16.1 Surety and Fidelity Bonds

Surety as a three-party guarantee

Surety bonds are tested heavily on the national exam because candidates confuse them with insurance. A surety bond is a three-party arrangement, while an insurance policy is a two-party contract. Memorize the three roles and never swap them on the exam.

• Principal - the party who agrees to perform an obligation (the contractor, the licensed professional, the court-appointed fiduciary).
• Obligee - the party protected by the bond and to whom performance is owed (the project owner, the government agency, the public).
• Surety - the company that guarantees the principal's performance and pays the obligee if the principal defaults.

The defining trap: in insurance, the insurer absorbs losses as a cost of doing business and prices them into the premium. In suretyship, the surety expects zero losses and, after paying a claim, has a legal right of reimbursement (indemnity/subrogation) against the principal. The premium is closer to a service fee for the credit guarantee than a charge for expected losses. This is why surety underwriting looks like credit underwriting: capital, capacity, and character (the "three C's").

A second structural difference: surety bonds are typically non-cancelable by the surety once issued, whereas an insurance policy can usually be canceled mid-term. The principal also signs a general indemnity agreement (GIA) promising to repay the surety, often pledging personal and corporate assets - the mechanism behind the surety's reimbursement right.

Contract bonds and the Miller Act

Contract (construction) bonds are the most commonly tested surety category. On federal public-works contracts over the statutory threshold, the Miller Act requires the contractor to furnish bonds; many states copy this in "Little Miller Acts." Know the three contract bonds:

The penal sum (bond penalty) is the maximum the surety will pay. Worked example: a contractor bids $2,000,000 on a public project with a 10% bid bond. The bid bond penalty is $200,000. If the contractor refuses the award and the next-lowest bid is $2,150,000, the surety's exposure is the $150,000 re-procurement cost, well within the $200,000 penalty, so the surety pays $150,000.

Other tested surety types: license and permit bonds (guarantee a licensee follows the law - for example, a contractor or mortgage broker license bond protecting the public), public official bonds (guarantee honest performance by elected/appointed officials), judicial/court bonds (appeal bonds, attachment bonds, and fiduciary bonds for executors, administrators, and guardians), and subdivision/site-improvement bonds (guarantee a developer installs roads and utilities).

Exam tip: a maintenance bond guarantees workmanship for a stated warranty period after completion, and a supply bond guarantees delivery of materials. When a question describes a guarantee that the winning bidder will sign the contract, the answer is the bid bond; will finish the job, the performance bond; will pay subs and suppliers, the payment bond.

Fidelity bonds and ISO commercial crime

Fidelity bonds protect an employer against loss from employee dishonesty - theft, embezzlement, forgery. This is a two-party relationship in everyday usage (insured employer and the fidelity insurer), and it bridges into the ISO Commercial Crime Program, which the exam treats as part of "other lines."

Know the two trigger forms, because the answer to "when must the loss occur or be discovered" depends on which one applies:

• CR 00 20 - Commercial Crime Coverage Form (Discovery): pays for loss discovered during the policy period (or extended discovery period), regardless of when the act occurred.
• CR 00 21 - Commercial Crime Coverage Form (Loss Sustained): pays for loss sustained (occurring) during the policy period and discovered within one year (often) after policy expiration.

Core commercial crime insuring agreements you should recognize: Employee Theft; Forgery or Alteration; Inside the Premises - Theft of Money and Securities; Inside the Premises - Robbery or Safe Burglary of Other Property; Outside the Premises; Computer Fraud; Funds Transfer Fraud; and Money Orders and Counterfeit Money.

Distinguish three takings that the exam loves to test side by side: robbery (taking by threat or force directly from a person), burglary (unlawful taking by forcible entry with visible signs of entry or exit), and theft (any act of stealing - the broadest term, covering both). Money and securities are valued at actual cash value; "other property" is also ACV unless endorsed. The form excludes any loss whose only proof is an inventory shortage or profit-and-loss computation, which prevents the policy from becoming a guarantee of accounting accuracy.

Worked numeric: ERISA fidelity floor

A retirement plan trustee handles $900,000 in plan assets. ERISA requires a fidelity (ERISA) bond of at least 10% of plan funds handled, with a $1,000 minimum and a $500,000 maximum (the maximum rises to $1,000,000 when the plan holds employer securities). Ten percent of $900,000 is $90,000, which sits between the floor and ceiling, so the required bond is $90,000. If the plan held employer securities, the cap would be $1,000,000 but the calculated requirement here is still $90,000.

Common exam trap: surety questions ask "which party seeks reimbursement after a claim is paid?" The answer is always the surety from the principal - the opposite of insurance, where the insurer absorbs the loss. Another trap: a bond's penal sum is the limit; the surety does not pay re-procurement costs above the penalty even if completion costs more.