There is a lot of confusion about financial institution bonds. The muddle becomes much clearer when you recognize that financial institution bonds come in various guises and are called by a dizzying array of names. The names, and the specifics of the coverage, vary based on what type of company is being protected.
Financial institution bonds designed to protect banks are generally referred to as ‘Bankers Blanket Bond’ insurance. The same general coverage for other types of financial institutions, such as ERISA fund managers is called a ‘Fidelity Bond’¹. Yet those same coverages, when protecting a non-financial institution, are called a ‘Commercial Crime Policy’.
What Risks Are Covered?
Whatever you call the coverage it typically protects against losses caused by:
- employee dishonesty
- forgery or alteration
- computer fraud
- funds transfer fraud
- kidnap, ransom, or extortion
- various money and securities fraud
Despite being called bonds, these instruments are really a form of insurance. Specifically, they protect against losses of money, securities or other tangible properties (as defined by the policies) incurred as a result of a dishonest act by an employee or other specified person.
These bonds protect the institution themselves, and not shareholders, making them a first-party coverage². (This also makes the coverage quite distinct from deposit insurance designed to protect the actual depositors.)
What Is The Purpose (Of The Insurance)?
This type of insurance protects a firm’s balance sheet against fraud. Any institution that is involved in the provision of financial services to third parties needs to consider some form of financial institution bond. This includes depository institutions, investment managers and investment funds.
One of the things that set financial institution bonds apart from other types of insurance coverage is that in many cases it a regulatory requirement.³ While fidelity bonds are generally a regulatory requirement for institutions such as banks, insurance companies, and stockbrokers – a prudent risk manager of any financial institution should seek this coverage regardless.
Protection Against Both Internal and External Hazards
The broad nature of the financial institution bond is intended to protect against distinct types of dishonest behavior and crime regardless of the origin of the malfeasance.
External hazard includes acts by the general public, such as robbery, burglary, and forgery. The FDIC sets clear rules for required vaults, safes, alarms and similar safeguards.⁴ Banks take additional steps to limit loss by keeping the amount of cash or negotiable securities held at any given facility to a minimum.
Yet despite the natural fear of bank robbers, it is the internal hazards which pose a far greater risk. Theft initiated by one’s own personnel invariably cost financial institutions more each year than any external cause. Banks protect themselves with effective controls and closely monitored systems. Despite these efforts institutions are generally required to maintain adequate insurance coverage to limit losses related to employee fraud and theft.
What Risks Are Not Covered?
Perhaps most critical is the fact that financial institution bonds are not to be confused with financial guarantees. Financial institution bonds do not supplant the basic role of the bank in extending credit and assuming the credit risk of the borrower. Making credit decisions is the business of the bank not the insurance company.
The courts are clear that a bankers blanket bond is not, and should never be confused with, “a form of credit insurance”.⁵
Another common misconception is that stolen information is covered – it is not. However, such coverage is available through network security policies.
Financial institution bonds market is an old market with established market participants and well-tested forms and policies.
The four key forms of financial institution bonds that are employed are:
- Form 14 is designed for stockbrokers, investment bankers, stock exchanges, securities firms and commodity brokers;
- Form 15 is designed for mortgage and finance companies and real estate investment trusts (REITs);
- Form 24 or the “Bankers Blanket Bond” is designed for commercial banks of all sizes, including trust companies, savings and loans, building and loan associations and domestic subsidiaries of foreign banks; and
- Form 25 is specifically for insurance and reinsurance companies.
While the forms are tailored to meet the needs of the various types of financial firms they all include basic elements and are structured in a similar fashion including the following critical clauses:
Clause (A) – Fidelity
The fidelity clause covers losses as a result of dishonest or fraudulent acts by officers and employees⁶. It excludes losses caused by a director, unless the director in question is also a salaried employee of the bank. “Dishonest or fraudulent acts” are defined as acts committed by such employee with
- the manifest intent to cause the insured loss, and
- obtain financial benefit for the employee or another party (other than salaries or other employee benefits).⁷
Clause (B) – On Premises
Loss of property is covered, if it is the result of
- robbery, burglary, misplacement, disappearance, or
- theft, common law or statutory larceny, committed by a person on the premises of the insured, while the property is located within the premises of the insured.
