As we kick off our construction surety law blog, let’s start with some basics. Among the most important things to understand about bonds is that they are not insurance. Many owners and contractors consider them to be the same things and often confuse the two when it is time to make a claim. Surety bonds and insurance policies are, however, not the same things.
By definition, insurance is a product purchased by a party to protect itself from losses (most commonly personal injury or property damage). As such, the party who is an insured under the policy is covered when the loss occurs.
Bonds, conversely, are fidelity obligations by which a third party that does not purchase the bond is protected. They are typically used to protect the economic “investment” of the third party in the project. The most common scenario in which this occurs is the purchase of a payment bond by a general contractor to protect an owner from payment claims by the general contractors’ subcontractors.
There are some other important differences between bonds and insurance. Here they are briefly:
(a) While both an insurance policy and a bond are contracts of sorts, an insurance policy typically has two parties to the agreement. A bond has 3 or more once the obligor (contractor), obligee (owner), and the surety are involved.
(b) Premiums for insurance are arrived at by using actuarial tables to compute the risk being assumed and the amount to be collected as an adequate price to cover the potential losses. The insurance company takes some level of risk. The premiums paid for bonds, however, are designed to make sure the principal (the contractor) fulfills its project and payment obligations. The risk taken by surety companies is not as big, as they prescreen the principal for its ability to meet its obligations. As a side note, this can be a useful tool to see if a contractor actually has the working capital to complete a project at the front end.
(c) Surety bonds mirror a credit card in a way. It is expected that the principal will repay the surety if a bond claim is paid. In fact, there are often indemnity agreements executed before the bond is issued to ensure this will happen. A payment made under an insurance policy typically doesn’t come with the expectation that the insurance company will recoup the loss.
In the end, insurance coverage and bonds are different things and cover different risks. They also work very differently in terms of how claims are made, when they have to be made, and the types of claims that can be made on each one. More on that in a future post though.