iAmid continued economic malaise, companies are paying more attention to what used to be among the most arcane and opaque standard insurance products: the fidelity bond and its close relative, the financial institutions bond. The old presumption was that this coverage applied to losses caused by employees who had their hands in the till. This limited coverage hardly merited management’s attention. To the extent that any insurance product got the attention of management or the board of a public company, it was likely to be directors and officers liability insurance because of its correlation with the so-called "big" claims. For businesses that advertise heavily or disseminate information, media and cyber-liability insurance policies might have also garnered some attention. Fidelity bonds, however, were too often treated as nothing more than standardized form coverage.
But times have changed. Management has been asking more questions, and we have seen more claims involving fidelity bonds in the last two years than in the prior 10 years combined. There are a number of reasons for this heightened focus.
Economic Factors
Perhaps as a result of the lingering economic downturn, losses have come to light that otherwise might not have been discovered or even occurred in the first place. For example, an employee who approved padded invoices from a supplier in return for a kickback might never have been discovered if the supplier did not subsequently experience financial difficulties and become unable to fill orders.
Likewise, in an optimistic market, it may have been easier to hide fraudulent transactions or loans. Under the pressures of a prolonged economic slump, however, such activity is more likely to lead to default, and the temptation to engage in dishonest or improper conduct may be greater. For example, a borrower may be tempted to use collateral that is already impaired or to misrepresent the ownership of such collateral. Or a relationship manager may be inclined to "help out" a borrower by manipulating payment records in the hope that these issues will eventually work themselves out. But frequently, such "loss chasing" only makes the situation worse and increases the magnitude of the eventual loss. It also raises potentially difficult coverage questions concerning the adequacy of internal policies and controls, as well as the timing of the discovery of the loss.
Although fidelity bonds are not meant to provide blanket protection against moral hazard or sloppy due diligence, the scope of the coverage provided is now typically broader than the classic employee theft/dishonesty coverage. Accordingly, if dishonest or improper conduct that resulted in a loss is discovered, it is prudent to assess promptly whether that loss may be covered under a fidelity bond.
Fidelity vs. Liability
There is an important difference in the nature of the protection provided by fidelity bonds and liability insurance policies. Fidelity coverage largely indemnifies the insured for its own losses resulting from a covered cause, while liability coverage applies to liabilities that an insured owes to third parties. The archetypal fidelity coverage extensions indemnify the policyholder for losses caused by employee theft/dishonesty and forgery. At its most straightforward, this coverage applies to the hypothetical bookkeeper who issues fictitious expense reimbursement checks to himself or herself. More complex are the situations involving an employee who is in collusion with a customer to approve substandard loans or with a vendor to approve inflated invoices. Typically, as a condition for coverage, the employee must have obtained some form of financial benefit as a result of the dishonest conduct, and the policyholder’s loss must be a "direct" result of that conduct. There is considerable variation across the states as to what constitutes a direct loss—ranging from the immediate cause to a proximate cause of the loss. Therefore, it is vitally important to have full mastery of the facts surrounding a particular loss, as well as familiarity with the applicable causation standard, so that a claim can be characterized both accurately and consistently with the conditions for coverage.
An important element of fidelity coverage is that such claims frequently concern circumstances implicating law enforcement. If an employee has committed theft or a borrower has submitted fraudulent documents to a lender, such conduct not only gives rise to a loss that may be covered under a fidelity bond but it also may be a crime. Even though a fidelity bond may require the insured to notify the authorities, policyholders are often hesitant to involve law enforcement in what may seem like an internal business matter. The authorities, however, may have their own concerns and priorities, which may not coincide with the policyholder’s desire to secure reimbursement from the insurer as quickly as possible. Although the best evidence of improper financial gain by an employee or fraud by a customer often comes out of a criminal prosecution, the pace of that process is rarely consistent with the deadlines for submitting a proof of loss to an insurer. As such, fidelity claims frequently require careful coordination between the terms and conditions of coverage and the prerogatives of law enforcement.
Filling the Gaps
In some instances, fidelity bonds may fill the gaps left by other types of policies and provide coverage for "new" risks such as "cyber-theft." A number of cyber-liability insurance forms provide coverage if a malware attack on the policyholder’s computer systems results in the disclosure of confidential customer information. The same forms, however, may not cover losses if hackers use information they have obtained from another source to access the policyholder’s e-commerce site and make unauthorized transactions. This type of cyber-theft does not involve a direct invasion of the policyholder’s computer systems by malware; rather, it involves the use of ill-gotten information to fraudulently sign in as an authorized user. Roughly speaking, this is the electronic version of cashing a check bearing a counterfeit signature. Thus it is imperative that, in the event of any electronic theft from customer accounts, policyholders consider fidelity bonds as an avenue for reimbursement. Of course, it is best to know in advance whether such a loss would be covered under the fidelity bond and, if it is not, to obtain such coverage either by endorsement to the existing fidelity bond or by purchase of a stand-alone cyber policy. In some cases, an endorsement (sometimes referred to as a “rider”) appears to cover cyber risks but, on closer examination, is burdened with conditions that are hard to find or comply with. It is, therefore, best to have an experienced lawyer or broker review these endorsements.
Increased Accountability
In the current environment, particularly at financial institutions, responsible managers are increasingly likely to seek fidelity bond recoveries for losses that might have once been written off to avoid internal controversy. If there is a loss, however, management has the responsibility—on behalf of the company and its shareholders—to determine the cause, to control and limit the loss, to prevent subsequent similar losses, and to attempt to make the company whole. Failure to meet these responsibilities may raise the ire of regulators or stakeholders. Of course, pursuing claims under a fidelity bond is not the complete answer, but it can be a key component of a comprehensive and prudent strategy for responding to losses.
When determining whether to submit a claim for a loss that may be covered under a fidelity bond, remember that these bonds typically have fairly short and rigid deadlines (such as within 60 days after discovery) for providing notice of a loss, as well as deadlines for submitting a proof of loss. The failure to provide timely notice too often results in a loss of coverage.
A Simple Lesson
The lesson for insured institutions and their management teams is simple: do not take fidelity bonds for granted in the context of a comprehensive risk management program.
- Be prepared to assess whether a loss may be covered under your fidelity coverage;
- Familiarize yourself with the terms and conditions of your fidelity coverage;
- Be prepared to dig into the difficult details necessary to establish a claim under a fidelity bond, as well as the possibility that fidelity claims may involve unique coordination issues; and
- Pay attention to coverage extensions in today’s fidelity bonds that often go beyond traditional boundaries.
Keeping these issues in mind, policyholders can utilize fidelity bonds as a valuable component of an effective strategy for responding to loss resulting from dishonesty, fraud and theft.
