People often mistake surety bonds for just another type of insurance. There are numerous differences separating the two. First, we will go over what they actually guarantee. Next, we will go over how they work. You will have a better idea of what they are after knowing what they do and how they function. The concept of surety bonding was created thousands of years ago, which has remained the same ever since.
Contrasting insurance and surety bonds
Parties Involved: Insurance only involves two parties, the insurance carrier and the principal. Suretyship involves three parties. The principal is the person or entity required to obtain a bond. The obligee is who is requiring the bond of the principal, they are also the beneficiary in the event of a claim. The surety is the bonding company backing the bond. To sum it up, the obligee requires a bond of the principal who obtains it from the surety.
Risk: With insurance, the risk is with the insurance company. In traditional surety underwriting the risk is with principal. In other words, the surety guarantees the principal’s performance to the obligee. However, the surety will look to the principal for payment if a claim arises. Many ask, if the surety has no risk than what is the principal paying for? While it is ideal that the surety has no risk, this is not the case. Companies and their owners could declare bankruptcy or refuse to pay a surety when a claim arises. The surety’s premium can be thought of as a service charge for their financial backing. When you look at the alternative of a letter of credit, suretyship looks like a great deal! With a letter of credit the principal would be required to put up the cash for the full amount of the guarantee and would be required to pay their banks service charges (which are usually comparable surety service charges).
Payment: Payment for bonds are usually paid in annual lump sums. One must be careful when obtaining a bond, as most bonding companies have premiums fully earned for the first years premium. This means that if a principal cancels a bond mid-term the surety will not return premium. A responsible bond agent will always make that clear to the principal when giving them a quote.
How do surety bonds work? The obligee requires that the principal obtain financial backing to guarantee their work. The principal looks to the surety for their guarantee their work. In exchange for the guarantee the surety charges the principal a fee. If the obligee files a claim, the surety will be required to take action on the guarantee they made. The surety will then look to the principal for payment of the claim. If the principal fails to reimburse the bonding company they will certainly see them in court.
The above should give you a good idea of what a surety bond is and how they work. If you are unclear on anything in this article, you can feel free to post a comment or start a dialog in our online forums.