Clause (C) – In Transit
The in-transit clause expands the On Premises Clause coverage to include property that is in transit. The property must be in the custody of a person acting as an agent or messenger of the bank. In cases where an armored vehicle is not used, loss is generally limited to written or electronic records, certified securities, and negotiable instruments.
Clause (D) – Forgery or Alteration
The optional forgery or alteration clause provides for loss resulting from forgery or alteration of physical checks or other negotiable instruments. Electronic transmissions are not covered.
Clause (E) – Securities
The optional securities clause protects against losses resulting from false securities. Protected is a loss resulting from the insured having, in good faith, acquired, sold, delivered, extended credit or assumed liability, on the faith of any original security or agreement that proves invalid.
Clause (F) – Counterfeit Currency
The counterfeit currency clause covers losses resulting from the receipt, in good faith, of any counterfeit or altered money of any foreign country in which the insured maintains a branch office.
Deciding the necessary amount of financial institution bond coverage a financial institution requires can present a serious challenge. While calculating the amount of money and securities susceptible to burglary or robbery is a relatively straightforward task, trying to estimate how much an institution might lose as a result of employee dishonesty is much more difficult. There are simply no ready measures and basic benchmarking may not be appropriate
Potential losses from external hazards, property values and the level of exposure from daily operations are generally ascertainable. The various types and amounts of transactions routinely conducted should also be appraised and considered when determining appropriate levels of insurance coverage.
The analysis becomes more problematic when determining an adequate amount of fidelity insurance on the bank’s own personnel. There is no single element that will determine the scale of the risk of employee infidelity. Likewise, a third-party breach can also create losses of a larger scale and is more difficult to quantify and anticipate.
Factors to consider will include:
- the amount of cash and securities normally held by the bank
- delegation of authority to employees
- personnel turnover rates
- the number of employees and their experience level
- the extent of trust, information technology, or off-balance sheet activities
All of these factors may increase a firm’s exposure to employee crime and should be given consideration.
Financial institution bonds are generally bought at the holding company level, and it is important to evaluate whether the limits are sufficient for any risks of the subsidiaries. The subsidiaries are generally required to pay their fair share of the premium consistent with the fair market requirements of Section 23B of the Federal Reserve Act.
Claims Made Basis vs Loss Sustained Basis
It is common for insurance companies to write financial institution bonds on a “claims made” or “discovery” basis. Under these terms, the insurance company is liable up to the full amount of the policy for losses covered by the terms of the bond that are discovered while the bond is in force, regardless of the date on which the loss was actually sustained.
However, bonds may also be written on the more restrictive “loss sustained” basis. This means the insurer is liable only for losses sustained during the period the bond is in force. Insurers may insist on writing on a loss-sustained basis when
- a previous carrier has cancelled a firm’s policy or the bank has a bad loss record
- poor internal controls
- or questionable management.
Despite the confidential nature of regulatory exams, insurance carriers may request to see a financial institution’s report. The need to disclose this sensitive information is controversial and should be considered carefully before simply conceding to such a demand.
An institution generally only has 30 days from the date of discovery to report a financial institution bond-related loss to their carrier. Failure to report, for almost any reason, can jeopardize coverage for the loss.
Discovery of an employee’s fraudulent or dishonest behavior immediately terminates any further coverage of that employee under the bond. This means that institutions must act quickly in removing an employee once they have learned of possible fraud involving that individual.
Before reinstating an employee it is important to have a written consent from the insurer.
Notice of Pending Legal Action
Banks have 30 days to notify their insurers after receiving notice of pending legal action. Insurers then have the option of defending against the claim. Further, if the insurer decides not to defend the action, they will not be liable for attorney’s fees.
One important aspect of financial institution bonds is that applications are actually part of the bond. This means that any misrepresentations in the application may void the coverage and be grounds for recession of the bond.
