You likely have at least a basic understanding of insurance. Your renter’s policy covers the items in your apartment or house. Business owners typically have a general liability policy. And an auto policy is a requirement for vehicle owners. The point is most individuals have or has had some type of insurance coverage.
Insurance is the transference of risk from one party to another. You pay a little bit of money monthly or annually as premium. So, when you incur a loss, your insurance company steps in and makes you whole based on the language in the written agreement. The insurance company only pays out after you fulfill your responsibility of paying the deductible.
Many large numbers are involved with insurance. The reason insurance works is because the insurance companies collects and pools premium from thousands or hundreds of thousands of people. Not everyone experiences a loss at one time, meaning funds are available for claims. If a catastrophic type of event, such as a hurricane or another type of natural disaster happens, the insurance companies work with their reinsurance.
When inquiring about a surety bond, most people assume this type of policy functions as additional insurance coverage. Many insurance agencies and brokers offer surety bond products, so the confusion associated with this type of policy is understandable. After all, umbrella policies containing multiple types of coverages exist. However, a surety bond is different than a traditional insurance policy, as it doesn’t serve to benefit you or your company.
A surety bond is a type of insurance, but there are technical differences. Insurance involves two parties tied to a contractual obligation. These two parties include the insurer and you as the insured. You’re purchasing the insurance as the insured to protect yourself or something belonging to you.
With a surety bond, there are three parties associated with the contract. There is the surety company providing the coverage. The principal (you), which is the party purchasing the coverage. And the third party, known as the obligee, is the entity requiring the surety bond. As the principal, you are not benefitting from the surety bond. The obligee is technically the insured and you are purchasing this coverage on their behalf.
Think of purchasing a surety bond as hiring a professional co-signer. The surety is guaranteeing your risk to the obligee. As the principal of the bond, you’re paying a premium to ensure to the obligee they are covered if you default on your obligation. Whether you don’t pay someone, file a document, obey a rule, comply with an agreement or fail to complete a task, you’re ensuring the action is going to be done or not. If there’s a fault or break in the set obligation, liability is now incurred. Different types of bonds exist and the type you need depends on the performance or obligation.
Sometimes, the obligee will offer the principal alternative options in place of purchasing a surety bond. You may be able to put up the specified bond amount as collateral or in the form of a letter of credit. However, with either of these options, you need to have the available funds on hand. Also, these funds will be inaccessible to you until after you fulfilled the terms of your contract with the obligee. A benefit of purchasing a surety bond is you only have to pay a small portion of the bond amount in premium, typically 1%-5%, without tying up a large amount of money.
Surety is known as a zero-loss industry. However, this is only in theory because there actually are losses in surety. But, the way loss happens with insurance is there are always going to be claims. Insurance companies write business knowing there are going to be claims. So, the insurance companies review the loss ratio to ensure they don’t lose money. A profit is made due to the law of large numbers. They have a massive scope of premiums they charge, so millions or billions of dollars are collected for the insurance product. A profit is made from some of the insurance provider’s accounts due to the 100% loss ratio.
With surety, there are many factors involved with underwriting. The big difference between insurance and surety is the underwriting in the situation of a possible loss. If the principal qualifies for the risk, an indemnity agreement may need to be signed by all involved parties and the surety company. In this situation, the principal has met a prequalification and now is able to receive the surety product. They have an entity co-signing for their obligations.
If a loss happens, the surety company has a contractual obligation allowing them to recover money from the principal. That is due to common law associated with the bond, but the indemnity agreement is an enhanced contract allowing them additional rights to recover all funds associated with the loss.
While surety bonds are a type of insurance product, they greatly differ from each other. Insurance provides coverage for you or your business. Whereas being the principal of a surety bond, you are not covered in the event of a loss. The entity requiring you to have the bond is covered if you fail in your agreed-upon obligations. You are responsible for repaying the surety back in full if a valid claim is made against your bond. The surety bond contract and indemnity agreement contract ensures the surety will be made finically whole by you after a payout of a claim.
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