Though commonly considered to be a form of insurance, surety bonds are a financial instrument that many companies rely on to secure funding and acquire new business.
Essentially, a surety bond is a promise or contract to pay one party (the obligee or project owner) a certain amount if another party (the principal) fails to meet some obligation, such as satisfying the terms of a contract. Surety bonds differ from traditional insurance policies in a number of ways. Insurance is a two-party contract between the insured (the buyer) and the insurance company that provides protection for covered losses, according to Ted Baran, surety manager at Alaska USA Insurance Brokers. Surety, on the other hand, is a three-party contract involving the principal, the obligee, and the surety company. "Unlike an insurance policy that can be cancelled by either party, a contract bond cannot be cancelled," Baran says. "A bond remains in force until all terms of the underlying contract are fulfilled."
As another area of dissimilarity, surety companies underwrite to the expectation that they will have no losses, Baran says. And when there is a loss, the surety company has the right of recovery from the defaulting principal, rather than indemnifying them the way an insurance company would. But in the world of property and casualty insurance, carriers expect a certain level of losses to be incurred. "While they may not be able to predict the frequency, severity, or value of losses, they understand that losses are part of their business," Baran says.
Ultimately, those losses are recovered from the principal or contractor that purchases the bond. So if there is a loss, the surety bond will pay out on it and then seek reimbursement from the principal. Often, informal steps can be taken to rectify problems before a claim is filed, according to Chris Pobieglo, president of Business Insurance Associates, an independent commercial insurance and surety brokerage located in Anchorage. In most cases, the principal will be contacted by the surety company and told to correct the situation, Pobieglo explains. "It's better if you self-correct and be responsible before the bond pays it out," he says. "In most cases, a call from the surety company is enough to move the process forward and get it resolved."
Most principals want to avoid a claim--which can involve expensive legal fees and a considerable amount of time--so they address project-related complications on their own...