by Wayne Messick, AFSB
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What’s the difference between surety bonds and insurance?
That’s a question I hear often, and it’s a good starting point for discussion. Knowing those differences helps contractors understand why they need both products. We can outline the limits of traditional insurance coverage. It also makes clear why Old Republic Surety is a good company to consider when you need surety protection.
In some ways, insurance and surety bonds are similar. Both are a type of coverage usually written by an insurance company. In both cases, the carrier assumes risks and charges a premium for that risk. They both protect against financial loss.
Two parties vs. three
There are some major differences, however:
Insurance is a two-party agreement between the insured (the policyholder) and the insurer (the insurance company). The insurance policy pays the insured for a covered loss.
A surety bond is a three-party agreement between the principal (the contractor), the surety (the underwriter of the bond) and the obligee (the project owner or municipality). The surety guarantees that the principal will complete its obligation to the obligee — i.e., finish the job and pay subcontractors and suppliers.
Surety losses are borne by the principal
With an insurance policy, the insurer is obligated to make the insured whole if there is a claim. With a surety bond, the principal assumes this obligation. If the principal defaults, the surety will make good on the obligation to the obligee — and will seek repayment from the principal.
An insurer expects losses on the policies it issues. When a surety issues a bond, it doesn’t expect any losses. The surety prequalifies the principal to a point where it expects the principal to perform its contractual obligations. The economic risk stays with the bonded principal.
An insurance company is not reimbursed for losses from insurance policies. Sureties, on the other hand, have signed indemnity agreements with their principals guaranteeing that if there are any losses paid on the principal’s behalf, the principal will repay the surety.
Similar to a banking arrangement
Another way of viewing a surety bond: Consider it as an extension of credit similar to a bank loan. The bank doesn’t expect to suffer any losses as a result of its lending agreement with the borrower. If there is a default on the loan, the bank has a right to pursue repayment from the defaulting borrower.
Similarly, the surety provides the principal for the benefit of its credit standing. If a principal defaults, the surety has the right to restitution.
Indemnity agreements
Many contractors are unfamiliar with the concept of indemnity, which is an integral part of the bonding process. An indemnity agreement protects the surety in the event the principal defaults on a project. It is a separate agreement between the principal and the surety that guarantees that the surety will receive all due payments from the bonded principal. The Indemnitor (principal) assumes full liability, giving the indemnitee (surety) legal protection in case it has to pay out a claim on the bond.
The principal’s majority owners are the parties to an indemnity agreement. An owner and a spouse may also need to indemnify, especially if the bond’s underwriting is based on the owner’s creditworthiness. In most instances, both corporate and personal indemnities are required. An indemnity may also be required for side or affiliated companies.
Better accounting means better bond pricing
Another difference between surety bonds and insurance is the level of financial information needed from the principal to underwrite a bond.
Smaller contractors sometimes face challenges in providing the accounting information a surety may ask to see. They may need to hire a CPA with construction experience. The CPA will help them prepare their financials, including a percentage-of-completion statement with a schedule of completed and uncompleted projects.
Accounting is important because it affects a contractor’s balance sheet. That, in turn, determines the size of the bond it can qualify for and the pricing it will receive. Without detailed financials, contractors are limited in the projects they can pursue. Some contractors will simply fall back on credit-based bonds that are tied to their personal credit.
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