16.1 Surety and Fidelity Bonds
Key Takeaways
- Surety bonds are three-party credit guarantees (principal, obligee, surety) where the surety expects no net loss and has a right of indemnity against the principal.
- Contract bonds: bid (will sign), performance (will complete), payment (will pay subs/suppliers); the Miller Act requires performance and payment bonds on most federal public works.
- Fidelity bonds are two-party first-party crime coverage protecting an employer from employee dishonesty - the opposite recovery direction from surety.
- Blanket position bonds apply a limit per employee; commercial blanket bonds apply one aggregate limit per occurrence.
- ERISA bonds require 10% of funds handled (min $1,000, max $500,000; $1,000,000 with employer securities).
What a Surety Bond Really Is
A surety bond is a three-party credit guarantee, not insurance in the traditional risk-transfer sense. The surety lends its financial strength expecting zero loss, because the principal is contractually obligated to make the surety whole. Exams test this distinction relentlessly: with insurance, the insurer absorbs the loss; with suretyship, the surety has a right of recovery (indemnity/subrogation) against the principal.
The three parties are:
- Principal - the party who must perform the obligation (e.g., a contractor).
- Obligee - the party protected by the bond, who receives payment if the principal defaults (e.g., the project owner or a government agency).
- Surety - the party guaranteeing the principal's performance, who pays the obligee on default and then pursues the principal.
The Underwriting Difference
Because the surety expects to be reimbursed, underwriting resembles bank credit analysis - the "three Cs": Capital, Capacity, and Character. The surety reviews the principal's balance sheet, work-on-hand backlog, and reputation. Premium is a service/credit charge, not a loss-funding charge. This is why a surety bond is frequently described on exams as a "guarantee of credit" rather than an indemnity contract.
Memory hook: In insurance, a loss is expected across the pool and funded by premium. In suretyship, a loss is not expected; the bond premium buys a guarantee, and any payout is recovered from the principal.
Contract (Construction) Surety Bonds
Contract bonds guarantee the obligations of a construction contract. The exam favorites:
| Bond | Guarantees |
|---|---|
| Bid bond | Contractor will sign the contract and furnish required bonds if awarded the job; protects owner against a low bidder who walks away |
| Performance bond | Project will be completed per contract terms if the contractor defaults |
| Payment bond | Subcontractors, laborers, and material suppliers will be paid (also called a labor and material bond) |
| Maintenance bond | Workmanship/materials are free of defects for a stated period after completion |
The Miller Act (federal) requires payment and performance bonds on most federal public-works contracts above a threshold (commonly cited at $150,000 for performance/payment). State equivalents are called "Little Miller Acts." This protects subcontractors because a mechanic's lien cannot attach to government property.
Other Bond Categories and a Worked Recovery
- License and permit bonds - guarantee a licensee complies with laws/ordinances (e.g., a contractor's license bond).
- Public official bonds - guarantee faithful performance by elected/appointed officials.
- Judicial/court bonds - e.g., fiduciary bonds (administrators, guardians) and litigation bonds (appeal, bail, attachment).
Worked example - surety recovery: A surety pays a $250,000 performance-bond claim to complete a defaulted project, plus $30,000 in legal/completion expenses. Under the signed General Indemnity Agreement, the surety has a right of full reimbursement. Recoverable from the principal (and its individual indemnitors): $250,000 + $30,000 = $280,000, subject to the principal's ability to pay. Contrast this with an insurer, which would not seek reimbursement from its own insured for a covered first-party loss.
Fidelity Bonds vs. Surety Bonds (High-Yield Trap)
A fidelity bond protects an employer (the insured) against loss from dishonest acts of its own employees - embezzlement, theft, forgery. It is functionally first-party crime coverage and behaves like insurance, even though it is called a "bond."
Key distinctions the exam tests:
| Feature | Surety Bond | Fidelity Bond |
|---|---|---|
| Parties | Three (principal, obligee, surety) | Two (insured employer, insurer) |
| Protects against | Principal's failure to perform | Employee dishonesty |
| Right of recovery | Surety recovers from principal | Insurer's recovery is against the dishonest employee, not the insured |
| Nature | Credit guarantee | First-party crime insurance |
- Blanket position bond - one limit applies per employee involved in a covered loss.
- Commercial blanket bond - one aggregate limit per occurrence regardless of how many employees were involved.
- ERISA bond - required for plan officials handling employee-benefit-plan funds; minimum coverage is 10% of funds handled, $1,000 minimum to $500,000 maximum ($1,000,000 if the plan holds employer securities).
Three Parties and the Underwriting Difference
A surety bond is a three-party agreement: the principal (who must perform), the obligee (who is protected if the principal fails), and the surety (who guarantees performance). Unlike insurance, the surety expects no losses — it prequalifies the principal much as a lender underwrites a loan and retains the right of reimbursement against the principal for any payment it makes. So a bond is a credit instrument, not a loss-sharing pool, which is the central distinction the exam draws between bonds and insurance.
Contract Surety Family and Fidelity Contrast
Contract (construction) bonds form a sequence: a bid bond guarantees the contractor will enter the contract at the bid price; a performance bond guarantees completion per specifications; and a payment bond guarantees subcontractors and suppliers are paid. License/permit bonds guarantee compliance with regulations; judicial/fiduciary bonds guarantee court-appointed duties; public official bonds guarantee honest service.
Worked recovery: a contractor defaults with $300,000 of work remaining on a $1,000,000 performance bond; the surety pays the obligee to complete the project and then pursues the principal (and any indemnitors) for the $300,000. Fidelity bonds differ — they protect an employer against employee dishonesty (functionally like crime insurance) and are first-party in effect even though structured as bonds.
After a bonded contractor abandons a project, the surety pays the project owner $400,000 to hire a replacement and complete the work. What is the surety's position regarding that payment?
Which instrument protects an employer against embezzlement by its own bookkeeper?