The Distinction Between Suretyship and Insurance
If you are like me, nothing is more jarring than to hear someone say that suretyship and insurance are the same thing. That drives me crazy, and it is particularly alarming to hear a judge say that or read it in a court opinion because you know that what follows next will not be good for the surety. Once a court makes the mistake of confusing suretyship with insurance then the door is opened wide for bad faith, improper failure to settle claims, improper claims handling, construe the policy against the issuer, etc. So, I thought it would be a good idea to create this blog post discussing the differences between suretyship and insurance. Now, if you have someone telling you that there is no difference between surety and insurance you can grab this post and hit them over the head with it (figuratively of course).
Suretyship has been described as:
a contractual tripartite relationship in which one party (the surety) guarantees to another party (the obligee) that a third party (the principal) will perform a contract in accordance with its terms and conditions. The surety promises the obligee to answer the debt, default, or miscarriage of the principal. Suretyship is a form of guaranty. In exchange for a premium, the surety lends its financial strength and credit to the principal on the condition that, if the surety has to satisfy the principal’s debt or default, the principal will indemnify the surety for its losses and expenses. In essence, the surety becomes the guarantor of the principal’s ability to perform its obligations to the obligee.
Edward Etcheverry, Rights and Liabilities of Sureties, Florida Construction Law and Practice at 8-7 (5th ed. 2006).
The surety’s relationship to its principal has been described as being more like that of a creditor/debtor than that of the traditional insurer/insured. See National Shawmut Bank of Boston v. New Amsterdam Casualty Co., 411 F.2d 843 (1st Cir.1969). Indeed, suretyship has been characterized as involving “an extension of standby credit by which the surety guarantees the principal’s performance of its contractual relationship.” 4A Bruner and O’Connor on Construction Law § 12:9 Suretyship Distinguished From Insurance (2003); Pearlman v. Reliance Ins. Co., 371 U.S. 132, 83 S. Ct. 232, 9 L. Ed. 2d 190 (1962) (“Suretyship is not insurance”); See also Cross, Suretyship Is Not Insurance, 30 Ins. Counsel J. 235 (1963). A surety company grants credit via a mechanism known as the “pledge guarantee.” Bruner and O’Connor, supra. In effect, the surety does not directly lend the contractor money, but instead allows its financial resources to back the contractor’s commitment. Id. Hence, a surety bond has been defined as a “financial accommodation.” See In re Adana Mortgage Bankers Inc., 12 B.R. 977, 987 (Bkrtcy. N.D. Ga. 1980); In re Wegner Farms Co., 49 B.R. 440, 444 (Bankr. N.D. Iowa 1985); Matter of Edwards Mobile Home Sales, Inc., 119 B.R. 857, 859 (Bankr. M.D. Fla. 1990).
Insurance on the other hand has been defined as
a contract whereby one, the insurer, undertakes to indemnify another, the insured, or pay or allow a specified amount or a determinable benefit upon determinable contingencies.
See Dadeland Depot, Inc. v. St. Paul Fire and Marine Ins. Co., 945 So.2d 1216, 1226 (Fla. 2006); Buck Run Baptist Church, Inc. v. Cumberland Sur. Ins. Co., Inc., 983 S.W.2d 501, 504 -505 (Ky. 1998).
The insurer undertakes the obligation based on an evaluation of the market risks and losses. An insurer actually expects losses, and, indeed, such losses are actuarially predicted. The cost of the predicted losses are then spread throughout the market by the price of the insurance – the premium. Thus, courts have noted that the defining feature of an insurance contract is the shifting of the risk of loss among policy holders.
In contrast, a surety bond is written based on an evaluation of a particular contractor and that contractor’s capacity to perform a specific contract or work program. No losses are expected by the surety. Capstone Bldg. Corp. v. American Motorists Ins. Co., 308 Conn. 760, 67 A.3d 961 (2013). Indeed, because of the underwriting process, the surety expects that the principal will fully perform the underlying obligation, or in the event of default, that the principal will possess the financial wherewithal to reimburse the surety for any loss sustained under the bond. Thus, the premium for the issuance of a surety bond is based on a fact-specific evaluation of the risks involved in each individual case, not on an actuarial basis. In addition, sureties typically follow up with their bond principals, checking on their financial performance periodically and checking with bond obligees as to performance and project status. Through this process sureties can evaluate whether to continue providing bonds, or whether to cancel bonds if possible. Sureties also generally require the contractor and other related persons and/or entities to sign a General Agreement of Indemnity in favor of the surety company. Thus, the surety will only sustain a loss if the principal fails to perform and then the principal and its indemnitors are financially incapable of reimbursing the surety for its loss. An insurer under an insurance policy has no right of reimbursement against its insured.
