Contractors are often required to provide insurance and/or bonds for licensing or for specific projects. Both provide protection for contractors and their customers, but the way they protect and who they protect are different. Let’s look at the key differences between insurance and bonds, so you know which you should use when the time comes.
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Insurance vs. bonds: What do they do?
Insurance policies protect contractors, their clients, and often finance companies and other project team members from financial loss due to the activities of a contractor. Coverages include physical damages, medical expenses, and workers’ compensation. All businesses are required to have general coverage to protect themselves, their employees, and those they come into contact with.
Bonds, however, protect only the parties spelled out on the bond form. Each bond has three parties involved: the applicant, the surety, and the obligee. The applicant purchases the bond to protect the obligee, and the surety ensures that payment is made if a claim should arise. If a claim is paid by the surety, the applicant must pay the surety back for the loss.
Differences between insurance and bonds
1. The parties involved
Insurance involves two parties
Insurance policies involve only two parties: the insurance company and the company purchasing the policy. The policy covers the company from financial loss due to its business operations. Claims can come from anyone who comes into contact with the insured, but the agreement is only between the insurance company and the insured. There’s only one agreement per policy, as the coverage remains the same no matter who is involved.
There’s an exception to this rule, of course. When a company is listed as an additional insured on a contractor’s policy, that company becomes a party to the insurance policy. They are afforded the same coverage as the company purchasing the policy. Project owners and general contractors are often listed as additional insured.
Bonds involve three parties
As was mentioned above, bonds involve three parties: the applicant, the surety, and the obligee. No one other than those mentioned on the bond can benefit from a claim on the bond. In this way, bonds are much more specific in the coverage they provide.
Contractors often have to issue multiple bonds for different projects, since the parties to the bonds change.
2. Scope of coverage
An insurance policy covers several types of activity
Insurance covers several types of business activities all under the same policy. While there are different policy types, they’re often wrapped up together in one agreement.
Activities covered include physical damage at a contractor’s place of business, damage on a jobsite, injuries, libel or slander, and cyber attacks, among others. Coverages are often broad and don’t apply to just one project.
These policies cover all the jobs the contractor may be working on and all the people or companies they come into contact with.
A bond covers a specific activity type
Bonds are specific in their coverage. Different bond types cover different types of business activities — so contractors often have to purchase multiple bonds.
For example, payment bonds cover only payments for one project, and performance bonds guarantee work performance for a project. Bonds offer limited coverage for a specific project or even a specific portion of the work on a project.
Insurance: The insurance company carries the financial risk
Insurance premiums are used to fund any required claim payouts. The insured essentially prepays for any potential claims that may occur while the policy is active through their premiums. The insurance company carries all the risk. Once a claim is made and paid, the insurance company is out the money.
Bonds: The applicant carries the financial risk
With bonds, premiums are paid to ensure that the surety will back the bond if a claim is made, but the applicant carries all the financial risk.
If a claim is made and paid by the surety, the surety requires the applicant to pay them back. While it’s considered quite normal for insurance claims to be made (as that is the purpose behind insurance), bond claims are not considered normal.
Bond premiums are lower than insurance because the financial risk is passed on to the applicant. Because of this, surety companies review contractors’ financial statements to ensure that they can pay for any claims that may come up before issuing a bond.
4. Claims process and payments
Insurance claims can be made by anyone in contact with the contractor
Insurance claims can be made by anyone a contractor comes into contact with — whether it’s an employee, driver, or customer. Once a claim has been proven, the insurance company pays the claimant for the damages or covers the costs of repairs.
Bond claims can only be made by the obligee
When a bond is involved, only the bond obligee can make a claim. The surety investigates whether the claim is valid, then decides how to rectify the situation. Sureties may pay out the claim to the obligee, provide financial assistance for the applicant to complete work, or hire another contractor to complete the work.
The surety’s goal is to guarantee that the work is completed, or payment is made, depending on the type of bond. Once the obligee has been satisfied, the surety then requests reimbursement from the applicant for any costs that were incurred.
Choosing bonds vs. insurance
While often the choice between a bond and an insurance policy is already made for you, the differences in coverage mean that there actually is a best choice for each situation.
If claims are expected or are a normal part of doing business, then insurance is the best protection. Although contractors pay more for the premium, that cost is spread out over time.
If claims are not expected or the scope of work to be protected is comparatively small, then a bond offers the best protection for the best price.
Contractors are required to provide both insurance and bonds during normal business operations due to the nature of the work they perform. Knowing how to protect your company from claims can save you on insurance premiums and lower the cost of protecting your projects with bonds.
Want to know more about bonds in construction? Get the lowdown with Construction Bonds: A Guide for Contractors and Suppliers.