Surety and Fidelity Bonds

Surety and Fidelity Bonds

Surety and fidelity bonds are not insurance in the traditional two-party sense, and the P&C exam tests that distinction hard. Insurance is a two-party contract (insurer and insured) where the insurer expects to pay losses from a pooled premium. Surety is a three-party arrangement in which a surety company guarantees the performance or honesty of a principal to an obligee, and the surety expects no losses—any payment made by the surety can be recovered from the principal through a written indemnity (right of subrogation/reimbursement) agreement.

Memorize the three parties before anything else:

• Principal – the party whose performance is guaranteed (the contractor, the employee, the licensee).
• Obligee – the party protected by the bond and to whom the guarantee runs (the project owner, the public, a government agency).
• Surety – the company issuing the bond and backing the principal's obligation.

Contract (Construction) Surety Bonds

Contract bonds guarantee a contractor's obligations on a construction project. The classic set, frequently tested on the Miller Act federal-project framework, includes three coordinated bonds:

Under the Miller Act, federal construction contracts over the statutory threshold require performance and payment bonds. A maintenance bond extends the guarantee to cover defective workmanship for a stated period (commonly 12 months) after completion. A supply bond guarantees delivery of materials per a purchase contract.

Penal Sum and Worked Example

The penal sum is the maximum the surety will pay, and it is not the same as the loss. On a performance bond the penal sum is normally the full contract price; the surety's actual outlay is the additional cost to complete above the unpaid contract balance.

Worked example. A contractor with a $2,000,000 contract and a $2,000,000 performance bond defaults after billing $1,200,000. The owner has $800,000 of contract funds left. A replacement contractor will charge $1,150,000 to finish.

• Cost to complete: $1,150,000
• Remaining contract funds applied: −$800,000
• Surety's payment: $350,000 (well under the $2,000,000 penal sum)

The surety then pursues the defaulting principal under the indemnity agreement to recover that $350,000. This recovery expectation is why surety underwriting looks like credit underwriting—the "three C's": Capital, Capacity, Character.

License, Permit, Court, and Fiduciary Bonds

Beyond construction, the exam tests several surety categories by their obligee and purpose:

• License and permit bonds – required of a licensee (e.g., a contractor, mortgage broker, or auto dealer) to guarantee compliance with the law or ordinance; the public is the obligee.
• Court bonds split into two groups: judicial bonds (appeal bonds, attachment bonds, injunction bonds) guarantee a litigant's obligation, and fiduciary/probate bonds guarantee that an executor, administrator, guardian, or trustee will faithfully perform duties.
• Public official bonds guarantee the faithful performance and honesty of an elected or appointed official.

A common trap: a license bond protects the public, not the principal who buys it. The principal pays the premium but receives no indemnity benefit—if the surety pays the public, it bills the principal back.

A second trap involves terminology direction: in surety the principal is the one being guaranteed, whereas in an agency relationship the principal is the one represented. On the exam, anchor on the obligee: ask "who is protected?" The obligee is always the protected party, and the bond amount (penal sum) is the obligee's maximum recovery, never an account the principal can draw on.

Fidelity Bonds and Crime Coverage

Fidelity bonds guarantee the honesty of employees, indemnifying the employer (obligee) for loss caused by employee dishonesty such as theft or embezzlement. They are the bridge between surety and commercial crime insurance.

The ISO Commercial Crime Coverage Form (CR 00 21) and the related Commercial Crime Policy package the major insuring agreements:

• Employee Theft (Insuring Agreement 1) – the modern successor to the fidelity bond; covers dishonest acts of employees.
• Forgery or Alteration – covers loss from forged checks, drafts, or promissory notes.
• Inside the Premises—Theft of Money and Securities and Robbery/Safe Burglary of Other Property.
• Outside the Premises, Computer Fraud, and Funds Transfer Fraud.

Crime forms are written on a discovery or loss-sustained basis. Discovery covers losses discovered during the policy period regardless of when they occurred; loss-sustained covers losses occurring during the period and discovered within a limited window (often one year) after the policy ends.

Two crime-form mechanics are frequently tested. First, the per-occurrence (per-loss) limit applies even when employee dishonesty spans years—a continuous embezzlement scheme is generally treated as a single occurrence subject to one limit, not multiplied by the number of years. Second, crime forms commonly exclude loss whose only proof is an inventory shortage or profit-and-loss computation, and they exclude acts by the named insured or its partners. Coverage for employee dishonesty terminates as to any employee the moment the insured learns of a prior dishonest act by that person.