Your company has spent a considerable amount on fidelity bond premiums. Do you understand fully the kinds of losses covered by the bond, or when it is appropriate to provide notice of a loss to your company’s insurer? The ability to recognize the types of losses that give rise to a claim is vitally important, since fidelity bonds typically have fairly short and rigid deadlines for providing notice of a loss or submitting a proof of loss (often 60 days after the loss is first discovered).

Further complicating the picture, considerable investigation may be required to determine the amount, extent and cause of a loss. As a result, it may be necessary to provide notice of a loss before its magnitude or cause is fully known. This can pose difficulties for an insured organization unless the officers and employees likely to discover a potential loss, as well as those charged with reporting losses within the organization, are attuned to the circumstances under which a loss might be covered under a fidelity bond.

Fidelity bonds — and their close relatives, financial institutions bonds — have long been viewed as highly standardized form coverage that is relevant only in limited situations. But times have changed and coverage extensions that were not part of older policy forms may now be available. One effect of the recent economic downturn has been an increase in oversight; fraudulent conduct that in the past might not have been discovered may be uncovered today. In addition, troubled transactions with questionable documentation may now be subject to more strenuous reporting requirements, making the reporting of  potential claims more likely.

As a result of these and similar considerations, we have seen more claims involving fidelity bonds in the last two years than in the prior 10 years. Nonetheless, we also regularly see situations in which potential claims have been allowed to lapse because a policyholder was not aware that a loss may have been covered under a fidelity bond. Under what circumstances is a loss potentially covered by a fidelity bond?

Do You Know What Your Bond Covers?

The following discussion of potentially covered types of losses and related exclusions will help illustrate this point. (Note, however, that it should not be construed as exhaustive, insofar as policy forms and terminology may vary between different insurers.)

Employee theft or dishonesty. The prototypical fidelity bond coverage extension is intended to make the policyholder whole for losses caused by employee theft or dishonesty. The relevant act of theft or dishonesty may be committed by the employee either alone or in collusion with others. Under this coverage, the theft or dishonestly typically must be committed in order to obtain some improper financial gain (other than salary or bonuses) and with the intent to cause loss to the insured entity. This can lead to substantial hurdles in establishing that a loss is covered, since the identification of improper financial gain and intent to cause loss often requires significant investigation or cooperation from a former employee who may be facing criminal prosecution.

A fidelity bond will also contain a number of limitations or exclusions to coverage that are likely to be raised by an insurer. For example, one such exclusion pertains to losses arising from acts committed after the insured entity first becomes aware of any dishonesty on the part of the subject employee. This type of employee dishonesty coverage extension potentially applies to any loss arising out of the following types of conduct, for example:

• A cashier with his or her hand in the till
• A bookkeeper who issues fictitious expense checks to a front company
• An employee who is in collusion with a vendor to approve inflated invoices
• A loan officer who approves substandard loans in return for some payoff.

Whenever there is reason to believe that a loss or potential loss may have been the result of theft or dishonesty on the part of an employee, that loss should be reviewed more closely to assess whether it may be covered by a fidelity bond.

Good faith reliance on false documents. Fidelity bonds also typically cover losses resulting from giving value or extending credit in good faith reliance on certain categories of forged, counterfeit or fraudulently altered documents. Such documents may include certificated securities, deeds or mortgages on real property, certificates of title or other documents of title, evidences of debt, guarantees, security agreements, or written instructions. This “forgery” coverage extension potentially applies to a wide range of transactions in which money is paid or credit is extended in reliance on documents that evidence ownership, debt or other obligations, and that ultimately prove to have been forged or altered. The following are examples in which this coverage extension may apply:

• Losses resulting from a factoring relationship in which the receivables assigned in the transaction are fraudulently altered
• Losses from a loan extended to a developer in reliance on sales contracts that are forged
• Losses from a floor-plan lending arrangement in which the car dealer submits stolen or forged proofs of vehicle ownership

There are a number of limitations and exclusions applicable to this coverage extension. For example, loan interest typically is not treated as a covered loss and some policy forms contain what appear to be anachronistic “original” document conditions. But as an important first step for securing coverage, whenever a loss is discovered that appears to have been caused because of reliance on forged, stolen or fraudulently altered documents, that loss should be reviewed more closely in order to assess whether it may be covered by a fidelity bond.

Reliance on counterfeit or unauthorized instructions. Fidelity bonds also regularly provide coverage for losses resulting from reliance on counterfeit or unauthorized instructions. This unauthorized instruction category of coverage is not limited to losses incurred because of reliance on a counterfeit signature on a check or other instrument; it also may include fraudulent electronic instructions. For example, if a hacker uses stolen customer information to access the policyholder’s e-commerce site, or uses stolen customer passwords to access a policyholder’s online banking site and directs transfers of funds out of a customer’s account, the resulting losses may be covered.