Moreover, as noted above, suretyship involves a tripartite relationship between the surety, principal, and obligee. The relationship is based on the terms of the bond which are normally prepared by the obligee. The surety is generally requested by the principal to issue the bonds which are either paid for by the obligee directly or built into the price of the contract and paid by the principal. Thus, a surety bond is generally not an adhesion agreement. Insurance on the other hand involves a direct two-party relationship between the insurer and insured in which the terms and extent of coverage are dictated by the insurer.
The distinctions between suretyship and insurance have been well recognized by courts around the country, both state and federal. See Dallas Fire Ins. Co. v. Texas Contractors Sur. and Cas. Agency, 159 S.W.3d 895 (Tex. 2004); National Shawmut Bank of Boston v. New Amsterdam Cas. Co., 411 F.2d 843 (1st Cir. 1969); W. World Ins. Co. v. Travelers Indem. Co., 358 So.2d 602, 604 (Fla. 1st DCA 1978); U.S. for Benefit and Use of Ehmcke Sheet Metal Works v. Wausau Ins. Companies, 755 F. Supp. 906 (E.D. Cal. 1991); Buck Run Baptist Church, Inc. v. Cumberland Sur. Ins. Co., Inc., 983 S.W.2d 501 (Ky. 1998); U.S. ex rel. SimplexGrinnell, LP v. Aegis Ins. Co., 2009 WL 90233 (M.D. Pa. 2009); Intercon Const., Inc. v. Williamsport Mun. Water Authority, 2008 WL 239554 (M.D. Pa. 2008); Dobson Bros. Const., Co. v. Ratliff, Inc., 2009 WL 806800 (D. Neb. 2009).
Indeed, even the Supreme Court has weighed in on this issue. In Pearlman v. Reliance Insurance Co., 371 U.S. 132, 83 S.Ct. 232, 9 L.Ed.2d 190 (1962), the Supreme Court stated that although suretyship and insurance have similar characteristics, “the usual view, grounded in commercial practice, [is] that suretyship is not insurance.” Id. at 140 n. 19, 83 S.Ct. 232. Similarly, in National Shawmut Bank of Boston v. New Amsterdam Cas. Co., 411 F.2d 843 (1st Cir. 1969), the Court observed that suretyship “is neither ordinary insurance nor ordinary financing. The business of a construction contract surety is not one of ordinary insurance, for the risk is not actuarially linked to premiums, nor is there a pooling of risks.” National Shawmut Bank of Boston, 411 F.2d at 845.
In Great American Insurance Company v. North Austin Municipal Utility District No. 1, 908 S.W.2d 415, 416 (Tex. 1995), the Supreme Court of Texas noted a further distinction between suretyship and insurance. The Court held that the policy factors that justify finding a special relationship between an insurer and its insured do not exist between a surety and a performance bond obligee. The court noted that there is no unequal bargaining power between an obligee and a surety as typically exists between an insurer and insured. The Court noted that the terms of the bond are typically specified by the obligee and are included in or required by the terms of the contract between the obligee and the contractor, which the court observed are negotiated by the obligee and principal without the surety’s involvement. Such bond forms can be and frequently are lopsided against the surety. In addition, the court opined that a surety is not in a position to take advantage of the claims resolution process as an insurer could. Insured parties typically can only look to the carrier for recovery of their losses and are at the mercy of the carrier’s claims handling process. Bond obligees on the other hand can seek recovery from the bond’s principal, remaining contract funds and retainage. As such, the Texas court concluded that an obligee’s recovery is not solely in the control of the surety.
In Cates Construction, Inc. v. Talbot Partners, the Supreme Court of California also addressed the issue of the distinction between suretyship and insurance. The court held that policy considerations such as contracts of adhesion and unequal bargaining power, public interest, and fiduciary responsibility are not present in suretyship. As the Texas Supreme Court noted, the Cates Court held that obligees are in a position to dictate the terms of the bond and have an ability to find a different contractor if their contractor is unable to secure a bond acceptable to the obligee. Similarly, obligees are not faced with an “economic dilemma” if the surety breaches its contract because the obligee has a significant and meaningful right of recovery against the principal. Moreover, the Supreme Court of California noted that because owners and developers involved with construction have the ability to demand contractual provisions for interest, attorney’s fees, and liquidated damages, there are already sufficient deterrents to prevent any misconduct by sureties in responding to claims. In addition, it should be noted that governmental owners can also control whether a surety is permitted to issue bonds on governmental projects, which serves as an additional check against a surety’s improper actions in responding to claims.
