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13 NovBonds versus Insurance Policies
While bonds are sold by licensed insurance brokers, but they aren’t actually insurance.
You see, with insurance, a person or business pays a premium to the insuring company which transfers most (if not all) of the risk from the customer purchasing the coverage to the insurance company. In the event of a claim or loss, the customer is only responsible for paying the deductible since the insuring company has assumed the customer’s risk.
Bonds are different.
The only similarity between insurance and bond, is that they are both sold by insurance agents and both require the payment of a premium.
When a person or business pays for a bond, they (the principal) does not transfer risk to the “surety” (the company issuing the bond). Instead the responsibility for the payment of claims will still fall on the principal (customer). You see, when dealing with bonds, the protection afforded from the purchase of the bonds goes to the person or entity that requires the principal to purchase the bond in the first place (referred to as the the “obligee”).
When dealing with losses under a normal insurance policy, it is the insurance company that is responsible for paying out claims. For example, assume a customer has an auto insurance policy that cost $600 and has a $500 deductible for comprehensive coverage. If that customer walked out in the morning to find that his or her car had been stolen, he or she would only be responsible for paying the $500 deductible listed in the policy; it is the insurance company that would be responsible for paying the remainder of the claim, even if it were $10,000 or $20,000 vehicle – which is far more than the policy itself cost. The risk was transferred to the insurance company with the purchase of the policy and the customer’s exposure to loss is limited to just the $500 deductible.
However, bond (aka “surety”) companies do not expect to make such payments on claims, and instead treat the premiums paid for bonds as service charges. In essence, the premiums just authorize the principal (customer) to use the bond company’s deep pockets for financial backing in the event of a loss (like a short-term loan), which is what provides the required ‘guarantee’. If you have a claim that it paid out by the bonding company, the company will turn around and expect you to repay them in full per the bond agreement. This is why a start-up company with few or no assets may not be able to obtain a $500,000 performance bond for a project. Sureties view their underwriting and issuing of a bond as a line of credit, so their focus is on the pre-qualification of customer’s and the selection process. Because of this focus, not everyone will be bonded. The truth is, in today’s market it is getting more difficult to be bonded and if you fall into this situation because of poor credit, or you are a start-up company with no credit, it may be more difficult and/or expensive to get ‘ bonded’ using a non-standard market.
In summary, the insurance industry is built around statistics, actuarial data, the calculated likelihood of loss, and the assumption that customers will file claims and need to use their insurance. In the bond industry, however, claims are not looked at as inevitable (like they are with insurance), but instead it is assumed that all parties involved will do everything in their power to avoid such losses and that the bond’s ‘guarantee’ will only be used as a last resort.
A Performance Bond vs. Professional Liability Insurance (E&O)
A Performance bond is a guarantee of compensation for monetary loss as a result of the failure of one party to meet his obligations as stipulated in the contract.
That means if you agree to finish a construction project for a client that you promised will be completed by a certain date and which will be built to certain specifications and you fail to deliver it at the appointed time, you will have to pay the bond. The bond can also be required to pay when a contractor fails to build the structure as stipulated by the design specifications or blueprints agreed upon.
A professional liability insurance policy is intended to provide coverage against “errors or omissions” made by a professional that resulted in a loss for the client or customer – whether this loss was physical or financial (but in most cases, the loss is financial).
For example, an accountant improperly calculated and submitted a business client’s taxes. The client later goes through an IRS audit and is charged a large fine for improperly reporting the company’s taxes or earnings. The client can then file a lawsuit against the accountant, stating that the accountant’s professional error caused his or her business to be charged a substantial amount of money. Here are some areas of difference between the two:
- Purpose. A performance bond is used to guarantee that a contractor will finish a project and ensure that the project meets the specifications. This includes protection against failures in workmanship or design defects. A professional liability insurance policy is used to protect the professional in case he makes an error that causes his client to suffer loss.
- Coverage. Usually, the bond will hold until the project is finished and is signed off by the client. Professional liability, on the other hand, can cover previous mistakes where the loss is felt just recently.
- Payments. The bond is put up by the Principal and will be paid to the client for default in the completion of a project. Upon the default of the Principal, the bond may be used to pay for inspection costs, administrative costs, and the cost to finish the project. Professional liability insurance, on the other hand, will pay for legal defense costs and will also pay for settlements or judgments with regards to the damages the professional is required to pay for errors made in the work performed or information or services ‘omitted’ that result in a loss to the client.
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