What is the difference between a surety bond and Insurance?
Many people think that insurance and surety is that same thing, but it clearly is not. Although most surety bond companies are divisions of large insurance companies (like AIG or Zurich), the operations of these different divisions are quite different.
What is a Surety Bond?
A surety bond is a three party contract. The first party is the Obligor. The Obligor is the company (or person, as the case may be) that is getting the surety contract for their benefit. That is the surety agreement is the contract that is providing that the Obligor will do what it, or he or she, says that they will do. The second party to the surety agreement is the Obligee. This is the party that is being guaranteed. The Obligor typically works for the Obligee or is providing goods or services to the Obligee. The final party to the contract is the Surety. As we mentioned above, the surety is typically a large insurance company, but it doesn’t have to be. It can be another company or even an individual.
Let’s look at an example. In a typical construction situation, the owner of the property will determine that they want something built, such as a hotel. The owner, who is the Obligee, goes out and puts the contract for building the hotel out to bid. Many general contractors come along and bid on the project. Finally, the owner / obligee chooses a general contractor and enters into an agreement with the general contractor to build the hotel. The contract that the owner signs with the general contract will typically require a performance and payment bond. The performance bond portion of the surety bond will make certain that the Obligor will actually perform according to the terms of the contract. That is, the general contractor will build the proper number of floors in the hotel, the hotel will have the right number of rooms and each room will have functional plumbing, etc. In addition, most performance bonds will have a maintenance clause, which provides that the hotel will still be functional for a defined period of time, such as one year after completion. The payment bond portion of the surety bond provides that the general contractor will actually pay all of his subcontractors that help him build the hotel. Further, the materials will have to be paid for. If anybody is not paid, or the owner is dissatisfied with the work on the project, then they will make a claim with the surety. Once a claim is made, the surety will then form an investigation committee (usually a lawyer, accountant or someone very familiar with the surety industry). Once they are done with the claim investigation, they will determine whether the claim is valid or not. If not, nothing will be paid. If the claim is valid, then the surety company will pay the claim (if its a payment bond) or find another company to finish the work in case of a performance breach by the general contractor. Upon the finish of the project, the surety company will then look to the general contractor for repayment.
How does Insurance Typically Work?
Insurance works in a completely different way. Instead of looking at jobs on an individual basis, insurance companies are in the business of risk-spreading. That is, each insurance company determines the number of people that are in a similar situation and put them into a “pool.” This pool determines the overall risk and then the premiums are set so that each member equally shares in that risk. For example, your local insurance broker may sell car insurance or fire insurance for your town. Now, nobody knows in advance who is going to have their home burnt down (at least, accidental fires). However, when it happens to an individual without insurance it is a devastating event. So, people buy insurance to protect against that devastation. The insurance company will set the premiums based on the certainty that there will be a claim – just that no one knows who will have that claim.
How does Insurance and Surety differ?
The fundamental difference between insurance and surety bonds is that a surety bond is written assuming that there will NOT be a claim. That is, the underwriting process is set so that each bond is written under the premise that the insurance company will not pay out anything. This is completely antithetical to insurance. In insurance, it is assumed that something will be paid out to a claimant. However, the concept of insurance is that the payment is a risk-spreading measure. In the surety bond context, there is not anticipated to be any claim.
Why Are Surety Bonds written Assuming no Claims?
There is a great reason as to why surety bonds are written assuming no claims. The simplest reason is that the pricing would be extraordinary. Instead of a cost of 1-3%, the cost would be 15-25% for most bonds. This makes the cost prohibitive. Further, surety bonds are written to help facilitate commerce and not be a slow down to commerce. What a bond can do is make sure that projects are completed timely and at the specifications set forth in the contract. If there wasn’t a bond, there could be substantial delays, which leads to a slowdown in commerce. Further, litigation would be much more extensive than it is today, which again would slow down the commercial engine.
It is easy to think that a surety bond and insurance are the same thing. However, as we have seen in this article, surety is much different than insurance. A surety bond agreement has three parties: the Obligor, Obligee and Surety. The surety agreement is written to avoid losses. Contrast that with insurance where losses are assumed and the risk is simply being spread around multiple parties.
I hope that this has been helpful and has helped you understand a bit more about surety bond and insurance. I appreciate your time.