What is a surety bond? Many confuse it with insurance. A surety bond is not an insurance policy. In insurance, there is an agreement between two parties – the insured and the insurance company. Utilizing an aspect of large numbers theory, the concept behind insurance is that no one person or business could financially weather a large loss due to property damage, personal injury, or liability (to name a few risks). However, if many people put a little money into a large pool, only a small percentage would incur loss in a given time period, and the loss would be paid out of the collective large pool of money. Insurance premiums are based on actuarial calculations that determine the minimum amount necessary for the entire pool of insureds to cover expected losses.
Surety, on the other hand, is a guarantee – “my word is my bond”. A bond guarantees performance of a contract or other agreement, fiduciary duty, or compliance with rules and regulations, plus many other types of obligations. The agreement is between three parties – the Surety (typically an insurance company), the Principal (similar to the insured – the one purchasing the bond), and the Obligee (the entity requiring the Principal to be bonded). Surety is selective – not all applicants/individuals/entities can be qualified to be bonded. The surety industry’s role is to qualify one for bonding and then guarantee the qualification. Because it is more of a guarantee than a risk management mechanism like insurance, surety can be considered more akin to the banking and lending industry than insurance. By virtue of laws essentially putting the surety on equal footing into the “shoes of the Principal”, and the selective nature of the surety qualification process, underwriting is done with an expectation of zero losses – unlike insurance, where losses are expected and accounted for in the pricing. Bond premiums are determined more as a fee commensurate with the work involved in the qualification process. Another distinction between insurance and bonds is this – because sureties expect zero losses, the guarantee is structured so that if a loss does occur, the bonded principal is obligated to pay the surety back. The surety secures this obligation by obtaining indemnity from whom is bonded, and by rights of subrogation.
There are 7 main classes of surety bonds:
- Contract (includes bid, performance & payment, and supply)
- License & Permit
- Civil Court
More great links to articles further explaining the difference between bonds and insurance are available by clicking here.