Surety bonds and insurance are often mistaken for each other. While they share some similarities, there are key distinctions between the two. In this post, we will examine the differences between surety bonds and insurance so that you can understand how each form of protection works.
How do surety bonds work?
Surety bonds are three-party agreements between an obligee, a principal, and a surety company. The principal is the party that must receive the bond and the obligee is the party that sets the bonding requirement. The surety company is responsible for issuing the bond.
Surety bonds are used to ensure that the principal meets the standards and requirements set by the obligee. They are often part of the licensing process for businesses and professionals. For example, companies that want to get a sales tax license must often get a sales tax surety bond. Or individuals that become notaries must get a notary surety bond.
Surety bonds are also used to provide financial protection to parties that are damaged by the principal’s actions. For example, let’s say a dealer sells a used vehicle to a consumer. The dealer tells the person that there are no lien holders on the vehicle. However, there are in fact liens on the vehicle. When the consumer gets home with this vehicle they may get a call from a repossession company asking for the lien to be satisfied or the vehicle impounded. In this instance, the surety bond would step in and satisfy the lien on behalf of the consumer.
With a surety bond, if the principal is unable to cover the damages, the surety company is responsible for paying out the claim. In the end, the surety company is not liable for the damages as the principal is required to repay them in full. Claims can be made up to the total value of the bond. Any claims that exceed the bond amount will not be paid by the surety.
The total value for a surety bond is determined by the bond’s obligee. The principal is responsible for paying the surety company a small percentage of the total amount as a premium to obtain the bond.
What is insurance?
Insurance is a two-party contract (or policy) between a policyholder and an insurance company. With the policy, the insurer agrees to give the policyholder protection against the risk of financial loss from certain types of events. For example, car insurance protects people who are in auto accidents. Or health insurance protects people that need medical care.
In exchange for the financial protection, the policyholder pays the insurer a premium. This payment is made on a recurring basis. Either in annual, quarterly, or monthly installments.
If the insured party needs to pay for an expense that is outlined in their coverage, they can make a claim against the policy. The insurance company then reviews the details and decides whether to reimburse the insured based on the contract.
Surety bonds vs insurance: What are the main differences?
Who gets protection
One of the biggest differences between surety bonds and insurance is who is protected in the agreement. With insurance, the policyholder is protected from financial loss. They are the ones that make claims against their policies, not third parties. Unlike a surety bond, the policyholder is not required to repay the insurance company for damages received.
With a surety bond, third parties are the ones who receive financial protection. The exact parties depend on the type of bond. Generally, it is governments, the general public, and customers of the bondholder.
What is covered
Insurance policies cover the risk of damage from uncertain and unpredictable events. In contrast, surety bonds cover the risk of the principal failing to meet a certain standard. For there to be a valid claim on a surety bond, the principal would have to be responsible for violating the contract in some manner. An insurance policyholder could be subject to a covered event due to no action of their own.
How premiums are calculated
Surety bonds and insurance also differ in how premiums are calculated. Insurance companies underwrite premiums by analyzing the possibility of loss given similar situations in the past. Insurance companies expect a certain number of policy claims and set their premiums to cover those costs while remaining profitable.
Surety companies, on the other hand, do not expect claims to be made against most bonds. Because of this, surety companies are more thorough with their underwriting process and will only issue bonds to qualified individuals.
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