16.1 Surety and Fidelity Bonds

Surety Is a Guarantee, Not Insurance

A surety bond is a three-party guarantee. The principal owes a duty; the obligee is owed the duty and is protected; the surety lends its credit and pays the obligee if the principal defaults. Unlike insurance, surety underwriting expects zero losses — the surety prequalifies the principal like a lender. After paying a claim, the surety enforces its right of subrogation/reimbursement against the principal under a signed General Indemnity Agreement (GIA).

Exam framing: insurance is a two-party loss-spreading contract; surety is a three-party performance guarantee with full reimbursement expected.

Contract (Construction) Bonds

These guarantee a construction project. Watch the four-bond sequence and what each one promises:

Miller Act (federal projects): federal construction contracts over $150,000 require a performance bond and a payment bond; contracts over $35,000 require a payment bond. Most states adopt parallel Little Miller Acts for public works. A subcontractor on a federal job cannot file a mechanic's lien against government property — the payment bond is its remedy.

Commercial Surety Bonds

These guarantee obligations outside construction.

• License and permit bonds — guarantee a licensee (contractor, auto dealer, mortgage broker) complies with the law; the public is the obligee.
• Public official bonds — guarantee faithful performance and honesty of an officeholder (treasurer, notary).
• Court / judicial bonds — fiduciary bonds (executors, guardians, administrators) and judicial proceeding bonds (appeal, injunction, replevin, attachment).
• Federal bonds — customs, excise, and ERISA bonds.

Trap: a bid bond penalty is typically a percentage of the bid (often 5–10%) and covers the difference between the defaulting low bidder and the next-lowest responsible bidder, not the entire contract.

Fidelity Bonds and the Crime Distinction

Fidelity bonds protect an employer against loss from employee dishonesty (theft, embezzlement, forgery). They are technically surety in form but function like crime insurance — there is no expectation the employer recovers, and the employee, not the obligee, is the wrongdoer.

Key forms and concepts:

• ISO Commercial Crime (CR 00 21 / CR 00 22) offers Employee Theft coverage on a loss-sustained or loss-discovered trigger.
• Discovery form: covers loss discovered during the policy period regardless of when it occurred (subject to a one-year extended discovery window).
• Loss-sustained form: covers loss occurring during the policy period and discovered within one year after expiration.
• ERISA fidelity bond: federal law requires 10% of plan assets handled, minimum $1,000 / maximum $500,000 ($1,000,000 if employer securities are held).

Worked Example — Surety Reimbursement

A bonded contractor defaults at 60% completion. The surety pays $250,000 to hire a replacement and finish the work, plus $30,000 in legal/consulting costs. Under the GIA the surety has a right of reimbursement against the principal and any individual indemnitors for the full $280,000 — not a depreciated or pro-rata figure.

Contrast with insurance: an insurer paying a $280,000 property loss has no right to recover from its own insured (only third-party subrogation). The reimbursement right is the defining surety mechanic on the exam.

Underwriting and the Three C's

Surety underwriters evaluate a principal much like a bank evaluates a borrower, weighing the three C's:

• Capital — the principal's financial strength and net worth.
• Capacity — the technical ability and equipment to complete the obligation.
• Character — integrity, reputation, and track record of performance.

Because the surety expects no loss, weak character or thin capital usually means declination, not just a higher rate. The penal sum (bond penalty) is the maximum the surety will pay; on a performance bond it usually equals the full contract price, while on a bid bond it is a percentage of the bid. Premiums are charged as a rate per $1,000 of contract price and reflect the principal's credit, not expected loss frequency. A contractor with a $5,000,000 contract and a 1.5% bond rate pays roughly $75,000 in premium for combined performance and payment bonds.

Surety vs. Insurance — Exam Comparison Table

The exam repeatedly tests how surety differs from insurance. Memorize this contrast:

A second tested point is the difference between a conditional and an unconditional guarantee: most surety bonds are conditional — the surety pays only after the principal actually defaults and the obligee proves the default and resulting loss. The obligee cannot simply demand payment without establishing breach. This is why a surety often has the option to complete the project itself, finance the principal, or tender a replacement contractor rather than write a check, choosing the cheapest cure.