16.1 Surety and Fidelity Bonds
Key Takeaways
- Surety involves three parties (principal, obligee, surety) and is a guarantee with a reimbursement right against the principal - not loss-spreading like insurance.
- Construction sequence: bid bond (5-20% of bid), then performance and payment bonds (each 100% of contract). The penal sum caps the surety's exposure.
- The Miller Act mandates payment and performance bonds on federal construction over $150,000; unpaid subs sue on the payment bond.
- Fidelity bonds protect the EMPLOYER from employee dishonesty - functionally insurance, the opposite direction from surety's third-party guarantee.
Surety Is a Guarantee, Not Insurance
A surety bond is a three-party guarantee that one party will perform an obligation owed to another. It is not insurance in the loss-spreading sense: the surety does not expect or price for losses. Instead it lends its credit, and if it pays a claim it expects full reimbursement from the principal.
Memorize the three parties:
- Principal - the party who must perform the obligation (the contractor, the licensed plumber, the court-appointed executor). The principal buys the bond.
- Obligee - the party protected by the bond, to whom the obligation is owed (the project owner, the licensing state, the court).
- Surety - the company that guarantees performance and pays the obligee if the principal defaults.
The single most-tested distinction: in insurance, the carrier absorbs the loss; in suretyship, the surety has a right of reimbursement (indemnity) against the principal. A two-party indemnity agreement signed by the principal at bond issuance is what makes this enforceable. Underwriting therefore resembles credit underwriting - the surety examines the principal's capital, capacity, and character (the "three Cs").
Contract (Construction) Bonds
Construction is the largest surety market. Three bonds appear in sequence on a typical public job.
| Bond | Guarantees | Typical penal sum |
|---|---|---|
| Bid bond | Bidder will sign the contract and furnish the required bonds if awarded the job | 5-20% of bid |
| Performance bond | Contractor will complete the project per the contract terms | 100% of contract price |
| Payment bond | Contractor will pay subcontractors, laborers, and material suppliers | 100% of contract price |
The penal sum is the maximum the surety will pay - it caps the surety's exposure just as a policy limit caps an insurer's. If a bonded contractor defaults and the surety spends $250,000 to hire a replacement contractor to finish, the surety pays the obligee but then pursues the defaulting principal for that $250,000 under the indemnity agreement.
The Miller Act (federal) requires performance and payment bonds on federal construction contracts over $150,000 (lower thresholds use a payment bond or alternative). Each state's equivalent is called a "Little Miller Act." A subcontractor on a federal job who is not paid sues on the payment bond, not the performance bond.
License/Permit, Court, and Fidelity Bonds
License and permit bonds are required by a government body before it issues a license (contractors, mortgage brokers, auto dealers). They guarantee the principal will comply with the law or ordinance; the obligee is the public or the government unit.
Court bonds divide into two families: judicial bonds (e.g., an appeal bond or injunction bond, guaranteeing a litigant pays damages if it loses) and fiduciary bonds (guaranteeing an executor, administrator, or guardian faithfully handles estate assets).
Fidelity bonds are the bridge to crime coverage and confuse many candidates. A fidelity bond protects an employer against loss from the dishonest acts of its own employees (embezzlement, theft). It is functionally first-party employee-dishonesty protection, even though it is called a bond. Contrast with surety, which protects a third-party obligee against the principal's nonperformance.
- Surety bond: three parties, guarantees performance, surety has reimbursement rights.
- Fidelity bond: protects the employer from employee theft - closer to insurance than to true suretyship.
Trap: candidates pick "the surety expects to be reimbursed" for a fidelity loss. A fidelity bond does not pursue the honest employer; like insurance, the carrier absorbs the loss (subject to subrogation against the thieving employee).
Underwriting and Premium Mechanics
Because the surety expects no losses, the bond premium is a service charge for lending credit, not a loss-funded rate. Contract-bond premiums often run a few percent of the contract price and decline in steps as the contract size rises. The surety can cancel few bonds once issued - a performance bond runs to project completion - so prequalification is everything.
Key exam points on bond mechanics:
- A maintenance bond guarantees workmanship for a stated period (often one year) after the project is accepted - distinct from the performance bond.
- A supply (or material) bond guarantees delivery of equipment or materials under a purchase contract.
- The obligee cannot recover more than the penal sum, even if completion costs exceed it; the principal remains liable for the excess.
Finally, distinguish a financial guaranty (guaranteeing payment of a debt or financial obligation) from a performance guaranty (guaranteeing an act is performed). Most construction and license bonds are performance guaranties, which carry different underwriting and reserve treatment than financial guaranties.
Bonds vs. Insurance — the Three-Party Structure
A surety bond is fundamentally different from insurance. Insurance is a two-party contract (insurer/insured) transferring risk. A surety bond is a three-party guarantee: the principal (who must perform), the obligee (who is protected and requires the bond), and the surety (who guarantees the principal's performance). If the principal defaults, the surety pays the obligee — then seeks reimbursement from the principal (right of indemnity/subrogation). Surety expects no loss and underwrites the principal's character, capacity, and capital like a credit decision, not a loss-frequency calculation.
Contract Bonds and Fidelity Bonds
Contract (construction) bonds guarantee a builder's obligations:
| Bond | Guarantees |
|---|---|
| Bid bond | The contractor will honor its bid and post the performance bond if awarded |
| Performance bond | The project will be completed per contract |
| Payment bond | Subcontractors and suppliers will be paid |
| Maintenance bond | Workmanship for a stated period after completion |
Other bond types include license/permit bonds, public official bonds, and judicial/court bonds (e.g., fiduciary or appeal bonds). A fidelity bond, by contrast, protects an employer against employee dishonesty — closer to crime insurance — and is the bridge to the crime forms. The exam's signature distinction: insurance expects and prices for losses; surety expects none and pursues the principal for reimbursement after paying the obligee.
A bonded contractor defaults on a public project. The surety spends $250,000 hiring a replacement to complete the work and pays the project owner. From whom does the surety seek to recover that $250,000?
On a federal construction contract, an unpaid drywall subcontractor wants to recover from the bond. Which bond responds, and under what federal statute is it required?