April 11, 2024

Surety Bonds: The Other Risk Management Tool

Surety Bond information on paper with glasses and pen

Surety premiums are only about one percent of property/casualty premiums ($769.3 billion in 2022), but sureties play a critical role in our economy.

According to the Surety & Fidelity Association of America (SFAA), surety contracts protect over $9 trillion in assets.

Surety bonds and insurance policies both provide financial security, but in quite different ways.

When you buy insurance, the insurer guarantees to reimburse you for a covered loss. When you buy a surety bond, it guarantees that you (the principal) will fulfill the terms of your contract or other obligation with a third party. If you fail to meet these obligations, the surety company will pay the other party (called the “obligee”).

The indemnity provision in a typical surety agreement grants the surety the broad legal right to recover from the indemnitor (usually the principal) whatever it pays on the principal’s behalf under the related bonds, as well as those amounts for which it remains liable.

When Do You Need Surety Bonds?

If your profession requires a license, the state will likely require you to have a license bond to protect your clients if you don’t uphold the regulations that govern your license. Project owners often use construction or performance bonds to guarantee that a project or job will be completed according to the contract; contractors many also be required to buy bonds to guarantee they will pay workers’ compensation claims. Crime bonds guarantee that a covered employee won’t embezzle your funds.

Insurance vs. Surety Bonds

Although insurance and surety bonds both transfer risk, they have significant differences.

  • In traditional insurance, the risk is transferred to the insurance company. In suretyship, the risk remains with the principal (as per the Indemnity provision mentioned above).
  • In traditional insurance, the insurance company takes into consideration that a certain amount of the premium for the policy will be paid out in losses.
  • In true suretyship, the premiums paid are ‘service fees’ charged for the use of the surety company’s financial backing and guarantee.
  • In underwriting traditional insurance products, the goal is “spread of risk.” In suretyship, surety professionals view underwriting as a form of credit, so the emphasis is on prequalification and selection.

When you apply for a surety bond, the surety company will make a thorough investigation of your company, including its finances, qualifications and experience. The premium you pay depends on how the surety underwriter assesses your default risk. The greater your perceived risk of default, the higher your premiums will be. If a surety company must make a payment to an obligee on your behalf, you must reimburse the surety. Each bond specifies a maximum amount of money the surety will pay, called the penal sum, in the event of your default. Guaranteeing a financial obligation such as a loan requires a different set of underwriting tools — and a different type of bond. Financial guarantees require the analysis of complex contractual terms and conditions and an evaluation of how they will affect your ability to pay the loan or financial obligation you want to guarantee. Because underwriting financial guarantees is so complex, insurance regulations permit only companies licensed expressly for that line of business to write it. Surety bonds can play an important role in your risk management program. For more information, please call us.

Article Courtesy of SmartsPublishing.com