The ABCs of a Surety Bond

This post is part of a series sponsored by Old Republic Surety.

What is the difference between securities bonds and insurance?

That's a question I hear often, and it's a great conversation starter. Knowing that difference helps contractors understand why they need it both products. We can state the limits of traditional insurance. It also explains why Old Republic Surety is a good company to consider if you need a construction surety bond.

In some ways, insurance and surety bonds are similar. Both are the type of cover usually written by the insurance company. In both cases, the carrier assumes the risk and charges a premium for that risk. Both protect against financial loss.

Two teams vs. three

There are major differences, however:

• Insurance is a two-party agreement between the insured (the policyholder) and the insured (the insurance company). Insurance pays the insured for covered losses.
• A surety bond is a three-party agreement between the principal (the contractor), the surety (the underwriter of the bond), and the responsible party (the project owner or municipality). A surety guarantees that the principal will discharge his obligation to the obligor — that is, complete the work and pay subcontractors and suppliers.

The loss of the collateral is borne by the principal

With an insurance policy, the insurer is responsible for making the insured whole in the event of a claim. With a surety bond, the principal assumes this responsibility. If the principal defaults, the surety will guarantee the obligee's liability — and will demand payment from the principal.

The insurer expects losses on the policies it issues. When a surety issues a bond, he doesn't expect it anywhere loss. A surety makes the principal eligible first until he reaches the point where he expects the principal to perform his contractual obligations. The economic risk remains with the principal of the bond.

The insurance company is not reimbursed for the loss of the policy. On the other hand, shareholders have signed indemnification agreements with their principals that guarantee that if there is a loss paid on behalf of the principal, the principal will pay the security.

It is like a bank arrangement

Another way to look at a surety bond is to view it as an extension of debt similar to a bank loan. The bank does not expect to lose anything because of its loan agreement with the borrower. If there is default on the loan, the bank has the right to pursue payment from the defaulting borrower.

Similarly, the collateral gives the principal the benefit of its credit standing. If the principal defaults, the surety is entitled to a refund.

Security agreements

Many contractors are unfamiliar with the concept of fines, which are an important part of the assembly process. An indemnity agreement protects the collateral in the event that the principal fails to perform a certain task. It is a separate agreement between the principal and the surety that guarantees that the surety will receive all payments due from the obligated principal. The Indemnitor (principal) assumes full liability, giving the defaulter (the surety) legal protection in the event that he has to pay a bond claim.

Most of the principal owners are party to the settlement agreement. The owner and spouse may have to repay, especially if the bond's underwriting is based on the owner's creditworthiness. In most cases, both business and personal incentives are required. A fee may be required from affiliates or affiliates.

Better accounting means better bond prices

Another difference between surety bonds and insurance is the level of financial knowledge required of the principal to underwrite the bond.

Subcontractors sometimes face challenges in providing financial information that a surety may request to see. They may need to hire a CPA with construction experience. A CPA will help them prepare their finances, including a percentage completion statement with a schedule of completed and unfinished projects.

Financial accounting is important because it affects the contractor's balance sheet. That, in turn, determines the size of the bond he can qualify for and the price he will get. Without detailed funding, contractors are limited in the projects they can pursue. Some contractors will simply fall back on debt-based bonds tied to their personal debt.

Old Republic Surety helps contractors grow by improving their financial statements. We sit down with them and explain how accounting affects their balance sheet. I know of several clients that we have taken from a debt-based program (FastBonds) to a regular program.

Unlike most lines of insurance, surety is a relationship-driven business. We really get to know our customers. We visit with the owners and managing partners. We go to work places. A relationship built on mutual trust. Making sure our clients understand the ABCs of construction surety bonds is just the beginning. For more information about promissory bonds, or to find an agency near you designated with Old Republic Surety, contact your local branch.

This blog was originally published on the Old Republic Surety website. Reproduced here with permission.