16.1 Surety and Fidelity Bonds
Key Takeaways
- Surety is a three-party guarantee (principal, obligee, surety) where the surety expects no losses and pursues indemnity from the principal.
- Fidelity bonds are two-party crime coverage protecting an employer against employee dishonesty, not a guarantee of performance.
- Contract bonds break down into bid, performance, and payment bonds covering different stages of a construction project.
- License and permit bonds and public official bonds guarantee compliance with law, not satisfaction or quality.
- Underwriting surety focuses on capacity, capital, and character because the surety has full subrogation against the principal.
Surety Bonds: The Three-Party Guarantee
A surety bond is a written guarantee that one party will perform an obligation owed to another. Unlike insurance, which spreads risk among many insureds, surety is a credit instrument: the surety expects to pay no losses and will recover from the principal if it does pay.
Three parties appear on every surety bond:
- Principal - the party who must perform the obligation (e.g., a contractor).
- Obligee - the party protected by the bond, who is owed the performance (e.g., a project owner or a government agency).
- Surety - the company that guarantees the principal's performance to the obligee.
If the principal defaults, the surety makes the obligee whole and then seeks reimbursement from the principal through the right of indemnity and subrogation.
Contract (Construction) Bonds
Contract bonds guarantee performance on construction projects and are commonly required on public works. The three core types track the project timeline:
| Bond type | When required | What it guarantees |
|---|---|---|
| Bid bond | At bidding | The winning bidder will sign the contract and post final bonds |
| Performance bond | At contract award | The work will be completed per contract terms |
| Payment bond | At contract award | Subcontractors and suppliers will be paid |
A bid bond is usually written for a percentage of the bid (often 5% to 10%). If the low bidder backs out, the surety pays the difference between that bid and the next acceptable bid, up to the bond's penal sum (the maximum amount stated on the bond).
Worked Example: Bid Bond
A contractor submits a low bid of $500,000 backed by a 10% bid bond (penal sum $50,000). After award, the contractor refuses to sign. The next acceptable bid is $540,000.
- Extra cost to the obligee: $540,000 - $500,000 = $40,000.
- The surety pays $40,000 because it is below the $50,000 penal sum.
- The surety then pursues the defaulting principal for the full $40,000 through indemnity.
If the next bid had been $560,000, the loss of $60,000 would exceed the penal sum, and the surety's payment would be capped at $50,000.
Other Surety Categories
- License and permit bonds guarantee that a licensee (contractor, auto dealer, mortgage broker) complies with the laws governing the license. They protect the public, not the licensee.
- Public official bonds guarantee faithful performance and honest handling of funds by elected or appointed officials such as a treasurer.
- Judicial / court bonds include fiduciary bonds (guardians, executors) and litigation bonds (appeal, injunction).
Common exam trap: a license/permit bond does not guarantee workmanship quality or customer satisfaction - only legal compliance. A consumer harmed by a violation may have a claim, but a consumer simply unhappy with the result does not.
On a surety bond, which party is guaranteed performance and is the one protected if the principal defaults?
Fidelity Bonds: Employee Dishonesty
A fidelity bond is two-party crime coverage that reimburses an employer for direct financial loss caused by dishonest acts of its employees, such as theft, forgery, or embezzlement. Despite the word bond, it functions like insurance: the employer pays a premium expecting that some losses will occur.
Key points tested on the exam:
- Coverage applies to employee dishonesty, not honest mistakes or poor judgment.
- A blanket bond covers all employees up to a single limit; a schedule bond names specific individuals or positions.
- The discovery period lets the employer report losses found after a position is canceled, often up to a stated number of days.
The ERISA fidelity bond is required for plan fiduciaries handling employee benefit funds, generally at 10% of funds handled, with a $1,000 minimum and a $500,000 maximum (or $1,000,000 if the plan holds employer securities).
Surety vs. Fidelity at a Glance
| Feature | Surety bond | Fidelity bond |
|---|---|---|
| Parties | Three (principal, obligee, surety) | Two (insured employer, insurer) |
| Loss expectation | None expected | Some losses expected |
| Right of recovery | Indemnity against principal | No recovery from employee planned |
| Nature | Credit guarantee | Crime insurance |
Remember: surety asks whether someone will perform a promise; fidelity asks whether an employer is protected from its own employees stealing. Mixing these up is a frequent miss on licensing exams.
The Three Parties to a Surety Bond
Every surety bond involves three parties — memorize the roles:
| Party | Role |
|---|---|
| Principal | The party who must perform the obligation (e.g., the contractor) |
| Obligee | The party protected by the bond (e.g., the project owner) |
| Surety | The company guaranteeing the principal will perform; pays the obligee then seeks indemnity from the principal |
The defining feature: unlike insurance, the surety expects no net loss because it has a right of indemnity to recover from the principal. The bond is closer to a credit guarantee than to insurance.
Common Bond Types
| Bond | Guarantees |
|---|---|
| Bid bond | The bidder will enter the contract and post the performance bond if it wins |
| Performance bond | The contractor will complete the work per the contract |
| Payment bond | Subcontractors and suppliers will be paid |
| License/permit bond | The principal will comply with laws/ordinances tied to a license |
| Fiduciary/court bond | An executor, guardian, or administrator will faithfully perform duties |
Fidelity Bonds and the ERISA Requirement
Fidelity bonds protect an employer against loss from employee dishonesty — theft, embezzlement, forgery. Because some loss is expected and there is no realistic plan to recover from the dishonest employee, fidelity is treated as crime insurance, not a true surety. A frequently tested rule: ERISA requires that anyone handling employee benefit plan funds be bonded for at least 10% of the funds handled, with a $1,000 minimum and capped maximum. A scenario asking how a pension-plan administrator's theft is covered points to a fidelity bond meeting the ERISA 10% rule — not a surety bond, and not the CGL.