16.1 Surety and Fidelity Bonds

Surety Is a Three-Party Guarantee, Not Insurance

A surety bond is a three-party agreement in which the surety guarantees to the obligee that the principal will perform a specified obligation. Compare this to an insurance contract, which has only two parties (insurer and insured) and transfers risk so the insured is indemnified for a fortuitous loss.

Quick Answer: In surety, the principal buys the bond, the obligee is protected, and the surety pays the obligee but expects full reimbursement from the principal.

The three roles map cleanly onto a construction job:

Because the surety expects reimbursement, surety underwriting resembles credit underwriting: it examines capital, capacity, and character (the "three C's") and expects a loss ratio near zero. A surety that pays a claim pursues the principal for indemnity. This right of indemnity against its own principal is the biggest contrast with insurance, where the insurer has no recovery right against its insured.

The Three Construction Bonds and the Miller Act

Federal construction contracts over a threshold are governed by the Miller Act, which requires three bonds. Most states adopt Little Miller Acts mirroring it.

Bid Bond

Guarantees that if the contractor wins the bid, it will enter the contract and furnish the required performance/payment bonds. If the low bidder backs out, the bid bond pays the obligee the difference between the defaulting bid and the next-lowest bid, up to the bond's penal sum.

Performance Bond

Guarantees the contractor will complete the project per the contract. On default, the surety may finance the original contractor, re-let the job to a completion contractor, or pay the obligee — up to the penal sum (the bond's maximum).

Payment Bond (Labor & Material Bond)

Guarantees that subcontractors and material suppliers are paid. Because a federal project cannot have a mechanic's lien filed against public property, the payment bond is the suppliers' substitute remedy.

Worked Example: Bid Bond Penalty

A contractor submits a $2,000,000 bid backed by a 10% bid bond (penal sum $200,000). After winning, it refuses to sign. The next-lowest responsible bid is $2,150,000. The obligee's extra cost is $2,150,000 - $2,000,000 = $150,000. Because $150,000 is below the $200,000 penal sum, the surety pays the full $150,000. Had the next bid been $2,300,000 (a $300,000 gap), the surety would pay only the $200,000 penal sum — the obligee absorbs the excess.

Other Surety Bonds

• License & permit bonds — guarantee a licensee complies with the law (e.g., a contractor or insurance agent bond).
• Court / judicial bonds — fiduciary bonds (administrators, guardians) and judicial bonds (appeal, injunction).
• Public official bonds — guarantee an officeholder's faithful performance.

Maintenance, Supply, and Subdivision Bonds

Surety extends beyond the three core construction bonds. A maintenance bond guarantees the contractor will repair workmanship and material defects for a stated period (commonly one to two years) after the project is accepted. A supply bond guarantees a vendor will deliver supplies or materials per a purchase contract.

A subdivision (or completion) bond guarantees a developer will build the public improvements — roads, sewers, sidewalks — a municipality requires before approving a plat. All of these are still three-party guarantees protecting an obligee, and the surety still retains its indemnity right against the principal.

Quick Answer: Any bond naming a principal, an obligee, and a guarantor is surety — the surety expects reimbursement, unlike an insurer.

Fidelity Bonds: Protecting the Employer from Employee Dishonesty

Where surety protects a third-party obligee, a fidelity bond protects the employer (the insured) against loss caused by dishonest acts of its own employees — theft, embezzlement, forgery. Fidelity coverage is delivered through the ISO Commercial Crime program on the discovery form (CR 00 21) or the loss-sustained form (CR 00 22).

Quick Answer: Fidelity = employee dishonesty coverage for the employer. Surety = performance guarantee for an outside obligee.

The key insuring agreement is Employee Theft (Insuring Agreement 1), which covers loss of money, securities, or other property caused by employee dishonesty. Other crime agreements address forgery/alteration, theft of money inside/outside premises, computer fraud, and funds transfer fraud.

Discovery vs. Loss-Sustained Trigger

ERISA Pension Bonds

Under ERISA, anyone who handles employee benefit plan funds must be bonded for at least 10% of the funds handled, with a minimum bond of $1,000 and a maximum of $500,000 ($1,000,000 if the plan holds employer securities). This is a frequently tested number.

Common Exam Traps

• Confusing the protected party. Surety protects the obligee; fidelity protects the employer.
• Expecting losses in surety. Surety underwriting expects a near-zero loss ratio and seeks indemnity from the principal.
• Penal sum cap. The surety never pays more than the penal sum, even if the obligee's cost is higher.
• ERISA 10% rule. Plan officials must be bonded for 10% of funds handled.

Crime Program Definitions and Exclusions

The ISO Commercial Crime program defines an employee broadly enough to include leased and temporary workers under the insured's direction, but it excludes the dishonesty of partners acting alone. Coverage applies to loss the insured directly sustains; indirect losses such as lost income are excluded.

The program also excludes any loss whose proof depends solely on a profit-and-loss computation or inventory shortage. A final tested point is prior dishonesty termination: coverage on any employee ends as soon as the insured learns of a dishonest act by that employee, so continuing to employ a known thief voids coverage for that person's later acts.