By Vic Lance
Navigating the entrepreneurial seas can be a challenging, yet highly rewarding endeavor. As a business owner, you’ve probably had to deal with a number of administrative issues and legal requirements that are all important but also time-consuming.
For many types of businesses, both surety bonds and insurance are prerequisites for obtaining a license or simply for being in compliance with the law. While both of these forms of security are needed on numerous occasions, it can be confusing to see the difference between a surety bond vs. insurance.
The purpose of having insurance is to obtain protection for your own business. It guarantees that you will be compensated in case your company undergoes certain risks that you are insured for.
On the flipside, surety bonds serve as protection for your customers and for the governmental bodies that regulate your trade. They guarantee that your business will act lawfully and so they safeguard the interests of the general public.
How does a surety bond vs. insurance work?
To make it easier, let’s start with the similarities. Both surety bonds and insurance are a form of protection. Obtaining both of them means you need to pay a premium, which is a fraction of the bond or insurance amount. However, the answer to the question “Is a surety bond insurance?” is negative.
Sometimes bonds are referred to as ‘surety bond insurance,’ but the phrase can be misleading. A surety bond is a three-party contractual agreement. Your business is the principal. The obligee is the authority requiring the bond, and the surety is the bond underwriter that guarantees for the principal. In a sense, the obligee transfers the risk associated with the principal’s operations to the surety.
On the other hand, insurance is a two-party agreement, where the risk is transferred from the insured to the insurance company. The insurer provides security for a large group of insured entities that face similar risks and pays claims occurring on them. In return for paying a premium, your business receives an insurance policy that functions like a contract and defines the cases in which you can receive reimbursement from the insurance company.
Differences in handling losses
Besides the differences in the ways surety bonds and insurance work, handling losses in these two cases is not the same either. Expectation of losses, as well as the way they are controlled, are managed in different manners.
In the case of surety bonds, losses are not a part of the game for surety companies. Before they provide bonding for a business, they examine whether it is trustworthy and financially stable. On the basis of this assessment, they determine the bond premium. It constitutes a larger percentage of the bond amount if the perceived risk of bonding is higher. For proven claims on the bond, the surety covers the losses at first, but the principal is expected to reimburse the bond provider in full. Not being able to repay these costs can lead to loss of licensure or even closure of business.
Insurance, on the other hand, accounts for projected losses from the start. Insurance companies pool the risk of all their clients through the numerous premiums they receive. The premiums are not set on a personal basis, so all businesses who have the same risks pay the same amounts in regular intervals. When a claim is made and is accepted by the insurance company, the pool of premiums collected is used to repay the claimant.
When do you need to obtain a surety bond or insurance?
What are the typical situations when you need to get bonded or insured? The most common cases include when applying for a professional license or when bidding on construction projects.
Licensing. If you are running an auto dealership, a mortgage brokerage, a freight brokering business, or a similar type of small businesses, often you need to get licensed with the relevant authority that oversees your trade. Obtaining a license bond, which is one of the major types of surety bonds, and an appropriate insurance are usually prerequisites for obtaining a license. The insurance protects your business from losses, while the surety bond safeguards your customers’ interests against any misuse and fraud you might engage in.
Construction contracts. Another typical situation in which you would need to post both a surety bond and insurance is if your construction company would like to participate in public or private project bidding. Liability and workers’ compensation insurance guarantee your business is financially protected against major risks, while the surety bonds ensure your company will complete all contractual obligations.
While the differences between surety bonds and insurance are quite clear, getting to know them in detail is important for business owners. Equipped with the right information, you will be well-prepared to handle different administrative requirements and avoid potential pitfalls. As an easy distinction, you can see insurance working as a financial shield for your business. On the other hand, surety bonds function like your reputation booster, guaranteeing to authorities and customers alike that your company is safe to do business with.
Have more questions about what is the difference between surety bonds and insurance? Don’t hesitate to ask them in the comments below.
Vic Lance is the founder and president of Lance Surety Bond Associates. He is a surety bond expert who helps business owners get licensed and bonded. Vic graduated from Villanova University with a degree in Business Administration and holds a Masters in Business Administration (MBA) from the University of Michigan’s Ross School of Business. Follow him on Twitter: @Lance_Surety