16.1 Surety and Fidelity Bonds

The Three-Party Structure

A surety bond is a written guarantee involving three parties, which separates it sharply from a two-party insurance contract. Memorize the roles, because every surety question turns on them.

• Principal - the party who must perform the obligation (e.g., a contractor).
• Obligee - the party protected by the bond, who receives payment if the principal fails (e.g., a project owner or government agency).
• Surety - the company guaranteeing the principal's performance.

Unlike insurance, where the insurer absorbs loss as a transferred risk, the surety expects zero losses. It treats the bond as an extension of credit. If the surety pays the obligee, it has a right of indemnity (and subrogation) against its own principal to recover every dollar paid plus costs.

Penal Sum

The penal sum is the maximum dollar amount the surety will pay under the bond. It is not a deductible-and-limit structure like a policy; it is a hard ceiling on the guarantee. A $500,000 performance bond obligates the surety up to $500,000 to complete or fund the defaulted work.

Contract (Construction) Surety

Contract bonds guarantee a construction contractor's obligations and come as a coordinated set:

Two less-common contract bonds also appear on exams. A supply bond guarantees a vendor will deliver materials per a purchase contract, and a maintenance bond guarantees the work will remain free of defects for a stated period (often one to two years) after completion.

Worked example. A contractor wins a $2,000,000 job and posts a performance bond at the full contract price. The contractor defaults at 60% complete. The surety can either finance the original contractor, tender a replacement, or pay the obligee. If completing the work costs the obligee $2,300,000, the surety pays up to the $2,000,000 penal sum, then pursues the contractor for indemnity.

Bid-bond example. A public agency requires a bid bond equal to 5% of each bid. On a $4,000,000 bid that is 5% x $4,000,000 = $200,000 of security. If the low bidder walks away and the agency must award to the next bidder at $4,250,000, the surety covers the $250,000 difference up to the $200,000 penal sum.

The Miller Act requires performance and payment bonds on federal construction contracts exceeding the statutory threshold (commonly tested at $100,000+ for performance; payment bonds apply above $35,000). State 'Little Miller Acts' impose parallel rules on public works.

Surety Underwriting - The 'Three C's'

Because surety is credit underwriting, sureties evaluate a principal on the Three C's: Capital (financial strength and net worth), Capacity (the technical ability and bonding capacity to perform), and Character (track record and integrity). A weak balance sheet or poor completion history can make a contractor unbondable, just as a bank denies a loan.

Miscellaneous Surety

• License and permit bonds - guarantee a licensee (contractor, auto dealer, mortgage broker) will comply with laws and regulations.
• Judicial bonds - guarantee performance in litigation (e.g., appeal bonds, attachment bonds).
• Fiduciary (court) bonds - guarantee faithful duty by executors, administrators, guardians, and trustees.
• Public official bonds - guarantee faithful performance by elected or appointed officials such as treasurers and notaries.

Fidelity Bonds - First-Party Crime

A fidelity bond is NOT a guarantee of a third party; it is first-party crime insurance that protects an employer against loss from employee dishonesty (theft, embezzlement, forgery). The insured and the protected party are the same: the employer. It is a two-party arrangement (insurer and insured), not the three-party surety relationship.

The ISO Commercial Crime program (forms such as CR 00 20 for the loss-sustained version and CR 00 21 for the discovery version) offers two coverage triggers:

• Loss Sustained Form - covers loss occurring during the policy period and discovered during the period or a short discovery window (often one year) after expiration.
• Discovery Form - covers loss discovered during the policy period regardless of when it occurred, subject to a retroactive date.

Employee dishonesty worked example. An employer carries an Employee Theft insuring agreement with a $100,000 limit per occurrence and a $5,000 deductible. A bookkeeper embezzles $72,000 over two years, discovered in the current period. On the discovery form the insurer pays $72,000 - $5,000 = $67,000, well within the limit.

Exam trap: Fidelity = first party (employer's own loss from its employees). Surety = third-party guarantee. Also, employee theft applies to employees - loss caused by independent third parties (robbery, burglary) is a different Commercial Crime insuring agreement, not the fidelity/employee-dishonesty grant.

Suretyship Is a Three-Party Relationship — Not Insurance

The defining exam point: a surety bond has three parties, while insurance has two.

Crucially, the surety expects no losses and prices the bond as a service fee, not a loss-funded premium. If the surety pays the obligee, it has a right of reimbursement (indemnity) against the principal — the principal ultimately bears the loss. This reimbursement right is what most sharply distinguishes a bond from insurance, where the insurer absorbs the loss.

Contract and Other Bond Types

Worked example: a contractor with a $2,000,000 performance bond abandons a job 60% complete; the obligee spends $900,000 to hire a replacement. The surety pays the obligee up to the bond penalty, then seeks reimbursement from the contractor (and its indemnitors) for that $900,000.

Exam trap — fidelity vs. surety: a fidelity bond is really first-party crime coverage protecting the employer against its own employees' theft (two-party in effect), whereas a surety bond guarantees a principal's performance to a third-party obligee. Federal contracts invoke the Miller Act, which requires performance and payment bonds on public construction over a threshold.