There are a number of conditions placed on the unauthorized instructions coverage extensions. For example, for voice or electronic instructions, policyholders typically are required to utilize certain verification protocols as a condition for coverage. However, if it appears that a loss has arisen as a result of an unauthorized or fraudulent instruction, that loss should be reviewed more closely in order to assess whether it may be covered under a fidelity bond.

In some instances, fidelity bonds also may fill gaps left by other types of policies and provide coverage for some categories of “cyber-losses.” As mentioned above, fidelity bonds may provide coverage for losses resulting from unauthorized electronic instructions directing the transfer of money. In addition, fidelity bonds may provide coverage for losses due to damage or destruction to electronic data or media caused by a hacker or other third party, as well as for losses caused by the fraudulent modification of electronic data or media. Such coverage extensions should not be viewed as a complete replacement for other kinds of cyber-liability coverage that may be found in stand-alone cyber-policies or property policies. Nonetheless, in the event of the loss or destruction of electronic data or media, it is important to assess whether such loss may be covered under a fidelity bond.  

General theft or fraud. Fidelity bonds also provide coverage in a number of circumstances that generally involve losses caused by theft or fraud. Broadly, these extensions include coverage for the following losses, among others:

• Losses of property because of robbery or burglary
• Loss of a customer’s property because of a robbery while the customer is doing business on the policyholder’s property
• Loss of money, records, securities or negotiable instruments because of theft while being transported
• Losses due to burglary from cash machines or other automatic devices.

In addition, fidelity bonds may provide coverage for losses resulting from the good faith receipt of counterfeit money or certain types of instruments containing counterfeit signatures. For each of these general categories of coverage, there are a number of conditions limiting the circumstances under which a covered loss can occur. But as a general matter, for an employee or credit officer responsible for internal reporting, losses arising as a result of any of the general causes described above should be reviewed more closely to assess whether they may be covered by a fidelity bond.

With Coverage Come Limitations

Even though modern fidelity bonds provide coverage for a wide range of losses, they are not intended to provide blanket protection against moral hazards, the failure to follow internal procedures, or sloppy due diligence. Nor do fidelity bonds insure against adverse economic developments. In addition to some of the limits on coverage discussed above, there are a number of recurring issues that frequently are a point of contention with insurers during the process of adjusting a claim. As such, it is necessary to be prepared for a difficult claim adjustment process.

The following are examples of such recurring issues: 

Direct cause. Fidelity bonds typically provide that a loss be the “direct” result of a covered cause. Whether a loss was the direct result of a covered cause, or there was an independent or intervening cause, is a common point of disagreement between insurers and policyholders. This dispute regularly arises in connection with the employee dishonesty, unauthorized instruction and forgery coverage extensions. While common sense does not dictate that a direct cause of a loss be the exclusive cause of that loss, it often is necessary to confront this or similar positions. The construction of the direct-result condition varies from state to state and it is important that a claim for coverage be presented with this provision in mind. 

Compliance with internal policies and controls. With the exception of employee dishonesty coverage, fidelity bonds generally exclude coverage for losses caused by an employee. It is not unusual for insurers to construe this general principle to mean that any employee error or failure to follow proper procedures is a bar to coverage. Taken to its extreme, some employee action or inaction can almost always be found in the chain of causation for a loss. But an employee's failure to detect a fraud or to prevent a loss should not, in and of itself, operate as a bar to coverage. When presenting a claim, it often is necessary to closely parse the circumstances of a loss in order to address an overly broad application of this exclusionary provision.  
When determining whether to submit a claim for a loss that may be covered under a fidelity bond, it is important to keep in mind that the process of adjusting such a claim may be arduous. It is imperative to have full mastery of the facts surrounding a particular loss, as well as familiarity with the applicable policy terms and limitations, so that a claim can be characterized both accurately and consistently with the conditions for coverage. 

The Best Preparation is... Preparation

What is the lesson for insured companies and their management teams? Put simply, do not take fidelity bonds for granted in this era of new risks and economic uncertainty. Among other things, policyholders should:

• Be prepared to assess whether a loss may be covered under their fidelity coverage.
• Familiarize themselves with the terms and conditions of their fidelity coverage.
• Be prepared to dig into the sometimes difficult details necessary to establish a claim under a fidelity bond, and to address the possibility that there may be unique coordination issues implicated by fidelity bond claims.
• Pay attention to coverage extensions in today’s fidelity bonds that often go beyond traditional boundaries, and to terms in fidelity bonds that are a relic of outmoded business practices
• If these considerations are kept in mind, policyholders can utilize fidelity bonds as a valuable component of an effective strategy for responding to losses resulting from dishonesty, fraud and theft.

If these considerations are kept in mind, policyholders can utilize fidelity bonds as a valuable component of an effective strategy for responding to losses resulting from dishonesty, fraud and theft.