16.1 Surety and Fidelity Bonds

What a Surety Bond Is

A surety bond is a three-party guarantee that one party will perform an obligation owed to another. Unlike an insurer, the surety prices in no expected loss: it lends its financial strength on the assumption that the principal will perform. If the surety must pay, it recovers the full amount from the principal under a signed agreement, so a paid claim is the principal's debt, not the surety's cost of doing business.

Quick Answer: A surety bond guarantees performance or payment, involves three parties, and any claim the surety pays is reimbursed by the principal.

The Three Parties

Surety Versus Insurance

Surety (suretyship) and insurance look similar but behave oppositely. Insurance transfers a risk of loss between two parties and prices premium on actuarial loss experience. Surety guarantees credit among three parties and prices premium like a loan fee on the principal's creditworthiness.

Exam Key: The surety expects to pay zero losses. A paid bond claim is recovered from the principal, which is the reverse of insurance, where subrogation runs against a negligent third party, never the insured.

Types of Surety Bonds

Contract (Construction) Bonds

Miller Act (federal projects): the statute references $100,000, but the operative threshold under the Federal Acquisition Regulation (FAR 28.102) is $150,000. Federal construction contracts above that amount require both a performance bond and a payment bond, each generally for 100% of the contract price. Between roughly $35,000 and $150,000 the FAR permits alternative payment protections. Most states have Little Miller Acts mirroring this for public works.

License and Permit Bonds

Required by a government body before it issues a license or permit. They guarantee the principal complies with the governing law and protect the public from misconduct. Examples: contractor license bonds, motor-vehicle-dealer bonds, and mortgage-broker bonds.

Court (Judicial) Bonds

Fidelity Bonds

Fidelity bonds guarantee employee honesty and overlap with the employee-theft coverage written on the ISO Commercial Crime Coverage Form (CR 00 22), Insuring Agreement A - Employee Theft. They protect the employer against loss from dishonest employees and are often required by clients or regulators. Because they reimburse the bonded entity for employee acts rather than guaranteeing a third party's performance, they straddle the line between crime insurance and traditional suretyship.

Worked Example - The Bid Spread

A city requests bids on a $2,000,000 water-main project and requires a bid bond equal to 10% of the bid, a $200,000 penalty. The low bidder, at $1,800,000, refuses to sign. The next acceptable bid is $1,950,000. The obligee recovers the bid spread - the $150,000 difference - up to the $200,000 penalty. Because the spread is below the penalty, the surety pays $150,000 and then recovers it from the principal under the indemnity agreement.

Underwriting the Three Cs and the GIA

The surety underwrites like a lender, evaluating the three Cs: character (reputation, claims history), capacity (technical and managerial ability to complete the obligation), and capital (working capital and net worth). Every commercial principal signs a General Indemnity Agreement (GIA), often joined by owners personally, pledging to reimburse the surety for any loss including legal fees. The GIA is the legal engine that converts a paid claim into the principal's debt.

Common Exam Traps

• "The surety expects losses" - false; it expects none and recovers what it pays.
• Bid versus performance - bid guarantees the contractor will sign; performance guarantees completion.
• Miller Act figure - the operative threshold is $150,000 under the FAR, not $100,000.
• Two versus three parties - surety has three; insurance has two.

The Three-Party Surety Relationship

A surety bond is a three-party credit instrument, fundamentally different from two-party insurance:

The surety prices for zero expected loss because it underwrites like a lender, evaluating the three Cs - character, capacity, capital. When a surety pays a claim, it enforces a General Indemnity Agreement (GIA) to recover the full amount from the principal and indemnitors - the opposite of insurer subrogation against a third party. The principal ultimately bears the loss, which is why a bond is credit, not loss protection.

Contract Bonds and Fidelity Bonds

Contract (construction) bonds guarantee different phases of a project:

• Bid bond - guarantees the bidder will enter the contract at the bid price if selected.
• Performance bond - guarantees completion per the contract terms.
• Payment bond - guarantees subcontractors and suppliers are paid.
• Maintenance bond - guarantees workmanship for a period after completion.

Under the Miller Act (implemented by FAR 28.102), federal construction contracts above $150,000 require both performance and payment bonds, protecting public funds and unpaid subcontractors who cannot lien federal property.

Fidelity bonds are different: they cover employee dishonesty and overlap with the ISO Commercial Crime Coverage Form (CR 00 22) Insuring Agreement A - Employee Theft. A fidelity bond protects the employer against loss from its own dishonest employees, whereas a surety bond protects a third-party obligee against the principal's failure to perform.