Small business owners have several ways to protect their financial position from loss, some of which are better understood than others. Insurance coverage, often in the form of liability insurance, and surety bonds are two of the most common types of protection small businesses may implement. While these terms are often used interchangeably, there are distinct differences that make them stand apart from one another. This brief guide provides insight into how surety bonds work, how that differs from insurance coverage, and when either is needed to safeguard a business and its customers.
The Ins and Outs of Surety Bonds
Being bonded and insured is not the same thing. Surety bonds – the first part of that phrase – provide protection to the customers and clients of businesses owners, licensed contractors, and other professionals. Bonds are provided by surety agencies as a way to reduce financial losses or damages incurred by the bondholder’s customer should the contract agreed upon not be completed. In some cases, surety bonds are required as part of the licensing process. However, regardless of the type of surety bond in place, each agreement works similarly for the surety agency, the bondholder, and the customer.
When a contractor or business acquires a surety bond, there are three parties involved in the transaction. First, the surety agency that provides the bond evaluates the business owner or contractor to determine if a bond can be put in place. If so, the individual requesting the bond receives a certificate of bonding after paying for the coverage. The third party is the job owner, or the customer, that requires a bond to be in play for a new project to begin. For instance, a construction contractor may have the job site owner as the third party, as that individual or company is at risk if the contractor does not perform as agreed.
When a claim is made against the bond because work is not done in-line with regulations or is not completed per the original agreement, the surety agency pays legitimate claims on behalf of the bondholder. In this sense, a surety bond is like insurance. However, the bondholder is then required to repay the claim amount back to the surety agency.
Breaking Down Insurance Coverage
Insurance coverage for a business or an individual contractor differs from surety bonds in several ways. First, business insurance is offered by an insurance company or agency, not a surety agency, and it is not always a requirement for licensing as a professional. Insurance coverage works to protect the business owner or contractor from financial losses. These losses may be the result of damage to the business or inventory, employee theft or other theft, fire, flood, or liability issues that arise with a customer or worker. There are only two parties involved in insurance: the insured and the insurer.
When a claim is made against an insurance policy, the insurance company pays out a benefit up to the limits of the policy for damages incurred, directly to the business or the contractor. This helps protect the individual or entity from financial ruin for circumstances beyond their control. There is no obligation to repay insurance benefits received, which differs from surety bonds for contractors.
Other Notable Differences
In addition to the organizations that offer surety bonds and insurance, and the fundamental ways each type of instrument works, there are other subtle differences between surety bonds and insurance coverage. First, surety bond pricing is based on the financial history and claims track record of the business or contractor. Because surety bond claims are paid by the surety agency and then repaid by the bondholder, individuals with surety bonds are extended a form of credit when getting a new bond. For this reason, surety agencies look closely at the financials of the individual and the business, including credit history and score. The cost of a surety bond is calculated as a percentage of the total bond amount put in place.
Insurance, on the other hand, is priced based on other risk factors. For instance, if a business owner has faced liability issues in the past where an insurance claim was paid, the cost of new insurance coverage may be high. However, most insurance companies do not review credit history or score when determining if a new policy can be issued. They focus more on the risks of the business, based on the type of insurance policy the individual is trying to secure. The cost of insurance is a monthly or annual premium that is paid based on these factors, not a percentage of the insurance policy taken out.
Both surety bonds and insurance coverage are valuable protection strategies for businesses and contractors. However, there are differences bondholders and insured individuals should be aware of before selecting the type of coverage necessary. Understanding these differences is beneficial in protecting your business, your customers, or both.
Eric Weisbrot is the Chief Marketing Officer of JW Surety Bonds. With years of experience in the surety industry under several different roles within the company, he is also a contributing author to the surety bond blog.