This article is the first installment of our Surety EDU series, which is brought to you by nationwide surety bond agency SuretyBonds.com. Check back next Friday for another in-depth look into how surety bonds work.

No matter how much or how little you know about bonding, you’ve probably heard the terms “surety bond,” “surety bond insurance,” “surety insurance” and “bond insurance” used interchangeably. In all actuality, when you hear one of these terms, the topic being discussed is a surety bond, plain and simple. Within the surety industry, there’s no such thing as surety bond insurance, surety insurance or bond insurance. These terms are slang that have evolved as people strive to better understand surety bonds and how they relate to the insurance industry.

So where does the confusion stem from?

If you’re wondering what surety bonds are, don’t worry because you’re not alone. The surety bond market is a little understood niche within the insurance industry. Although the surety bond market functions within the insurance industry, surety bonds and insurance policies should not be confused. There are three primary reasons people mistakenly assume “surety bond” and “insurance” are synonymous.

1. Surety bonds are underwritten by insurance companies.

Although both insurance policies and surety bonds are underwritten by insurance companies, their individual structures differ. Insurance policies are two-party contracts that include the policyholder and the insurance provider. Surety bonds are three-party contacts.

• The obligee is the person or government agency requiring the bond to ensure an individual or business fulfills a certain obligation.
• The principal is the person or business that purchases a surety bond as a guarantee that an obligation will be fulfilled.
• The surety is the insurance underwriter that issues the bond, thereby guaranteeing that the principal will fulfill the obligation as outlined in the bond contract.

2. Surety bonds and insurance policies both provide financial protection.

Although both insurance policies and surety bonds provide financial protection, the party who is ultimately responsible for the financial protection differs. Insurance providers assume that a certain number of claims will be paid out over time. Calculating this loss ratio is crucial to predicting the likelihood of future claims.

When an insurance provider underwrites a specific insurance policy, it calculates the risk by considering the likelihood that a claim will be made against that individual, which directly affects the premium an individual pays for his or her insurance policy. If a valid claim is made against an insurance policy, the insurance provider pays the claim accordingly and absorbs the loss.

This is not the case with surety bonds.

When an insurance provider underwrites a surety bond, no losses are expected. The surety will pay valid claims, but it will then require full reimbursement from the bonded principal. As such, surety bonds actually function more like lines of credit rather than insurance policies.

Surety bond risk is calculated based on the inherent risk associated with the bond (how many claims have been made on the certain bond type in the past) combined with an individual’s ability to repay the surety if a claim is paid. This is why credit is such an important indicator of risk in the surety market.

A low credit score indicates that an individual has had problems repaying owed funds in the past. A principal with low credit is far less likely to reimburse the surety than a principal with high credit. As such, an individual’s credit worthiness almost always affects the bond’s premium, which is why applicants with poor credit scores typically pay higher surety bond rates. (A few low-risk surety bond types don’t require a credit check, however, and are issued to all applicants for a flat rate.)

3. Surety bonds regulate the insurance industry.

Further confusing the language surrounding bonding and insurance is the fact that insurance professionals themselves frequently have to purchase surety bonds before they can be legally licensed to work in certain states.

The government agencies that regulate insurance professionals in many states  require that insurance brokers file insurance broker surety bonds. Depending on a bond’s specific contractual language, it might protect consumers against insurance professionals who:

• use inflated or false quotes to increase profit
• coerce consumers to purchase inappropriate insurance products
• encourage customers to misrepresent themselves or their financial situation on insurance applications

If a bonded insurance professional fails to fulfill the obligations as outlined in the bond, then the bond’s obligee can make a claim on the bond to recover losses. As discussed earlier, if a claim is paid by the surety, the individual insurance broker who broke the bond’s terms will be expected to repay the surety.