SURETY 101

An introduction to bonds for young agents

By Dale Wolcott

When I started my career in the insurance industry, one of the first pieces of advice I received was that if you can navigate and solve a problematic bond situation for a prospective client, their P-C program will follow and be an easy win. Seven years later, I’ve found this to be resoundingly true. 

The truth is that, while most agencies do insurance well, many struggle with surety. It’s a different animal, and a completely different thought process is required to underwrite a bond versus a builders risk policy for a new construction project or a business auto policy for a courier service.

When I was young in my career, I received a referral for a client struggling to get a $25,000 institutional surety bond for their new venture. One aspect of their business was an adult educational class, “Introduction to Advanced Manufacturing.” The state required the bond for their accreditation, and the company’s usual insurance provider had communicated that the only way to obtain this bond for their new business would be to provide collateral of $12,500 (exactly half of the bond penalty) plus a $2,500 annual fee. For the client, shelving away the amount of collateral required was not feasible for their new business.

While our agency does not churn out institutional surety bonds daily, we are fortunate to have great relationships with several surety partners and a wealth of knowledge and experienced staff within the agency. After reviewing the case with some of our specialty markets, we were able to get this bond approved for the client at an annual renewable premium of $250.

Sure, we expended a lot more time and energy researching the ins and outs of the institutional surety bond and gathering the required financial information than we could earn in a decade of commissions generated by a $250 bond sale to make a profit, but the client became a sizeable property and casualty account within a few months.

More recently, I had a longtime commercial general contracting client reach out to me with a challenging situation they hoped could be solved through an insurance policy. My client was building an apartment complex of which one exterior exposure was adjacent to an existing residence, with very little easement between the home and the apartment complex.

Their painting subcontractor had bid the job without visiting the site and, upon arrival to start their portion of the project, quickly realized they would not have space between the apartment building and the existing home to set the man lift needed to complete the painting of the upper portion of the building.

They were presented with two options: place their lift on the neighboring driveway or rig a swing state from the apartment building roof to reach one side of the building, an additional cost of several thousand dollars that they had not incorporated in their bid.

Unfortunately, the home owner was unwilling to grant the contractor use of their newly constructed, exposed aggregate driveway for fear of the heavy equipment causing damage. The solution was not apparent; the home owner wanted to guarantee that if the contractor damaged the driveway, the contractor or their insurance policy would cover the repair or replacement. Of course, the contractor and their insurance agent could not guarantee insurance coverage for a potential future claim.

However, the terms of a contract can be guaranteed—with a bond. The painting contractor and home owner worked together to draw up an agreement granting the use of the driveway for a specified time for a fee that included a maximum amount of damages to be paid if the contractor cracked, scratched, or otherwise damaged the driveway.

Leaning on the expertise of those in my agency and our surety underwriters, we were able to bond that contract and provide the home owner a guarantee that if their driveway were to sustain damages during or after the contractor’s use of the property, the repairs would be funded by the surety company in the event the insurance policy or contractor could not pay the claim.

Again, the bond cost here was minimal at an annual fee of $400, but our agency’s commitment to providing this bond was contingent on an opportunity to provide a quote for their upcoming insurance renewal.

Types of bonds

For agencies or agents unfamiliar or inexperienced with surety, bonds differ from insurance in several distinct ways. They can be divided into two categories: contract bonds and commercial bonds.

Both contract and commercial bonds share a common thread that differentiates them from insurance products: indemnity. In the insurance world, premiums are paid to the carrier for financial protection against loss. In the event of an insured loss, the carrier pays the claim to the insured, less the stated deductible. With surety, however, if the carrier pays a claim, their loss is recouped through the indemnity of the principal.

During the underwriting phase of a surety bond or bond program, an agreement is made between the principal and the surety as to how the indemnity will be structured. Typically, the indemnity package will include the business’s and its owners’ assets, personally.

Indemnity can be structured in various ways by limiting the maximum amount of personal indemnity, waiving personal indemnity for principals whose business assets alone are sufficient to indemnify their bond needs, or adding to the indemnity package a capital retention agreement that triggers personal indemnity for business owners only when the business equity dips below a predetermined threshold.

A second distinct difference between surety and insurance is the number of parties involved. While an insurance policy is a two-party agreement between the insured and the insurer, a surety bond is a three-party agreement between obligee, surety, and principal. The surety is the carrier that provides the bond and guarantee, while the principal is the party who obtains the bond from the surety company and has some obligation to fulfill for the obligee.

There are many differences between contract and commercial bonds, but the basics are that, while contract bonds guarantee that the terms of a contract are met, a commercial bond guarantees compliance with a set of regulations, usually by a state or federal institution.

For example, in a standard construction contract, the contractor and owner agree during the development phase of a project that a defined scope of work will be performed to a determined level of quality in a specified amount of time for a set dollar amount. The project owner or obligee may want a guarantee from the contractor or principal that the terms of this contract are met via a performance and payment bond.

If, during construction, the contractor fails to uphold their obligations, the owner can make a claim against the contractor’s bond, protecting their financial investment in the project. The performance and payment bond not only guarantees that the contractor will complete the project to the terms of the contract but also guarantees that the contractor will pay their subcontractors and vendors, ensuring the principal that these parties do not pursue payment from them in the event of the contractor’s default.

Further, the contract will typically state how long the contractor will guarantee their workmanship. Because the bond guarantees the terms of the contract, the work will continue to be warranted by the surety company even if the contractor were to become insolvent after the successful completion of the project.

Adding an element of surety to your book of business is a great way to diversify, and having

a basic knowledge of bonds will be beneficial when a client calls with a bond need.