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What is Fidelity Bond for Investor Protection?

Fraud risk, presented by Ponzi schemes and other fraudulent activities at financial institutions including lenders and asset managers, is not new to investors. Yet the mechanism by which an investor can protect themselves from such fraud risk is still not fully understood even at the highest levels of the global investment community. So let us dive right into what we see as one of the highest priority solutions for investors to protect themselves against fraud risk factors.

What is Fidelity Bond?

Also known as crime insurance coverage or fidelity insurance bond or financial institution bond, a Fidelity Bond is a type of insurance that protects an entity from fraud risk including fraud committed by its own employees. For many companies including financial institutions, various regulators around the world require such commercial insurance to be purchased. However, what regulators as well as the buyers of this type of commercial insurance overlook most of the time is the fact that the Fidelity Bond can be reworded so that (a) clients, aside from the insured entity itself, are also protected; and (b) coverage responds to relevant loss scenarios specific to the buyer and resulting from fraud risk factors, as opposed to only the scenarios covered by the original wording of the Fidelity Bond.

What ends up happening traditionally is that when a company buys a Fidelity Bond through an insurance broker or company, they essentially buy a product of which wording has been drafted by the insurer for their own benefit and not the benefit of the buyer (you can read more about how commercial insurance is created and distributed). The product therefore effectively checks the box of management and regulators, but in reality includes coverage discrepancies that only come to fruition when a loss occurs and the Fidelity Bond fails to pay out. This gets sold by insurance brokers regardless of their level of awareness and sophistication simply due to their business model as distributors of insurer products.

Sample Fidelity Bond coverage
Sample financial institution bond coverage summary or declarations page showing the Fidelity coverage under insuring agreement (A) which provides coverage for employee fraud risk. Note that coverage summaries should not be relied on to form coverage decisions.

Example of a Loss that can be covered by a Fidelity Bond

A senior executive, called Fraudster, embezzles $5 million from their employer that is an asset manager managing money on behalf of investors (the senior executive also happens to be a shareholder of the firm). After several years, the asset manager’s auditor points to a discrepancy within the firm’s financial statements that cannot be traced and suspects it could be due to certain fraud risk factors. An investigation shows evidence that Fraudster had used company money to fund their own personal luxury purchases of real estate and fancy cars. But because Fraudster was also a member of the Audit Committee and with a strong influence over the CFO, they were able to hide trace of such money yet misrepresent to investors investment performance figures showing strong results, enough to avert any redemption calls by investors but also to get new investor money enabling their fraud to continue. Ultimately it was investor money that was embezzled.

The following are real life events in which investors could have used the Fidelity Bond for fast repayment from the insurer instead of going through the motions of launching lawsuits against the asset managers or financial institutions involved.

Bernie Madoff Ponzi Scheme – Year: 2008

Bernie Madoff’s Ponzi scheme is the largest in history and involved defrauding thousands of investors out of tens of billions of dollars over a period longer than 17 years. The scheme was discovered in 2008 when Bernie Madoff was no longer able to hide the fraud due to too many investor redemption requests in the wake of the global financial crisis back then, which prompted him to confess it all to his sons who then turned him in to authorities.

Investors should have scrutinized the Fidelity Bond or Financial Institution Bond carried by Bernard L. Madoff Investment Securities LLC.

Bridging Finance – Year: 2021

The Ontario Securities Commission (OSC) investigated executives and shareholders of one of Canada’s largest private lenders on allegations that investor funds were misappropriated. The firm had around CAD 2 Billion in Assets under Management specializing in lending to small-mid-sized businesses. An Ontario court placed the lender in receivership. 

Investors should have scrutinized the Financial Institution Bond carried by Bridging Finance Inc.

Can Investors be protected from Fraud Risk?

YES. There are several ways to provide protection to investors depending on their size, sophistication, and influence over the investee. For institutional investors, a comprehensive fraud risk management approach should be applied in which the process starts with a fraud risk assessment, which includes identifying and measuring fraud risk factors, followed by rewording or auditing the Fidelity Bond carried by the investee around the fraud risk factors that are of most concern in terms of frequency and severity.

For retail or smaller investors, it is very important for them to request an audit, or proof thereof, of the investee’s Fidelity Bond or Financial Institution Bond, as part of their risk due diligence process. This has to be done before signing an agreement to invest funds with any financial institution including asset managers. The audit must be performed independently of any insurance broker or company (check out our AI-based audit) and must match the insurance policy wording to the various relevant fraud risk scenarios. Any high priority wording amendments to the fidelity insurance bond carried by the financial institution must be implemented successfully with evidence thereof provided to investors.

