriting process. As a result, insurance generally has a higher rate of claims than the surety.
Premium covers expenses: Because claims are not generally expected, the majority of the premium collected as the initial payment for the bond is used to cover the operational expenses of the surety company.
Premium covers both losses and expenses: Because claims are expected, the premiums paid in the beginning typically pay for both the expenses of creating the policy and any expected losses detailed by the contract’s coverage.
Losses recoverable: After a claim is paid by the surety, it expects to recoup at least part of its loss from the principal.
Losses unrecoverable: The insurance company must pay qualified claims and does not expect to recoup claims from the principal.
There are a few common misconceptions about surety bonds vs insurance that we often encounter as a surety agency.
Firstly, some customers believe purchasing a surety bond and obtaining an insurance policy are interchangeable. Customers often think that purchasing a surety bond means they don’t need insurance and vice versa. This is not true. Surety bonds are required for specific licenses, permits, or projects as a guarantee to the obligee that the principal is qualified or will follow through on their promises. Insurance is often an additional financial tool for policyholders to avoid being financially liable for all losses and unforeseen circumstances regarding certain projects, property, and more. Each specific case will require a specific surety bond or insurance policy suited to the scenario; in some cases, one will need both to comfortably proceed in their project.
Secondly, some customers believe that surety bonds offer protection for the purchaser. It’s actually the opposite. Surety bonds do not protect the bond purchaser or the bondholder, and instead hold them liable for any failure to fulfill their bond provisions.
Another misconception arises when people believe that surety bonds are simply another form of insurance. While surety bonds are technically considered insurance, their unique purpose, underwriting processes, and claims procedure sets them apart from the main forms of insurance we are familiar with. Surety bonds are unique and separate from the insurance policies that insurance agents work with normally.
Furthermore, some believe that surety bonds and insurance are only necessary for large businesses or corporations, when in reality, every business, no matter its size, should have some form of financial protection.
Additionally, many people believe that claims are equally frequent for both surety bonds and insurance. In fact, claims on surety bonds are relatively rare due to the stringent underwriting process and the expectation that the principal will fulfill their obligations. Insurance claims, conversely, are more common, as insurance is designed to cover a wide range of potential losses and damages. This difference underscores the distinct functions and risk management strategies inherent in surety bonds and insurance.
Lastly, another misconception is that the process of securing a surety bond is the same across all types of bonds. Each bond type, whether it be a performance bond, payment bond, or license bond, has specific requirements and conditions tailored to its purpose. This complexity often requires the guidance of a professional surety agent to navigate effectively. On the other hand, insurance policies are generally standardized within their categories, such as auto, health, or property insurance, making them more straightforward for consumers to understand and obtain. Understanding these nuanced differences helps businesses and individuals make more informed decisions regarding their financial protection needs.
Understanding the differences between surety bonds and insurance is crucial for anyone seeking to purchase. While they both provide a safety net for potential losses, they operate under different terms and conditions. Insurance protects against damages caused to a person or property, while surety bonds provide coverage for contractual obligations. It is important to note that acquiring surety bonds can be a complex process, but with a reputable surety bond company, this process can be streamlined. If you have any questions regarding obtaining a surety bond, please feel free to reach out to our specialists, who are available 24/7 to provide assistance.
We hope that this article has provided you with a greater understanding of the unique differences between surety bonds and insurance, enabling you to make more informed decisions when it comes to your protection needs.
For more information or to get started with your surety bond, contact SuretyNow. We're here to help you navigate the process smoothly!
