16.1 Surety and Fidelity Bonds
Key Takeaways
- Surety is a THREE-party guarantee (principal, obligee, surety) and expects zero net loss; the surety recovers paid losses from the principal via indemnity, unlike two-party insurance.
- Contract bonds progress as bid (5-20% penalty), performance (100% of contract), payment (protects subs/suppliers), and maintenance (post-completion workmanship).
- The Miller Act requires performance/payment bonds on federal jobs over $150,000; states use 'Little Miller Acts.'
- Fidelity bonds protect employers from dishonest EMPLOYEES and behave like insurance (loss expected); discovery vs. loss-sustained and blanket vs. scheduled forms are key distinctions.
- ERISA fidelity bonding = 10% of funds handled, $1,000 minimum / $500,000 maximum ($1M if employer securities are held).
Surety Bonds Are Not Insurance
A surety bond is a three-party guarantee that one party will perform an obligation owed to another. This distinguishes it sharply from insurance, which is a two-party contract. Exam writers love this trap: insurance transfers risk from insured to insurer and the insurer expects to pay losses; surety expects zero net loss and prices the bond as a service fee, not as a loss-funding premium.
The three parties are:
| Party | Role |
|---|---|
| Principal | The party who must perform (e.g., the contractor). Buys the bond. |
| Obligee | The party protected, to whom performance is owed (e.g., the project owner / government). |
| Surety | The company guaranteeing performance; pays the obligee if the principal defaults. |
The critical concept is the right of subrogation/indemnity: when the surety pays an obligee on the principal's default, the surety recovers that amount from the principal. The principal ultimately bears the loss. Underwriting therefore resembles credit analysis (the "three C's": capital, capacity, character), not hazard analysis.
Contract Bonds
Contract (construction) surety is the largest segment. The progression follows a project's life cycle:
- Bid bond - guarantees the bidding contractor will enter the contract at the bid price and furnish required performance/payment bonds if awarded. Typical penalty: 5% to 20% of the bid. If the low bidder backs out, the bid bond pays the obligee the difference between the defaulting bid and the next acceptable bid, up to the penalty.
- Performance bond - guarantees the contractor will complete the work per contract specs. Penalty usually equals 100% of the contract price.
- Payment bond (labor & material bond) - guarantees subcontractors and suppliers are paid, protecting the owner from mechanic's liens.
- Maintenance bond - guarantees workmanship for a stated period after completion (commonly 1-2 years).
Worked Example - Bid Bond Recovery
A contractor submits a low bid of $2,000,000 with a 10% bid bond ($200,000 penalty). The contractor refuses the award. The next acceptable bidder is at $2,150,000. The obligee's re-letting cost is $2,150,000 - $2,000,000 = $150,000. Because $150,000 is below the $200,000 penalty, the surety pays the full $150,000 and then seeks indemnity from the defaulting principal. Had the gap been $260,000, the surety would cap payment at the $200,000 penalty.
The Miller Act (federal) requires performance and payment bonds on federal construction contracts exceeding a threshold ($150,000 for performance/payment as commonly tested). State equivalents are called "Little Miller Acts."
The Three-Party Surety Relationship
A surety bond is a three-party agreement, unlike insurance's two-party contract. The principal is the party who must perform an obligation, the obligee is the party protected (who requires the bond), and the surety guarantees the principal's performance. If the principal defaults, the surety pays or completes the obligation and then seeks reimbursement from the principal through its right of indemnity/subrogation. This reimbursement expectation is the central distinction the exam tests: surety expects no net loss, whereas insurance prices in expected losses.
Contract and Commercial Surety Bonds
Contract (construction) bonds support building projects: a bid bond guarantees the contractor will enter the contract at the bid price and furnish required bonds; a performance bond guarantees completion per the contract; and a payment bond guarantees that subcontractors and suppliers are paid. Commercial surety includes license and permit bonds (guaranteeing compliance with laws), public official bonds, and judicial/court bonds (appeal, fiduciary). The surety underwrites the principal's character, capacity, and capital, much like a credit decision.
Fidelity Bonds Versus Surety
A fidelity bond is closer to insurance: it protects an employer (the insured) against loss from employee dishonesty, such as embezzlement or theft. Unlike surety, the protected party and the premium payer are the same, and the bond functions as crime coverage. Forms include name schedule (specific named employees), position schedule (covered positions), and blanket (all employees). Recognizing that fidelity protects against dishonesty of one's own employees, while surety guarantees a third party's performance, prevents the most common bond mix-up.
On a $2,000,000 contract with a 100% performance bond, the contractor defaults after completing $1,200,000 of work. A replacement completes the job for an additional $1,050,000. The surety's obligation (before indemnity recovery) is:
Commercial Surety, License & Permit, and Court Bonds
Beyond construction, surety includes:
- License and permit bonds - required by a government before issuing a license (contractors, auto dealers, mortgage brokers). They guarantee the principal complies with the licensing law/ordinance; the public is often the beneficiary.
- Public official bonds - guarantee faithful performance of elected/appointed officials (e.g., a county treasurer).
- Court bonds, split into:
- Judicial bonds - guarantee payment of costs in litigation (appeal bond, attachment bond, injunction bond).
- Fiduciary bonds (probate bonds) - guarantee faithful performance by executors, administrators, guardians, trustees.
Fidelity Bonds - The Crime Crossover
Fidelity bonds protect an employer against loss from dishonest acts of its own employees (theft, embezzlement, forgery). Note the structure: the employer is both the insured and effectively the obligee, and there is generally no indemnity recovery against the honest party. For this reason, fidelity coverage behaves much like insurance and is frequently sold via the ISO Commercial Crime program (Employee Theft insuring agreement) rather than a true surety bond.
Key fidelity distinctions tested on the exam:
- Discovery form vs. Loss-sustained form - the discovery trigger pays for losses discovered during the policy period regardless of when they occurred (subject to retroactive limits); loss-sustained pays for losses occurring during the period and discovered within a stated extended period (often 1 year) after termination.
- Blanket vs. Schedule coverage - a blanket bond covers all employees up to a single limit; a scheduled/named bond lists specific employees or positions.
- ERISA bonds - federal law (ERISA) requires fidelity bonding for persons handling employee benefit plan funds, generally 10% of funds handled, minimum $1,000, maximum $500,000 ($1,000,000 if the plan holds employer securities).
Trap: A surety bond's premium is fully earned as a fee and is not a loss reserve; questions implying the surety "expects to pay claims like an insurer" are wrong. Conversely, fidelity bonds DO anticipate loss payment.
An employee benefit plan handles $4,000,000 in plan assets (no employer securities). Under ERISA's fidelity bonding rule, the required bond amount is: