Surety and Fidelity Bonds

A surety bond provides compensation for a party when a contract is not performed or the performance is unsatisfactory. A common example is when a building contractor agrees to construct a building, such as a school. Usually, the building contractor will buy the surety bond that will pay the school if the contractor fails to construct the school. The school can then use the money to pay another contractor to do the job. Meanwhile, the insurance company paying the money can sue the contractor for failing to construct the school.

There are always 3 parties to a surety bond: principal, obligee, and obligor. The principal is the party that promises to perform the work, or to fulfill certain obligations. In many cases, the principal also purchases the surety bond as a condition for getting the contract. The obligee is the other party to the contract, and is paying money for the principal to perform the work agreed to. If the principal fails to perform the work, then the surety (aka obligor), which is the party, usually an insurance company, that issued the bond pays the obligee if the principal fails to perform as required by the contract.

There are 2 important distinctions between surety bonds and most insurance contracts, and both are related to the fact that there are 3 parties with 3 different relationships to a surety bond instead of just 2. The 1st difference is that the surety's duty is to the obligee, not to the principal, even when the principal pays for the bond. Thus, even if the principal is dishonest and makes false statements on the insurance application, the insurance company is still obligated to the obligee, whereas, with most insurance contracts, material misrepresentations by the insured will generally relieve the insurance company from paying on a claim.

The 2nd important distinction is that if the principal fails to perform and the insurance company must pay the obligee the amount of the bond, then the insurance company has the right to sue the principal for the amount of the bond. This is because the surety is guaranteeing the performance of the contract, and is, therefore, guaranteeing the performance of the principal—something over which the principal has direct control. Therefore, the surety has no reason to expect losses, and has the right to recover from the principal if the principal fails to fulfill the contract satisfactorily. For this reason, a bonding company will not provide any more coverage than the value of the liquid assets owned by the principal. The surety's right to sue is subrogated for the obligee's right to sue for the nonperformance of the contract.

Surety Bond Underwriting

Because the surety is guaranteeing, to the obligee, the performance or the integrity of the principal, the surety carefully selects which principals it will insure. For all surety bonds, the surety will consider the integrity of the principal, including the principal's creditworthiness. Because the surety will sue the principal, if it is obligated to pay the obligee on the surety bond, a major consideration will be the financial assets, debts, and working capital of the principal.

When performance is guaranteed, the surety will consider the experience and success of the principal in doing similar projects.

Since many contracts require that the principal be bondable, particularly in the construction industry, the business success of the principal depends on their bondability, so most businesses that must be bonded to be awarded contracts work hard to maintain their bondable status.

Types of Surety Bonds

There are various types of surety bonds that have a sizable market and, therefore, have more specific names.

Contract bonds guarantee that the principal will perform everything that is required of a contract satisfactorily. Different types of contract bonds guarantee different phases of the contract.

License and permit bonds are required by businesses that need a license or a permit to work within a township or other political entity. The bonds guaranteed that the laws that the principal will comply with the law in their work. For instance, a license and permit bond can guarantee that a carpenter, plumber, or electrician has any required permits, and performs the work according to the local building code.

Some large businesses that are regulated by federal agencies may require a federal surety bond, which guarantees that the principal will comply with the agencies' rules and regulations, and pay required taxes.

A public official bond is usually required by state law for elected or appointed public officials who have access to public funds that guarantees that the public official will not embezzle the funds.

Judicial bonds are usually required by the court for litigants or people appointed to perform certain duties, and are of several types.

There are also other types of surety bonds, sometimes referred to as miscellaneous surety bonds, that constitute smaller markets. Most of these bonds insure either against loss or theft of money by the principal, such as an auctioneer's bond that guarantees receipts of an auction, or against legal liability by the action of an agent, such as an insurance agent bond that protects the insurer from liable acts of its agents.

Small Business Administration (SBA) Surety Bond Guarantee Program

To promote small business and to promote more competition, which generally leads to lower prices for the project owners, which, in many cases, will be federal, state, or municipal governments, or agencies thereof, the Small Business Administration (SBA) guarantees bid, performance, and payment bonds issued by preapproved surety companies for qualified small businesses through its Surety Bond Guarantee Program. The SBA guarantee is free for bid bonds, but the SBA charges the principal 0.729% of the contract price to guarantee payment or performance bonds, for contracts worth up to $6.5 million. For federal projects that require the SBA guarantee for small businesses, the contract price limit is $10 million. The SBA also charges the surety 26% of the fee charged to the principal by the surety.

Fidelity Bonds

A fidelity bond (a.k.a. employee dishonesty insurance) is a bond purchased by employers to protect them against the dishonesty, including theft, of their employees. Fidelity bonds are much like surety bonds, in that 3 parties are involved, except that the contractual obligations exist only between principal—the employer—and the insurance company, and the insurance company pays the employer for any loss caused by its covered employees. Banks and other financial institutions have a great need for fidelity bonds—often called financial institution bonds—because they typically require many employees to handle money and other valuable assets.

A blanket coverage fidelity bond covers any employee working for the employer, whereas a scheduled fidelity bond covers only specifically named people or positions in the company.