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How Bond Insurance Works – A Step-By-Step Guide for Investors

Being bonded and insured is essential for many businesses. However, many people need clarification on the differences between a bond and an insurance policy.

A bond is an agreement between the obligee (person or business that requires the bond), the principal, and the surety. The bond protects the obligee against loss from the principal’s failure to fulfill an obligation.

Issuer

While insurance and bonds are often lumped together, they are quite different. For example, an insurance policy is a contract between the insured and the insurer. It covers financial loss in exchange for a premium. The insurer expects losses and calculates the risk based on coverage, deductible, and industry risks.

On the other hand, bond insurance is a form of credit enhancement. It guarantees scheduled principal and interest payments on debt securities in the event of a payment default by a bond issuer. Bond insurance also improves market liquidity for bonds issued by the bonded entity since they are more likely to be purchased and traded in the marketplace.

When a person applies for a bond, the underwriter reviews their creditworthiness to determine eligibility and bond cost. This is common for all investments, including loans, mortgages, and credit cards. The underwriter typically considers the individual’s credit score and any other financial issues or insolvencies on their record.

Obligee

The third-party protected by the bond is called the obligee. This is usually the entity requiring that your business purchase the bond – they could be a government agency, local municipality, employer, or customer. A bond protects the obligee from financial loss should your business fail to fulfill a work-related agreement or contract. When a claim is made against the bond, the surety company that issues and backs it launches an investigation similar to when an insurance company investigates a policyholder’s claim.

Just like an insurance policy, if the claim is legitimate, the obligee can receive compensation up to the full penal sum of the bond. However, if the claim is fraudulent, the obligee may have to reimburse the surety company for the time and resources invested in investigating the case. This is another reason why reputable bond claim processing technology is essential to ensure claims are filed correctly.

Insurer

When a claim is filed against a bond, the surety agency that issued and backed the bond launches an investigation. The surety agency compensates the claimant when the investigation reveals a valid claim. This is similar to how insurance companies settle claims.

However, the surety agency never accepts liability for the bonded principal. This is why bond insurance exists: to provide a third-party layer of protection if a claim is made against a business.

As a result, bond insurers can often work directly with issuers to prevent defaults or restructure debt on a consensual basis, reducing the need for litigation. There are also several ways businesses can sidestep bond claims by building trust with project owners and adhering to best practices in their industry. Doing so can avoid a costly claim and keep their business running smoothly.

Claim Process

As a small business owner, it’s not something you want to hear – but in case it happens, understanding the bond claim process and having an action plan can help you avoid a hit to your reputation and finances.

The first thing that the bonded business should do if a claim is made against them is to formally respond to the claimant and communicate that they have received notice of the claim. From there, they should investigate the claim to evaluate it.

If a claim is validated, the surety company has to reimburse the obligee for any losses they have incurred. This is why a bonded business needs to remain honest and ethical in all their work so that claims are unlikely to be made against them. It can also help to stay on top of all work-related deadlines and follow industry regulations. This way, neither the public nor the state will have any reason to claim them.

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