Consumers usually have a basic understanding of how insurance policies work. When it comes to surety bonds, however, professionals and consumers alike are often unaware of their purpose. Even those required by law to purchase surety bonds find themselves confused as to why exactly they need them. Many inaccurately assume surety bonds are another form of insurance, but surety bonds are actually a different product entirely.

Why do people confuse surety bonds and insurance policies?

First of all, surety bonds are almost always underwritten by insurance companies, which is a fact that only furthers the misunderstanding. Another confusing aspect is that both products allow harmed individuals to collect recompense in certain situations. As a last resort, surety bonds give individuals the ability to collect reparation when a bonded entity fails to meet the bond’s contractual language. Similar to insurance claims, this is a retroactive way to do right by the harmed individual. Although surety bond claims can be made when necessary, they aren’t nearly as common as claims against insurance policies.

So how do surety bonds work, then?

Their main purpose is to prevent illegal and otherwise unethical business practices. Governments establish surety bond requirements to keep unqualified individuals from gaining access to a position through which they might take advantage of consumers.  As a neutral third party, the surety that issues the bond thoroughly reviews every applicant’s credentials before issuing a bond. Those who fail to meet the qualifications cannot get a bond, and thus won’t be allowed to work in the industry. In this way surety bonds function as risk mitigation tools that reinforce industry regulations.

Each surety bond executed provides a financial guarantee that a principal will follow industry regulations and avoid certain business practices. For this reason license and permit bonds are some of the most prevalent in the surety market. Surety bonds are even used to regulate insurance professionals themselves. For example, insurance broker bonds protect consumers from brokers who coerce clients into purchasing unnecessary or inappropriate insurance products.

Who receives surety bond protection?

There are tens of thousands of specific surety bonds available, and each works as a protective financial guarantee in its own way. That said, surety bonds typically offer protection in two major ways.

1. They protect government agencies, project owners or financiers from losing their financial investment in a project. These bonds are known as contract bonds and are used within the construction industry. For example, all contractors must purchase a contractor bond in the state of California before they can receive a valid business license and work in the state. This type of bond guarantees that a contractor will follow all licensing requirements as outlined by industry regulations. Failure to follow stipulations outlined in the bond means the obligee, which is typically a government agency, could make a claim on the bond.
2. They protect the general public in case a professional’s work should harm an individual in some way. These bonds are known as commercial bonds. For example, if a mortgage loan professional like a broker were to encourage clients to commit fraud while applying for a mortgage, the broker would probably get his or her license revoked. If the broker’s performance adversely affected the client and money was lost, a claim could be made on the bond.

It’s important to note that while claims can be made on bonds when a principal is at fault, most obligees never need to make a claim because surety providers only issue bonds to qualified applicants.

So, are there any similarities between surety bonds and insurance policies?

Yes. As discussed earlier, some situations involving surety bonds allow harmed parties to collect recompense when a bonded entity is at fault. In these cases, surety bonds do function similarly to insurance policies. Also, insurance companies and surety providers both sell their products with the understanding that some claims will be inevitable.

Insurance companies and surety providers also use similar approaches when calculating premiums for their clients. When an individual purchases a health insurance policy, the agent might determine the individual’s risk by reviewing reports that summarize physical, mental and emotional health conditions. Similarly, a surety specialist will evaluate an applicant’s financial health conditions before executing a bond.

Although certain aspects of surety bonds and insurance policies are similar, they’re still two separate products that are not interchangeable. Recognizing their similarities and their differences can help consumers and business owners alike better understand how surety bonds work and why they need them.

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