Understand requirements & options to protect your company from risk
by Jon Gottschalk
April 27, 2016

The work that contractors perform carries with it inherent risks that, if unaccounted for, have the potential to result in significant financial and physical harm to both the contractor and the party for whom the contractor is working. Therefore, many regulatory agencies require that contractors obtain both an insurance policy and a surety bond as part of the licensing process. Though these requirements make it clear that applicants must purchase both before becoming licensed, there are often misunderstandings regarding exactly what the two of them are, why they are required and how they differ. A misunderstanding could result in financial disaster.

What Is Insurance?

An insurance policy is an agreement between two parties—the insurance company, or insurer, and the insured—in which the insured pays an annual premium to the insurer. In return, the insurer guarantees payment to cover any losses covered by the policy. However, applicants should be familiar with the type of insurance they will need, since there are many unique insurance policies with differing types of coverage. For example, if a contractor is told they need insurance immediately contacts an insurance agent and purchases a $100,000 automotive policy, they will be in serious trouble should a third party incur property damage as a result of an accident, due to the fact that nothing in the automotive insurance policy would cover those damages. Therefore, the contractor without the proper insurance may be liable to cover costs out of pocket. When contractors are told they must obtain insurance, it is typically one of two types of insurance that are being referred to—general liability insurance and workers' compensation insurance.

  • General liability insurance—As the name implies, liability insurance policies absolve the insured of certain liabilities up to the limits of coverage established in the policy. For example, the policy protects the contractor by guaranteeing that the insurer will cover the cost if a third party suffers any damage. More specifically, general liability insurance covers bodily injury and property damage suffered only by a third party.
  • Compensation insurance—No matter how diligent a contractor is when ensuring that their employees are safe at work, accidents happen and people get hurt. This is why some regulatory entities mandate that contractors must have workers' compensation in order to become licensed. Unlike general liability insurance policies that benefit third parties who suffer property damage or bodily injury, workers' compensation is in place to protect those employed by contractors if they are injured during the course of business by covering the employee's medical expenses, lost wages and legal fees if the employee files a lawsuit against the contractor.

What Are Surety Bonds?

For contractors seeking licensure in states or counties that require it, purchasing a surety bond is one of the most frequently misunderstood aspects in the licensing process. In short, surety bonds are three-party contractual agreements among the principal, the obligee and the surety. The contractor seeking licensure is the principal, the obligee is the entity that requires the bond in order to issue the license and the surety is the company that writes the bond and gives financial assurance in the event that the contractor fails to meet any requirements established by the bond.

Although there are many different types of surety bonds, those that are required to receive a license are known as "license and permit bonds." However, in order to work on certain projects, contractors may also be required to provide bid bonds, which guarantee the project owner that they are able and qualified to complete the project. There are also performance bonds, which insure that the project is carried out according to the contract.

What's the Difference?

Contractors must understand the differences between bonds and insurance in order to get the most out of their policies and be aware of what they are actually purchasing. As stated previously, an insurance policy is a contract between the insurer and the insured in which the insurer will financially protect the insured from losses that are covered in the policy. Because a traditional insurance policy is a unilateral contract, the insurer is the only party in the contract that has made legally enforceable promises. Thus, the insurer has a legal obligation to settle claims on behalf of the insured (as long as the insured pays their premiums), but the insurer is not legally bound to pay their premiums. The insured's failure to do so will result in a void insurance agreement.

Unlike an insurance policy that benefits the insured by protecting them from financial loss, surety bonds do not provide any protection for those who purchase them. Should a contractor fail to comply with all rules and regulations determined by the bond, then a claim may be filed against that contractor. If the surety company determines the claim to be valid, payment up to the full amount of the bond must be made to the obligee by the surety.

While the insurer assumes risk and when issuing policies, surety companies write bonds with the assumption that there will never be a claim against the bond. Therefore, the principal pays a premium to the surety in order for the surety to make funds available to the obligee, rather than the principal having to set aside their own money for the duration of the bond's term. In order to help the surety guarantee that they will not suffer a loss resulting from a claim, they typically require principals to sign hold-harmless agreements, also known as "indemnity agreements," that transfer liability from the surety to the principal. These agreements make it so that if a claim is settled by the surety, the principal guarantees to the surety that they will reimburse them for any money paid.

Although it may seem like the bond requirement is making the contractor personally liable, in reality, claims are typically a result of the contractor's deliberate, avoidable actions that violate the terms of the bond. Therefore, contractors who operate in accordance with all pertinent regulations need not worry about claims being made against their bond.

Determining Insurance & Bond Premiums

For insurance policies, underwriters take a close look at the amount of coverage being sought, as well as statistical data, such as the frequency with which accidents occur to determine the applicant's premium. The higher the likelihood that an accident will occur, the higher the premium. However, contractors that have not filed claims on their insurance may qualify to pay less when it is time to renew their insurance.

Because surety underwriters assume there will be no loss, they calculate premiums a bit differently. First, they look at the amount of the bond that is being required, as that is the maximum amount they will have to pay in the event of a claim.

Then, they will typically look at the applicant's credit score to determine the likelihood that the applicant can financially handle the cost of a claim. Therefore, applicants with lower credit scores will be assessed higher premiums. As with insurance premiums, underwriters will look to see if credit has improved and there are no claims when it is time for the bond to be renewed. The contractor's premium for the next bond term may be decreased or increased depending on what the underwriters find.

Regardless of who is issuing the license, almost all contractors will be required to be bonded and insured at some point, so it is extremely important to be familiar with what kind of bonds are guaranteed.

To ensure that the bond and insurance will be acceptable to the entity from whom the license is being sought, contractors should contact the state or county to determine their required coverage amounts, as well as other important licensing information.