16.1 Surety and Fidelity Bonds
Key Takeaways
- Surety bonds are three-party guarantees (Principal, Obligee, Surety) where the surety expects no loss and recovers any claim payment from the principal under a General Indemnity Agreement
- Contract bonds run bid - performance - payment - maintenance; the Miller Act requires performance and payment bonds on federal construction contracts above the $150,000 FAR threshold
- License/permit bonds guarantee statutory compliance; court bonds include appeal, attachment, and fiduciary bonds
- Fidelity coverage (ISO Commercial Crime Employee Theft agreement) reimburses an employer for losses from its own dishonest employees and is effectively two-party
- Blanket crime limits apply per occurrence regardless of the number of employees involved, while scheduled bonds apply a limit per named person
Surety Bonds: A Three-Party Guarantee, Not Insurance
A surety bond is a written guarantee, not a policy of indemnity. Insurance is a two-party contract where the insurer accepts a transferred risk and expects to pay losses. Suretyship is a three-party relationship in which the surety expects to pay nothing and treats every claim as an extension of credit it will recover.
- Principal - the party who must perform the underlying obligation (the contractor, the licensee).
- Obligee - the party protected by the bond and entitled to make a claim (the project owner, the state).
- Surety - the company that guarantees the principal's performance to the obligee.
The defining trap on the exam: when the surety pays a claim, it has a right of indemnity (reimbursement) against the principal. The principal signs a General Indemnity Agreement (GIA) pledging personal and corporate assets. This is why surety underwriting evaluates the three Cs - Character, Capacity, and Capital - the same way a lender evaluates a borrower.
Contract (Construction) Bonds and the Miller Act
Contract bonds guarantee performance of a construction or supply contract. Memorize the sequence:
| Bond | What it guarantees | Typical penal sum |
|---|---|---|
| Bid bond | Bidder will enter the contract and post final bonds if awarded | 5-20% of bid |
| Performance bond | Project will be completed per specifications | 100% of contract |
| Payment bond | Subcontractors and suppliers will be paid | 100% of contract |
| Maintenance bond | Workmanship for a stated period (often 1-2 yrs) | varies |
The Miller Act requires performance and payment bonds on most federal construction contracts exceeding $150,000 (the FAR threshold). State equivalents are called Little Miller Acts. The bond amount, called the penal sum, is the maximum the surety pays - it is NOT a deductible and does not reduce by claim payments the way an aggregate limit might.
License, Permit, and Court Bonds
- License/permit bonds are demanded by a government body before issuing a license; they guarantee the principal will obey the relevant statute or ordinance (e.g., a contractor or mortgage-broker bond).
- Court/judicial bonds include appeal bonds, attachment bonds, and fiduciary bonds (guaranteeing an executor, guardian, or administrator faithfully performs duties).
Worked example - penal sum recovery. A surety issues a $400,000 performance bond. The contractor defaults at 70% completion; the obligee hires a replacement who costs $120,000 above the remaining contract balance to finish. The surety pays the $120,000 (within the $400,000 penal sum), then pursues the principal under the GIA for the full $120,000. Net expected surety loss after recovery: ideally $0 - the model is reimbursement, not loss-sharing.
Surety vs. Fidelity vs. Insurance
A surety bond is a three-party guarantee: the principal (who must perform), the obligee (who is protected), and the surety (who guarantees the principal's performance). It is not insurance for the principal — if the surety pays the obligee, it seeks reimbursement from the principal. A fidelity bond, by contrast, protects an employer against loss from dishonest employees (theft, embezzlement) and functions more like first-party crime insurance.
| Bond | Parties | Loss Covered |
|---|---|---|
| Contract/performance | Principal, obligee, surety | Contractor fails to complete the job |
| License/permit | Licensee, government, surety | Violation of an ordinance/law |
| Fidelity | Employer (insured), insurer | Employee theft/dishonesty |
| Judicial/court | Litigant, court, surety | Failure to meet a court obligation |
The defining exam point: in surety, the surety has a right of recovery against the principal (no transfer of risk to the principal); in fidelity and ordinary insurance, the carrier absorbs the loss. The federal Miller Act requires performance and payment bonds on most federal construction contracts above a threshold.
A contractor defaults and its surety pays the project owner $90,000 under a performance bond. What is the surety's right against the contractor?
Under the Miller Act, federal construction contracts above the FAR threshold require which bonds?
Fidelity Bonds: Protecting Against Dishonest Employees
Fidelity bonds reimburse an employer for loss caused by the dishonest or fraudulent acts of its own employees - embezzlement, theft, forgery. Unlike surety bonds, fidelity coverage is effectively two-party (the bonded employer is the insured) and the carrier does not expect routine reimbursement, though it retains subrogation against the dishonest employee.
The modern ISO vehicle is the Commercial Crime Coverage Form, with the Employee Theft insuring agreement being the direct successor to old fidelity bonds. Key structural points the exam tests:
- Loss-sustained form vs. discovery form - a discovery form covers loss discovered during the policy period regardless of when it occurred; a loss-sustained form covers loss occurring during the policy period (with a limited discovery tail after cancellation).
- Blanket coverage applies a single limit to all employees; a schedule/name basis covers only listed individuals or positions.
- Coverage excludes loss the insured cannot prove except by inventory shortage computations alone - you need independent proof of an employee's dishonesty.
Numeric trap. A blanket Employee Theft limit of $250,000 per occurrence is per loss event, even if three employees colluded - it is not multiplied per employee. A scheduled bond, by contrast, applies its limit per named person, so collusion among three scheduled employees at $100,000 each could expose up to $300,000.
Three employees collude in a single embezzlement scheme. The employer holds a blanket Employee Theft coverage with a $250,000 per-occurrence limit. The proven loss is $400,000. How much does the form pay?