13.7 Bonds

Bonds provide financial protection against certain types of loss but differ from insurance policies in their purpose, structure, and pricing. Bonds are generally divided into two main categories:

• Fidelity bonds protect employers against losses caused by employee theft or dishonesty. This protection is similar to the Employee Theft Insuring Agreement found in Commercial Crime policies.
• Surety bonds guarantee that a specific obligation to a third party will be fulfilled. The obligation may arise from a contract, court order, or law. Because they guarantee performance rather than protect property, surety bonds are more closely related to liability insurance than to property insurance.

Parties to a Bond

Unlike an insurance policy, which generally involves two parties, a bond involves three parties:

• Principal (Obligor) – The party that purchases the bond and is responsible for fulfilling the required obligation
• Obligee – The party that benefits from the bond and is protected if the principal fails to meet the obligation
• Surety (Guarantor) – The party that issues the bond and guarantees the principal's performance by paying covered damages if the principal fails to fulfill the obligation

Note

When comparing insurance policies and bonds, the insurer in an insurance contract is most similar to the surety in a bond, while the insured is most similar to the obligee, because both receive financial protection if a covered loss or default occurs.

With insurance, the risk of loss is transferred to the insurer. As a result, the insured is generally not required to repay the insurer for covered losses. With a bond, the risk remains with the principal, who is ultimately responsible for the obligation. If the surety pays a claim to the obligee, the principal is generally required to reimburse the surety.

If the principal defaults, the surety must either fulfill the principal's contractual obligation or compensate the obligee for the actual loss. Before issuing a bond, the surety evaluates the principal's ability to perform, financial strength, and performance history. Most surety bonds remain in effect for the duration of the underlying contract.

Example

If Good Construction purchases a Commercial General Liability policy, the risk of covered financial loss is transferred to the insurer. If a covered claim occurs, the insurer pays the loss, protecting Good Construction.

If Good Construction purchases a surety bond, the risk remains with Good Construction as the principal. If the company fails to fulfill its obligation to its client, the obligee, the surety will either fulfill the obligation or compensate the obligee for the loss. Good Construction must then reimburse the surety for any amounts paid on its behalf.

Fidelity Bonds (Honesty Bonds)

Fidelity bonds, sometimes called honesty bonds or dishonesty insurance, protect employers against direct losses caused by dishonest or fraudulent acts committed by employees, primarily employee theft. Although fidelity bonds function much like Crime insurance, they are limited to employee dishonesty and do not include the broader coverages available under a Commercial Crime policy. For example, an employee dishonesty bond protects the employer against employee theft losses, while a business services bond allows a business to reimburse customers for losses of money or property caused by employee theft.

Types of Fidelity Bonds

Several types of fidelity bonds are available to meet different employer needs:

• Individual bonds – Cover a single named employee.
• Name schedule bonds – Cover multiple named employees, each of whom may have a different scheduled bond amount.
• Position schedule bonds – Cover a specific job position, regardless of who occupies the position or how often the employee changes.
• Commercial blanket bonds – Cover all current and future employees under a single bond amount without naming individual employees.
• Blanket position bonds – Provide the same bond amount for each employee individually, offering a more efficient alternative to issuing multiple individual bonds with identical limits.

Surety Bonds (Performance Bonds)

Surety bonds guarantee that a specific obligation will be fulfilled. For example, a builder and a homeowner enter into a contract to construct a home. To ensure the builder completes the project according to the contract terms, the homeowner may require the builder to obtain a surety bond.

Contract Bonds

Contract bonds are a type of surety bond that guarantee a contractor will fulfill the terms of a construction contract. If the contractor fails to perform, the surety is responsible to the obligee for covered losses up to the bond limit, which is often equal to the contract value. Depending on the project, different types of contract bonds may be required.

Bid Bond

Before a construction project begins, the project owner may invite contractors to submit bids describing the work they will perform, the price they will charge, and the time required to complete the project. A bid bond guarantees that if the contractor's bid is accepted, the contractor will enter into the contract and provide the required performance bond. If the contractor refuses to proceed, the surety pays the project owner the difference between the contractor's bid and the next lowest acceptable bid, up to the bond limit.

Bid bonds may also be used by subcontractors when submitting bids to general contractors. The bond guarantees that if the subcontractor's bid is accepted, the subcontractor will enter into the contract and fulfill the required obligations.

Performance Bond

A performance bond guarantees that the contractor or subcontractor will complete the project according to the terms of the contract. If the principal fails to perform, the surety will either fulfill the contractual obligation or compensate the obligee for covered losses up to the bond amount, which is often equal to the contract value.

Labor and Materials Bond

A labor and materials bond guarantees that subcontractors, laborers, and suppliers will be paid for the labor and materials required under a construction contract. This bond may be issued separately or included as part of a performance bond.

Court Bonds

Court bonds are surety bonds required by a court to guarantee that a party will fulfill certain legal obligations or comply with court orders during legal proceedings.

Judicial Bond

Judicial bonds guarantee that a party involved in a legal proceeding will meet financial obligations associated with the case, such as court costs, damages, or judgments, if required.

Fiduciary Bonds

Fiduciary bonds, also called probate bonds, guarantee the honest and faithful performance of a person—such as an executor, trustee, administrator, or conservator—who has been appointed by a court to manage another person's affairs or assets.

License and Permit Bonds

License and permit bonds guarantee that the principal will comply with applicable laws and regulations. Government agencies and other public entities often require these bonds before issuing a license or permit to engage in certain activities. Common examples include:

• Contractor license bonds – Guarantee that a contractor complies with laws and regulations governing their trade.
• Tax bonds – Guarantee that a business complies with tax payment requirements.
• Broker bonds – Guarantee that insurance, mortgage, or title brokers operate in accordance with applicable laws.
• Motor vehicle dealer bonds – Guarantee that a motor vehicle dealer complies with applicable laws and regulations.

For license and permit bonds, the business or individual obtaining the license or permit is the principal, and the government agency issuing the license or permit is the obligee.

Example

A construction contractor obtains a contractor license bond before receiving a state license. The contractor is the principal (obligor) because they are responsible for complying with applicable laws and licensing requirements. The bonding company is the surety (guarantor). The state licensing agency is the obligee, because it is protected if the contractor fails to meet the legal requirements covered by the bond.

Public Official Bonds

Public official bonds guarantee that public officials—such as judges, notaries, and tax collectors—will faithfully perform their duties and handle public funds in accordance with the law. These bonds are often required before the official assumes office.