16.1 Surety and Fidelity Bonds
Key Takeaways
- A surety bond is a three-party guarantee (principal, obligee, surety); the surety expects to recover any payout from the principal via indemnity.
- Bid bonds guarantee contract entry, performance bonds guarantee completion, and payment bonds guarantee that subs and suppliers are paid.
- The federal Miller Act requires performance and payment bonds on federal construction contracts above $150,000.
- Fidelity bonds protect an employer from its own employees' dishonesty; position schedule forms survive turnover without endorsement.
- The penal sum is the surety's aggregate maximum liability, not a per-occurrence limit that resets.
What a Surety Bond Is
A surety bond is a three-party agreement, not an insurance policy in the ordinary sense. The exam tests the distinction relentlessly. Insurance spreads loss among many insureds and the carrier expects to pay claims; a surety expects to pay nothing because the bond guarantees the principal's performance, and any loss the surety pays is recovered from the principal through indemnity.
The three parties are:
- Principal - the party who must perform (contractor, license holder, fiduciary).
- Obligee - the party protected by the bond (project owner, government, the public).
- Surety - the company that guarantees performance and pays the obligee if the principal defaults.
Surety vs. Insurance - The Tested Differences
| Feature | Insurance | Surety bond |
|---|---|---|
| Parties | Two (insurer, insured) | Three (surety, principal, obligee) |
| Premium reflects | Expected losses | Service/credit fee, low loss expectancy |
| Loss recovery | Insurer absorbs loss | Surety recovers from principal (indemnity) |
| Cancellation | Often mid-term | Many bonds non-cancelable |
Because the surety expects full reimbursement, underwriting is closer to credit analysis than to hazard rating - the surety examines the principal's capital, capacity, and character (the "three C's").
Contract (Construction) Bonds
Contract bonds guarantee a construction obligation. Three appear on every exam:
- Bid bond - guarantees that if the contractor wins the bid, it will enter the contract and furnish the required performance/payment bonds. If the low bidder backs out, the bond pays the obligee the difference between the low bid and the next acceptable bid, up to the penal sum.
- Performance bond - guarantees completion of the project per the contract. On default, the surety may complete the work, finance the original contractor, or pay damages up to the penal sum.
- Payment bond (labor & material) - guarantees that subcontractors and suppliers are paid, protecting the owner from liens.
The Miller Act
The federal Miller Act requires performance and payment bonds on federal construction contracts above the statutory threshold (currently $150,000 for performance/payment bonds). State "Little Miller Acts" mirror this for state public works.
License/Permit, Court, and Public Official Bonds
- License and permit bonds guarantee that a licensee will comply with the law governing its business (e.g., a contractor, mortgage broker, or auto dealer). They protect the public, not the principal.
- Court bonds include judicial bonds (appeal, attachment, injunction) and fiduciary bonds (administrator, executor, guardian) that guarantee a fiduciary will faithfully account for property.
- Public official bonds guarantee that an elected or appointed official will perform duties honestly.
Note the penal sum - the maximum the surety pays. It is not a coverage limit that resets; it is the aggregate cap on the surety's liability for the bonded obligation.
The Three Parties and the Reimbursement Twist
Every surety bond involves three parties, which is what separates suretyship from a two-party insurance contract.
| Party | Role |
|---|---|
| Principal | The party who must perform (the contractor) |
| Obligee | The party protected by the bond (the project owner) |
| Surety | The party guaranteeing performance (pays the obligee if the principal defaults) |
Exam trap: Unlike insurance, the surety expects no losses and subrogates against the principal - the principal must reimburse the surety for any payment. A bond is closer to a credit guarantee than to insurance; the premium is a service charge, not a pooled-risk premium.
The Bond Family
Contract bonds break into bid (guarantees the bidder will enter the contract), performance (guarantees completion), and payment (guarantees subcontractors/suppliers are paid). License/permit bonds guarantee a licensee follows the law; court bonds (judicial, fiduciary) guarantee duties in litigation or estate administration; public official bonds guarantee faithful performance of office. Underwriting evaluates the three C's - character, capacity, and capital - because the surety is underwriting the principal's ability to perform, not insuring a fortuitous loss.
After a bonded contractor defaults, the surety spends $300,000 completing the project under a performance bond. The bond's penal sum is $500,000. From whom does the surety ultimately seek to recover that $300,000?
Fidelity Bonds
Fidelity bonds are sometimes grouped with surety but function differently - they protect an employer against dishonest acts of its own employees (theft, embezzlement, forgery). Functionally they overlap heavily with commercial crime Employee Theft coverage.
Two forms drive exam questions:
- Name schedule - lists each covered employee by name; coverage applies only to those scheduled.
- Position schedule - covers everyone holding a listed position, regardless of name, so turnover does not require endorsement.
- Blanket bond - covers all employees with a single limit, no schedule needed.
The ERISA fidelity bond is mandatory for those who handle employee-benefit-plan funds, generally 10% of plan funds, minimum $1,000 and maximum $500,000 ($1,000,000 if the plan holds employer securities).
Underwriting and the Three C's
Because the surety expects reimbursement, it underwrites the principal's ability and willingness to perform, not the chance of a fortuitous loss. Examiners frame this as the three C's:
- Capital - the principal's financial strength and net worth, the cushion that lets it absorb cost overruns.
- Capacity - the technical and operational ability to complete the bonded obligation (equipment, staff, completed-work history).
- Character - the principal's reputation, credit, and willingness to honor commitments.
The surety also requires a signed General Indemnity Agreement (GIA) from the principal and often its owners personally, contractually guaranteeing repayment of any loss. This is why surety losses, when paid, are theoretically recoverable and why the premium functions more like a service fee than a loss-funding charge.
A company experiences frequent turnover in its cashier roles and wants fidelity coverage that does not require an endorsement each time a new cashier is hired. Which form best fits?