16.1 Surety and Fidelity Bonds

Surety Bonds: A Three-Party Guarantee

A surety bond is not insurance in the ordinary sense. It is a three-party agreement in which the surety guarantees that the principal will perform an obligation owed to the obligee. If the principal defaults, the surety makes the obligee whole and then seeks reimbursement from the principal.

Quick Answer: In suretyship the surety expects to be paid back by the principal. In insurance the insurer absorbs the loss with no recovery from the insured. That single difference drives most exam questions.

Because the surety extends what is essentially credit, underwriting focuses on the principal's character, capacity, and capital (the "three C's"), much like a lender. The premium is a service fee for the guarantee, not a pooled loss charge.

Contract (Construction) Bonds

The most heavily tested surety category is the contract bond, used on construction projects. Three types form a sequence across the life of a job:

• Bid Bond - guarantees that, if awarded the contract, the bidder will enter into the contract and furnish the required performance and payment bonds. If the low bidder walks away, the bond pays the difference (up to the penal sum) between that bid and the next acceptable bid.
• Performance Bond - guarantees the contractor will complete the work according to the contract specifications. On default, the surety may finance the original contractor, hire a completion contractor, or pay the obligee.
• Payment Bond (Labor and Material Bond) - guarantees subcontractors, laborers, and material suppliers will be paid, protecting the owner from mechanic's liens.

The Miller Act

The federal Miller Act requires performance and payment bonds on federal construction contracts exceeding $150,000. State "Little Miller Acts" impose parallel requirements on state and municipal projects. This $150,000 threshold is a frequent exam fact.

Other surety classes include license and permit bonds (guaranteeing a licensee follows laws/ordinances), public official bonds, judicial/court bonds (e.g., fiduciary and appeal bonds), and federal/customs bonds.

Penal Sum and the Surety's Recovery Rights

Every bond states a penal sum - the maximum the surety will pay. Unlike a policy limit that may be reinstated, the penal sum is the absolute ceiling for the obligation.

After the surety pays the obligee, it has the right to recover its loss from the principal. Three related doctrines appear on the exam:

• Exoneration - the surety can compel the principal to perform or pay before the surety has to.
• Indemnification - after paying, the surety recovers from the principal under the general indemnity agreement signed at underwriting.
• Subrogation - the surety steps into the obligee's rights against the defaulting principal.

Worked Example: Bid Bond Penal Sum

A contractor submits the low bid of $2,000,000 on a public project backed by a bid bond with a 10% penal sum ($200,000). The contractor refuses to sign the contract. The next acceptable bid is $2,180,000. The owner's added cost is $180,000. Because that figure is below the $200,000 penal sum, the bid bond pays the full $180,000. Had the cost overrun been $250,000, the surety's payment would be capped at the $200,000 penal sum.

Fidelity Bonds: First-Party Protection Against Dishonesty

A fidelity bond protects an employer against financial loss caused by the dishonest acts of its own employees - theft, embezzlement, forgery. Unlike a surety bond, a fidelity bond is effectively a two-party, first-party coverage: the employer is both the buyer and the party protected, and there is no expectation that the dishonest employee will repay the bond company.

Fidelity coverage is the core of the ISO Commercial Crime Coverage Form (CR 00 20 / CR 00 21) through the Employee Theft insuring agreement. Crime forms can be written on a discovery basis (loss discovered during the policy period) or a loss-sustained basis (loss occurred during the period, discovered within a limited window after expiration).

ERISA Fidelity Bonding Requirement

Federal law under ERISA requires that every person who handles funds of an employee benefit plan be covered by a fidelity bond. The required amount is at least 10% of the plan funds handled, subject to a minimum of $1,000 and a maximum of $500,000 ($1,000,000 if the plan holds employer securities). These figures are commonly tested.

Worked Example: ERISA Bond Amount

A 401(k) plan administrator handles $3,000,000 in plan assets and the plan holds no employer securities. Ten percent of $3,000,000 is $300,000. Because $300,000 falls below the $500,000 cap and above the $1,000 floor, the required ERISA bond is $300,000. If the plan handled $8,000,000, 10% would be $800,000, but the bond requirement would be capped at $500,000 (no employer securities).

Common Exam Traps

• "Suretyship is insurance." It is a guarantee; the surety recovers from the principal, so there is ultimately no expected loss to the surety.
• Bid vs. performance. The bid bond guarantees the contractor will sign and bond the job; the performance bond guarantees completion.
• Fidelity protects the employer, not the employee. It never indemnifies the dishonest worker.
• Miller Act threshold is $150,000 (federal), not $100,000 or $1,000,000.
• ERISA cap is $500,000 unless employer securities are held (then $1,000,000).