However, in spite of the well-recognized differences and distinctions between suretyship and insurance, some courts and legislatures have characterized, defined or equated suretyship to insurance and bonds to insurance policies, and, in so doing, have applied various common law and statutory duties to sureties which are normally applied only to insurance. For example, the Supreme Court of Arizona, in Dodge v. Fidelity & Deposit Co. of Maryland, 161 Ariz. 344, 778 P.2d 1240 (1989), held that the surety on a bond could be held liable under the common law for the tort of bad faith failure in investigating a claim on the bond or in failing to remedy the principal’s default. Id. at 1241. In reaching its conclusion, the Arizona court noted the legislature’s inclusion of suretyship in Arizona’s Insurance Code as one of the types of insurance regulated by the Code. Id. at 1241-42. The court recognized the differences between liability insurance and suretyship, but reasoned that the analysis is not directed to whether there are differences, but rather, whether the legislature included suretyship among the classes of businesses it intended to regulate under the Insurance Code.
As in Arizona, other states, by specific statutory reference, include suretyship to as subject to all or some aspects of insurance regulation by the state’s insurance code. See DeWitte Thompson, The Fidelity and Surety Desk Reference Book (ABA 2006). In the publication DRI For The Defense, Larry Jortner authored an article titled “Contract Surety vs. Insurance – Functional Differences and Why They Matter” specifically addressing this issue. 55 No. 3 DRI For Def. 46 (2013). Mr. Jortner observed that perhaps the best way to understand how surety is functionally different from insurance is to consider that the very purpose of suretyship is to cover risks that are typically uninsurable. Specifically, a surety bond protects against a principal’s failure to pay subcontractors and suppliers and a principal’s faulty and defective work, breach of contract and failure to perform the work. Insurance only applies to fortuitous or accidental losses. Insurance does not protect against self-induced damage to someone’s own construction work or for not paying subcontractors hired to help perform contracts. Id. To do so would be a “moral hazard” because it could make it advantageous for someone not to keep his or her work and monetary commitments. Id.
The authors of the treatise Couch on Insurance noted a similar distinction stating “[t]he nature of the risk assumed by the party in the role of ‘insurer’ is a major distinction between insurance and the arrangements of guaranty and surety. As a broad general rule, the risk can be characterized in terms of the degree to which the contingency is within the control of one of the parties. In the classic instance of insurance, the risk is controlled only by chance or nature. In guaranty and surety arrangements, the risk tends to be wholly or partially in the control of one of the three parties. . . . whether a construction contractor defaults on a contractor’s bond is partly within the contractor’s control . . . 1 Couch on Ins., Third Edition – The Insurance Industry and Insurance Relationships § 1:18 How concepts differ (2021).
Mr. Jortner continues with his observations “[u]nlike an insurance policy, which is a bilateral contract between an insurer and an insured, a surety is one of three parties in a tripartite contract: the surety is between an owner claiming default and wanting action from the surety, and also between a principal who may deny the default allegation and want the surety to resist the claim. The stakes are high as the owner-obligee needs a project completed, and the contractor-principal faces loss of bonding capacity–if not its business–if it defaults on a contract and the bond.” Of course, if a surety performs under its bond it may be accused of having acted as a volunteer by its bond principal, who may then refuse to indemnify the surety. Id. These considerations are not typically part of the insurer-insured dynamic and serve as an additional distinction.
It is important for all those in the surety industry to make sure that we always preserve the distinction between suretyship and insurance in all of our dealings in the industry and courts.
If you have questions regarding the issues discussed in this post, please do not hesitate to contact Michael A. Stover, Esq. (410-659-1321 / mstover@wcslaw.com) or any member of the Surety and Fidelity Practice Group.
Update: In providing further examples on the distinction between suretyship and insurance, the following excerpt was shared by one of our readers and is pulled from the case Henry Angelo & Sons, Inc. v. Property Dev. Corp., 63 N.C.App. 569, 306 S.E.2d 162 (1983).
“In the first decision, Guilford Lumber Mfg. Co. v. Johnson, 177 N.C. 45, 97 S.E. 732 (1919), a suit by suppliers and laborers against a defaulting building contractor and his performance bond, the Court, in strictly construing the bond against the surety, used this language: “… guarantee or indemnity bonds of this character are regarded in this jurisdiction and under well-considered authority elsewhere as being in the nature of insurance contracts and, for like reasons, subject to similar rules of interpretation.” (Emphasis supplied). Id. at 48, 97 S.E. at 734. But this, of course, no more justifies the conclusion that sureties are insurers and performance bonds are contracts of insurance than does the commonly known fact that sheep are somewhat like goats justify the conclusion that sheep are goats.”