If we would ask anyone what is the most important thing in life, we would probably get tons of different answers, but every one of them would eventually boil down to feeling safe and not being harmed in any way. Unfortunately, life is full of twists and turns and staying entirely out of the harm’s way is virtually impossible. Surety bonds and insurance are two most popular methods for individuals and businesses to retroactively compensate for the situations when they were somehow harmed and, at least partially, right these wrongs. However, this is the point where the similarities end, as these two methods feature a number of different properties that make them more or less suitable for different persons and businesses. Let us take a look at those key differences.
The Number of Involved Parties
- Surety bonds. One of the most noticeable differences between these agreements is the fact that surety bonds are a three party risk transfer mechanism. Namely, in this case the Obligee, or in other words the party that is protected by the bond, transfers the risk to the insurance company because the party who is required to secure a bond (the Principal) has failed to meet contractual obligations.
- Insurance. Insurance is the risk transfer mechanism that condenses this somewhat convoluted system to only two parties – the Obligee and the Insurance. As the name suggests, insurance insures a large pool of risks similar to the ones of the Obligee, pays the claim if those risks occur and collects the profit out of the unclaimed and premium insurances.
The Expected Losses
- Surety bonds. Surety bonds are not expected to incur any losses. In fact, losses occur very rarely and when they do happen, the Principal is expected to compensate them in their entirety. If Principals are not able to fully compensate for the losses, they are sanctioned with penalties that range from losing the license to going out of business.
- Insurance. Insurance, on the other hand, comes with expected losses. Insurance companies expect them to be incurred one way or another and pool the risk with the law of large numbers.
The Number of Payment Sources
- Surety bonds. Essentially, a surety bond is paid out of two different sources. One of them is the surety company that pays the claim to the Obligee. However, the role of the surety company does not end here. The surety company then goes out to ensure the full indemnity on behalf of the Principal.
- Insurance. Insurance companies, again, are making things a little bit simpler, by eliminating the role of the Principal, and compensating for the losses entirely by themselves. As we mentioned earlier, insurance claims are paid out of the insurance pool that remains viable because of the huge number of unclaimed and premium insurances.
The Methods for Determining Risk Factor
- Surety bonds. Surety bonds rely almost entirely on underwriting. Because of that, the underwriters must take a very thorough and very personal look at each of the Principals to determine the amount of involved risk. Once the evaluation is complete, the underwriters are able to assign the appropriate premium amount so they are covered in the case of loss.
- Insurance. Unlike surety bonds, insurance takes into account the bigger picture and relies on the theory of probability to control losses. Premiums that are assigned to individuals who share the same risk factor are assigned by counting in the law of large numbers and loss ratios.
The Role in Prevention
- Surety bonds. Last but not least, surety bonds are very flexible and can be used as means of prevention. For example, one of the many types of surety bonds, performance bonds are used to ensure the contractor will perform required work according to an earlier agreement and compensate the owner if the agreement is not held. Otherwise, contractor must continue its obligations until the works are done.
- Insurance. In this case, insurance takes much more passive role. Namely, insurance is used almost exclusively to transfer the risk from a client to an insurer and has very little or virtually none impact on the prevention of the eventual loss.
As we can see, although they share a very similar purpose, surety bond and insurance feature a lot of profound differences. The most important thing here, however, is staying safe and protected, so whichever of these two agreements you eventually choose for yourself and your business, you cannot go wrong.