Understanding the Difference Between Surety Bonds and Insurance

by Eric Weisbrot

Businesses large and small have two main options for protection – surety bonds and insurance coverage. While some use the terms interchangeably, there are differences between the two that should be understood. Both insurance and surety bonds have unique features that fit specific protection needs, either for the business itself or for the customer. They also differ in terms of when they are needed, and how much coverage costs. Here are the ways surety bonds and insurance differ from one another.

How Surety Bonds Work

Many business owners may be aware of the concept of surety bonds, but understanding how they work in practice is not widely known. Surety bonds, offered by surety agencies or companies, provide protection to business customers through a unique framework. When a business owner purchases a surety bond, a contract is created. This contract includes three parties – the individual taking out the surety bond, the entity or individual requiring the surety bond, and the surety company backing the bond.

When a bond is in place, the entity requiring a surety bond has the opportunity to make a claim against it should the business, or bondholder, not perform in-line with certain rules and regulations. If a claim is successful, the surety agency pays up to the limits of the bond on behalf of the bondholder. Then, the bondholder is required to repay the claim amount, either in full or over time. A surety bond is a form of credit to the bondholder, but it offers protection to the entity or individual requiring the bond should things not go as planned.

How Insurance Works

Insurance differs from a surety bond in that it offers protection against loss directly to the business owner. When insurance coverage is purchased through an insurance agency, the policyholder gains valuable coverage that can limit financial losses due to any number of events. For instance, life insurance pays out a benefit in the event of the business owner’s death, while disability insurance pays a portion of wages or income when an individual is sick or injured and cannot work for an extended period. Businesses may also secure liability insurance that protects them from claims of liability from customers or other businesses.

Insurance is not a form of credit, but instead, a transfer of risk to an insurance provider. Should a claim be made and paid, there is no obligation for the policyholder to repay the benefit amount back to the insurance company. This is the most significant difference between surety bonds and insurance coverage.

Pricing of Surety Bonds and Insurance

Another are of difference between surety bonds and insurance is the pricing structure of each. First, surety bonds, because they are a form of credit to the bondholder, are priced based on the financial track record and credit history of the individual requesting the bond. When personal credit is not strong, a bond will cost more than if a person’s credit history is free of negative marks. Surety bond agencies, however, only require a percentage of the total bond amount as payment for coverage, making getting a bond less of a financial burden for most.

Insurance is priced based on the amount at risk. A larger policy that covers more financial loss will cost more than a smaller policy. The type of coverage also plays a role in the pricing of insurance coverage. Business owners who have a minimal claims history with other insurance policies will be viewed as a lower risk than those with several claims in the past. However, insurance coverage does not typically consider an individual’s credit history as part of the cost calculation.

When They are Needed

Finally, business owners must be aware of when surety bonds and insurance are required. In many professions, a surety bond is a requirement as part of the licensing process. This requirement falls on the shoulders of licensed contractors, mortgage brokers, freight brokers, and many others. The state or the municipality in which a business operates dictates the amount of the bond, based on the work performed.

Insurance is not always a requirement to operate a business legally. Instead, it is offered as additional protection against financial loss from common events or disasters. However, business owners may be required to have insurance in place when using certain equipment, having employees, or when signing a lease for office or commercial space.

The differences between surety bonds and insurance may seem subtle, but understanding how each works is crucial to success as a business owner. Take time to recognize the parties involved in surety bonds and insurance coverage, and what factors dictate the cost of coverage. Then, be sure to understand when one or both are requirements for operating a business in line with the law.