Surety and Fidelity Bonds
Key Takeaways
- Surety bonds involve three parties: principal (performs), obligee (protected), and surety (guarantees); the surety subrogates against the principal after a claim.
- Bid bonds run 5%-10% of the bid; performance and payment bonds are typically 100% of the contract price; the penal sum is the maximum payable.
- Performance-bond payouts equal the completion shortfall after the owner applies unpaid contract funds, not the gross cost to complete.
- Court bonds divide into judicial (litigation conduct) and fiduciary (executors, guardians, trustees) bonds.
- Fidelity bonds protect employers against dishonest-employee losses and are written through the ISO Commercial Crime program on discovery or loss-sustained forms.
Surety Bonds: A Three-Party Guarantee
A surety bond is not insurance in the traditional two-party sense. It is a three-party agreement that guarantees one party will fulfill an obligation to another. Exam questions love testing the three parties, so memorize them cold:
- 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 and to whom the obligation is owed (the project owner, the state licensing board, the court).
- Surety - the company guaranteeing the principal's performance. If the principal defaults, the surety pays the obligee.
The critical distinction from insurance: in a surety bond, the surety expects no losses and prices the bond as a service fee, not a loss-funded premium. After the surety pays a claim, it has a right of subrogation against the principal - the principal must reimburse the surety. In ordinary insurance, the insurer absorbs the loss and does not seek repayment from its own insured.
Contract Surety Bonds
Contract bonds support construction projects and come in a predictable sequence the exam tests as a set:
| Bond Type | What It Guarantees | Typical Penal Sum |
|---|---|---|
| Bid bond | The bidder will enter the contract at the bid price and furnish required bonds | 5%-10% of bid |
| Performance bond | The contractor will complete the project per the contract | 100% of contract price |
| Payment bond | Subcontractors, laborers, and suppliers will be paid | 100% of contract price |
| Maintenance bond | Workmanship/materials are free of defects for a stated period | Varies (often 10%-20%) |
The maximum a surety pays is the penal sum (also called the bond penalty) - the face amount of the bond. Unlike a liability policy, there is no separate per-occurrence and aggregate; the penal sum is the cap regardless of how the loss arises.
Worked Example: Performance Bond Penal Sum
A contractor wins a $2,400,000 municipal contract and posts a 100% performance bond and a 100% payment bond. The contractor abandons the job when 60% complete. The owner hires a replacement contractor to finish at a cost of $1,150,000, but the remaining contract balance held by the owner is only $960,000 (40% of $2.4M).
The surety's exposure is the shortfall the owner cannot cover from the unpaid contract balance:
- Cost to complete: $1,150,000
- Less unpaid contract balance available: -$960,000
- Surety pays: $190,000
The $190,000 falls well within the $2,400,000 penal sum, so the surety pays it in full - then pursues the defaulting principal for reimbursement. Watch the trap: candidates wrongly assume the surety pays the entire $1,150,000. The owner must apply the funds it still holds first.
License, Permit, and Court Bonds
License and permit bonds are required by government bodies before they grant a license (contractors, motor vehicle dealers, mortgage brokers, electricians). They guarantee the principal will comply with the law or ordinance governing the licensed activity. If the principal violates the code and harms a member of the public, the injured party recovers against the bond up to the penal sum, and the surety then bills the principal for reimbursement.
Court bonds split into two families. Judicial bonds guarantee a litigant will not cause loss by an improper court action - for example, an appeal bond guarantees payment of a judgment if an appeal fails, and an attachment bond protects a defendant whose property is seized. Fiduciary bonds (also called probate bonds) guarantee that an executor, administrator, guardian, or trustee appointed by a court will faithfully and honestly handle the assets entrusted to them. The exam frequently asks candidates to classify a given bond into the judicial-versus-fiduciary buckets.
Fidelity Bonds and Commercial Crime
Fidelity bonds are the cross-over between surety and insurance: they protect an employer against losses caused by dishonest employees - theft, embezzlement, forgery, or fraudulent transfers. The employer is both the insured and the obligee, and the dishonest employee is effectively the principal whose honesty is guaranteed.
The ISO Commercial Crime program writes employee theft coverage on either a discovery form (covers losses discovered during the policy period regardless of when they occurred) or a loss-sustained form (covers losses sustained during the policy period and discovered within a stated extended-reporting window after expiration).
Related crime insuring agreements the exam tests include forgery or alteration, theft of money and securities (inside and outside the premises), computer fraud, and funds transfer fraud. A key trap: employee theft under Commercial Crime is insurance, but it traces its roots to the three-party fidelity bond, so the insurer's right of recovery against the dishonest employee still applies.
The Three Parties and the Bond-Type Recap
A surety bond's defining feature is its three-party structure — the principal (who must perform), the obligee (who is protected and requires the bond), and the surety (who guarantees performance and expects reimbursement from the principal after paying a claim, unlike insurance, which does not seek repayment from the insured).
The exam groups bonds into contract (bid, performance, payment, maintenance bonds supporting construction), license and permit (required to obtain a business license, guaranteeing compliance with the law), court/judicial (fiduciary bonds for executors/guardians and litigation bonds such as appeal bonds), and public official bonds. The penal sum caps the surety's exposure. Contrast all of these with a fidelity bond, which is essentially first-party crime coverage guaranteeing the honesty of the insured's own employees — the cross-over point between surety and crime insurance.
A contractor holds a 100% performance bond on a $1,800,000 contract. He defaults at 50% completion; the owner still holds $900,000 of unpaid contract funds. A replacement contractor finishes the work for $1,200,000. How much does the surety pay?
In a surety bond, which party guarantees performance and pays the obligee if the principal defaults?