16.1 Surety and Fidelity Bonds
Key Takeaways
- A surety bond is a three-party agreement among principal, obligee, and surety; insurance is a two-party contract.
- The surety expects no losses and pursues indemnity from the principal for any claim it pays.
- Contract bonds (bid, performance, payment) and the Miller Act dominate the construction questions.
- Fidelity bonds cover employee dishonesty and are first-party, loss-of-money coverage, unlike third-party surety obligations.
- License, permit, judicial, and fiduciary bonds are common exam-tested commercial surety categories.
The Three-Party Structure
A surety bond is a written guarantee that one party will perform a specified obligation. Unlike an insurance policy, which is a two-party indemnity contract, a surety bond involves three distinct parties. Memorize the roles, because every exam question depends on them.
- The principal is the party who must perform the obligation (for example, the contractor).
- The obligee is the party protected by the bond and to whom the obligation is owed (for example, the project owner or a government agency).
- The surety is the company that guarantees the principal's performance and pays the obligee if the principal defaults.
Guarantee, Not Indemnity
A crucial concept: the surety does not expect to suffer a loss. In ordinary insurance, the insurer prices premium to fund expected claims. In suretyship, the surety underwrites the principal much like a lender underwrites credit, expecting zero losses.
When the surety pays an obligee, it has a right of indemnity against the principal and pursues full reimbursement. The principal signs a general indemnity agreement before the bond is issued. So the principal is ultimately liable for any amount the surety pays out, plus costs.
Surety vs. Fidelity Bonds
| Feature | Surety Bond | Fidelity Bond |
|---|---|---|
| Parties | Three (principal, obligee, surety) | Two (employer/insured and insurer) |
| Guarantees | Performance of an obligation | Honesty of employees |
| Loss covered | Principal's failure to perform | Employee dishonesty/theft |
| Right of reimbursement | Surety can recover from principal | No subrogation against the dishonest employee in the same way |
| Example | Contract performance bond, license/permit bond, court bond | Employee theft (ISO Form A), ERISA bond |
Contract (Construction) Bonds
The most heavily tested surety category is the contract bond, used on construction projects. There are three closely related types you must distinguish:
- A bid bond guarantees that a contractor who wins a bid will actually enter the contract and furnish the required performance bond. If the low bidder walks away, the surety pays the difference up to the bond penalty.
- A performance bond guarantees the contractor will complete the work according to the contract terms and specifications.
- A payment bond (labor and material bond) guarantees that subcontractors and material suppliers will be paid.
The Miller Act and Penal Sum
On federal construction contracts above a statutory threshold, the Miller Act requires both performance and payment bonds. Many states have a parallel "Little Miller Act" for public works.
The maximum amount a surety will pay is the penal sum (bond penalty). Worked example: a contractor wins a $2,000,000 project and posts a performance bond with a penal sum equal to 100% of the contract. The contractor defaults when the project is 60% complete. If completing the remaining work costs the obligee $950,000, the surety pays up to the $2,000,000 penal sum, here the full $950,000 completion cost.
Construction Bonds, Penal Sum, and Exam Traps
Construction (contract) surety divides into three bonds that the exam tests as a set. A bid bond guarantees the contractor will honor its bid and post the required performance bond if awarded. A performance bond guarantees the project will be completed per contract. A payment bond guarantees subcontractors and suppliers are paid. The Miller Act requires performance and payment bonds on federal construction contracts above a statutory threshold.
| Bond | What it guarantees | Beneficiary |
|---|---|---|
| Bid bond | Contractor will sign and bond the contract | Project owner (obligee) |
| Performance bond | Completion of the work | Project owner |
| Payment bond | Subs and suppliers get paid | Subcontractors/suppliers |
| License/permit bond | Compliance with laws/ordinances | Government / public |
The penal sum is the maximum the surety will pay; it is not a premium and not an annual aggregate but the ceiling of the guarantee. Because surety is a guarantee, not insurance against the principal's own loss, the surety has a right of reimbursement (indemnity) against the principal after paying the obligee — the opposite of how fidelity coverage treats a dishonest employee.
Worked scenario: A contractor with a $2,000,000 performance bond abandons a job 70% complete. The surety pays to complete the work, spending $650,000, then pursues the contractor and its indemnitors for that amount. If completion had cost $2,300,000, the surety's payment would be capped at the $2,000,000 penal sum, leaving the owner to absorb the excess.
On a surety bond covering a paving contractor, who is the principal?
Commercial Surety Bonds
Beyond construction, several commercial surety categories appear on the exam:
- License and permit bonds guarantee a licensed business (contractor, auto dealer, mortgage broker) will comply with the law governing its license.
- Judicial bonds are used in court proceedings, such as an appeal bond posted to stay a judgment, or a plaintiff's attachment bond.
- Fiduciary bonds (probate bonds) guarantee that a court-appointed administrator, executor, or guardian will faithfully manage assets.
- Public official bonds guarantee honest performance by elected or appointed officials.
Fidelity Bonds
Do not confuse surety with fidelity. A fidelity bond protects an employer (the insured) against financial loss caused by the dishonest or fraudulent acts of its own employees, such as theft, embezzlement, or forgery.
Fidelity coverage is effectively a first-party crime coverage and overlaps with the ISO Commercial Crime program (the employee theft insuring agreement). Key distinctions:
- Fidelity = loss the insured suffers from its own employees.
- Surety = a guarantee to a third party (the obligee) of the principal's performance.
- A fidelity bond can cover named employees (name schedule) or all positions (blanket).
An accounting firm wants protection against an employee embezzling client funds. Which product fits best?