16.1 Surety and Fidelity Bonds
Key Takeaways
- Surety bonds are three-party guarantees (principal, obligee, surety) where the surety expects zero losses and recovers any paid claim from the principal under a General Indemnity Agreement.
- Contract bonds include bid (5%-20% of bid), performance (usually 100% of contract), payment, and maintenance bonds; the Miller Act requires payment and performance bonds on federal jobs over $100,000.
- The surety pays the lesser of the obligee's actual loss or the penal sum, then pursues full reimbursement from the principal.
- License/permit and court (fiduciary, litigation) bonds guarantee statutory or judicial compliance, not workmanship.
- Fidelity bonds cover the employer's loss from its own employees' dishonesty under the ISO Commercial Crime form; ERISA requires at least 10% of plan assets in fidelity coverage.
What a Surety Bond Is
A surety bond is a three-party guarantee that one party will perform an obligation to another. Unlike insurance, the surety does not price an expected loss into the premium; it lends its credit and financial strength, fully expecting the principal to perform. If the surety must pay a valid claim, it holds a right of reimbursement against the principal under a signed General Indemnity Agreement (GIA).
Quick Answer: A surety bond guarantees performance or payment. Three parties are involved, and a paid bond claim is ultimately the principal's debt, not the surety's loss.
The Three Parties
| Party | Role | Construction Example |
|---|---|---|
| Principal | Owes the obligation; buys the bond | The contractor |
| Obligee | Protected by the bond; requires it | The project owner |
| Surety | Guarantees the principal's performance | The bonding (surety) company |
Memorize the direction of protection: the bond protects the obligee, but the principal pays the premium. This is counterintuitive because the party paying is not the party protected.
Surety vs. Insurance - The Defining Contrast
| Feature | Surety Bond | Insurance |
|---|---|---|
| Parties | Three | Two (insured, insurer) |
| Expected loss | None priced in | Losses expected and priced |
| Premium logic | Principal's creditworthiness (like a loan fee) | Actuarial loss experience |
| Recovery | Surety recovers from the principal | Insurer generally cannot recover from its insured |
| Cancellation | Often non-cancelable by surety once issued | Cancelable per policy conditions |
Exam Key: The surety expects to pay zero losses. Underwriting resembles lending - the surety evaluates the principal's character, capacity, and capital (the "three Cs"). A paid bond claim is recovered from the principal, the opposite of insurer subrogation against a third party.
Contract (Construction) Bonds
The most heavily tested category. On public projects, the Miller Act (federal) requires payment and performance bonds on contracts over $100,000; state "Little Miller Acts" mirror this for state/municipal work.
- Bid bond - guarantees the bidder will enter the contract at the bid price and furnish the required bonds if awarded. Typical penalty: 5%-20% of the bid.
- Performance bond - guarantees the contractor will complete the work per the contract. Penalty usually equals 100% of the contract price.
- Payment bond - guarantees subcontractors and suppliers are paid (protects the obligee from mechanics' liens).
- Maintenance bond - guarantees against defective workmanship for a stated period after completion (often 1-2 years).
- Supply bond - guarantees delivery of materials per contract terms.
On a public project, a contractor refuses to honor its winning bid and walk away. Which bond responds to protect the project owner for the extra cost of re-bidding?
Worked Example - Bid Bond Loss
A contractor bids $2,000,000 on a municipal job with a 10% bid bond. The contractor refuses to sign. The next lowest qualified bid is $2,250,000.
- Penal sum (max the surety pays): 10% x $2,000,000 = $200,000
- Obligee's actual extra cost: $2,250,000 - $2,000,000 = $250,000
- Surety pays the lesser of actual loss or penal sum = $200,000
The obligee absorbs the uncovered $50,000. After paying, the surety pursues full $200,000 reimbursement from the principal under the GIA - the principal does not escape the debt.
License, Permit, and Court Bonds
- License/permit bonds - required by a government body before issuing a license (e.g., contractor, mortgage broker, motor-vehicle dealer). They guarantee the principal complies with the underlying law/ordinance; the public is the effective beneficiary.
- Public official bonds - guarantee faithful performance and honesty of an elected/appointed official.
- Judicial/court bonds - guarantee outcomes in litigation. Fiduciary bonds (administrators, executors, guardians, trustees) guarantee faithful handling of estate assets; litigation bonds (appeal, attachment, injunction, replevin) protect a party during a lawsuit.
Trap: A license/permit bond does NOT cover poor workmanship for the customer's benefit - it guarantees compliance with the statute for the government's benefit.
Fidelity Bonds - The Crime Crossover
Fidelity bonds protect an employer against loss from dishonest acts of its own employees (embezzlement, theft, forgery). They are technically two-party guarantees and overlap with commercial crime coverage.
- Employee dishonesty / employee theft coverage is the core fidelity grant under the ISO Commercial Crime Coverage Form (CR 00 21) or Crime and Fidelity program.
- Written on a discovery form (loss covered if discovered during the policy period) or a loss-sustained form (loss must occur and be discovered during the period plus an extended discovery window).
- Blanket bonds cover all employees; scheduled bonds name specific individuals or positions.
- ERISA requires a fidelity bond of at least 10% of plan assets (min $1,000, max $500,000; $1,000,000 if the plan holds employer securities) for anyone handling employee-benefit-plan funds.
A retailer suffers a $90,000 loss because its bookkeeper embezzled funds over two years. Which coverage responds?
Common Exam Traps
- Premium is not a loss reserve. Surety premium is a service fee for lending credit; profitable underwriting assumes a near-zero loss ratio.
- Reimbursement always runs to the principal, never the obligee. The GIA is what makes this enforceable.
- Penal sum caps the surety's exposure even if actual damages are higher.
- Fidelity = your own employees; surety = a third party's performance. A fidelity claim is NOT recovered from the employer-insured.
Contract Bond Types and the Indemnity Agreement
Construction (contract) surety bonds come in three linked forms: a bid bond guarantees the bidder will enter the contract and post the final bonds if it wins (paying the difference if it refuses); a performance bond guarantees the contractor completes the work per the contract; and a payment bond guarantees subcontractors and suppliers are paid. The surety that pays a loss has a right of indemnity against the principal — the defining contrast with insurance, where there is no such recovery from the insured. Federal Miller Act bonds are required on most public construction projects, a frequently tested fact.