Information Technology (IT) Coverage
Financial institution bonds have struggled to keep up with the rapid changes in the world of technology and electronic funds transfers. Coverage is naturally provided in the bond for bank employees.
Over the years the definition of “employee” has expanded. This definition now includes any natural person, partnership, or corporation authorized by the insured to perform services for the bank such as data processing or accounting.
As recent events have repeatedly taught, the ability for outside computer hackers to access an institution’s system significantly raises the potential for major losses. The important distinction is that while stolen funds are protected by financial institution bonds, the stolen data generally is not.
It is widely agreed that the current forms of financial institution bonds are long overdue for updating. To compensate for the current shortcomings in the forms, a number of riders are commonly added to expand the coverage under the existing policies.⁸ Understanding the available riders is critical to guaranteeing that one’s policy truly covers all of the risks that the insured seeks covered.
Here are a few of the more common riders:
Deductible and Self Insurance Riders
To reduce cost of the coverage financial institutions will use deductible or retention clauses to customize the amount of risk they are willing to self-insure. The deductible amount is directly related to the willingness and ability of the bank to absorb risks. A financial institution with few past claims may choose to lower its premium by accepting a higher deductible on its bond. The size of the deductible and accompanying savings is included as part of this rider.
Automated Teller Machine Riders
The basic version of most financial institution bonds were written well before ATMs were in common use. This rider covers loss involving automated devices used for disbursing money, accepting deposits, or cashing checks when such devices are not permanently staffed by an employee at one of the institution’s insured locations.
Kidnapping, Ransom and Extortion Rider
This rider covers losses arising from any form of extortion whereby the safety of a person or persons is, or is believed to be, imperiled.
Computer Systems Rider
Covers losses occurring when data is fraudulently entered or changed in an institution’s computer system and results in the transfer of money or other properties (as defined by the policy).
Excess Employee Fidelity Coverage
The purpose of this coverage is to extend the basic protection, particularly where larger volumes of assets are at risk. Usually written in increments of $1 million such excess policy only comes into play when the basic Financial Institution Bond policy is exceeded. Such coverage is really intended as protection against catastrophic losses.
Other Specialized Bank Insurance
There are a number of specific coverages that are available including, but not limited to:
Combination Safe Depository
Covers losses when the bank is obligated to pay for loss of property held in safe deposit boxes.
Registered Mail and Express Insurance
Insures property shipped by registered mail, registered air mail, express, and air express.
Valuable Papers and Destruction of Records Policy
Covers the cost of reproducing valuable records damaged or destroyed including the cost of any necessary research required to replace the information contained in the documents.
1 Fidelity Bonds may vary depending upon the type of financial institution and the regulatory requirements imposed on that type of institution. (Return.)
2 ‘First party coverage’ in insurance terms provides for losses sustained directly by the insured. A good example is a fire insurance policy. It is designed to provide coverage for fire loss to the insured’s own property. This contrasts with ‘third party coverage’ (also known as liability insurance). Third party coverages provide for losses sustained by other persons, not the insured, but for which the insured may be legally responsible. (Return.)
3 While a U.S. bank may offer alternate arrangements in lieu of the usual insurance bond, this virtually never happens. Section 18(e) of the Federal Deposit Insurance Act (FDI Act) provides that the FDIC may require such coverage, and if it is not obtained, the regulator may contract for such protection and add the cost to the bank’s deposit insurance assessment. (Return.)
4 Part 326 of the FDIC’s Rules and Regulations. (Return.)
5 Liberty Nat’l Bank v. Aetna & Casualty Co., 568 F. Supp 860, 866 (D.N.J. 1983) (Return.)
6 Case law suggests that this clause includes attorneys retained by the bank and even certain non-employees such as data processors. (Return.)
7 Coverage of losses resulting from loan activity is restricted. Loan losses are covered only in the case of collusion with another party to the transaction where the employee receives a financial benefit. (Return.)
8 As with all addendums to contracts, riders should be carefully reviewed to assess their impact on the overall agreement. (Return.)