Investors that have a controlling ownership stake in a business must apply this same process to the fidelity insurance bond carried by the business.

How much does a Fidelity Bond cost?

This all depends on the buyer’s profile as well as the amount of insurance limit required along with other insurance terms and conditions outlined within the Fidelity Bond contract wording. Regulatory driven Fidelity Bonds are typically inexpensive compared to other commercial insurance products when looking at the annual premium as a percentage of the insurance limit, which can be as low as 0.1% for a $1,000,000 aggregate limit. With that said, it is important for any buyer to ask themselves whether a cheap product would provide them with relevant risk management aside from checking the box with regulators. We encourage buyers to put themselves in the shoes of insurers and think about whether or not they would insure meaningful fraud risk of a counter-party for the premium that was quoted to them.

How to get a Fidelity Bond?

You can contact us if you are looking to buy a Fidelity Bond for your organization. If you already purchased a Fidelity Bond, you can have us audit it to ensure that it does what you intend it to do from an operational standpoint respecting fraud risk.

Getting a Fidelity Bond is an easy process yet important at the same time. Any commercial insurance broker can be approached for a quote whether it is through an online insurance broker platform or not. One can simply google ‘fidelity bond quote’ (or ‘fidelity bond canada’ if searching within Canada for example) and will be exposed to many different options. HOWEVER, is this the right way to get a Fidelity Bond?

The short answer is NO unless the buyer does not care at all about using the commercial insurance as a risk management tool to protect their own financials and clients. The reason for that is as mentioned above, which is the buyer must never rely on the Fidelity Bond wording that has been designed by an insurer and sold by a broker who is compensated by the insurer for such a sale. The fidelity insurance bond will simply not pay out the majority of times on large losses related to fraud risk, which would make paying the annual premium a complete waste.

In order to avoid the mistake that many buyers do, one must engage risk experts that are completely independent from any insurance broker or company when procuring the fidelity insurance bond. Independent risk experts can be licensed as operational risk consultants, independent insurance consultants, or other insurance and risk management consultants. The involvement of such risk experts should be done before any formal purchase is completed, however it can also be done after the purchase (ie. any time during the term of the fidelity insurance bond). Remember that there is no such thing as an independent insurance broker: many insurance brokers call themselves ‘consultants’ and ‘independent’ but that is a play on words that is technically incorrect since at the end of the day they are compensated directly or indirectly by an insurance company. Make sure the word ‘independent’ is used in a non-deceiving way! One way of finding out whether an insurance broker is truly independent is to ask them if they receive any direct or indirect compensation from the insurance company in the form of commission or a bonus on the portfolio of business they place with insurers (often called contingency commission).

When engaged, independent risk experts should review the different loss scenarios linked to your fraud risk factors and then reword the insurance contract wording to reflect such loss scenarios. They can directly negotiate with the insurance broker on your behalf or simply equip you with the analytics for your own negotiations with the broker. Some risk experts, such as our team, specialize in additional services such as triggering the insurance contract in the event of a loss.

The typical process of procuring a fidelity insurance bond, without the input of independent risk experts, entails the broker presenting a fidelity bond or crime insurance application for the buyer’s completion as well as asking them a few relatively straightforward questions about their business, following which a fidelity insurance bond quote is presented to the buyer that summarizes the premium, deductible levels, different coverage sections (known as insuring agreements), as well as any corresponding list of endorsements. The buyer would then send their binding instructions to the broker if they wish to purchase the fidelity insurance bond, following which an insurance binder and/or policy documents would be issued by the insurer and presented to the buyer by the insurance broker alongside the corresponding invoice for payment.

Is a Fidelity Bond the same as a Surety bond?

No, it is not. You can visit our products page for a summary and description of the various commercial insurance products available. Just always keep in mind that these products need to be reworded to fit your business risks!

Does a Fidelity Bond protect investors in a Crypto Exchange?

The short answer is NO unless the bond has been audited and reworded by risk experts independent of insurance brokers/companies. If the fidelity insurance bond is reworded correctly then it should protect investors against fraud risk related to a crypto exchange, there could also be some coverage for cyber risk loss scenarios depending on how the bond is worded. While many crypto exchanges buy insurance and use it in their marketing efforts to attract clients, investors should ask for a copy of a Certificate of Insurance Audit that shows them that the commercial insurance in force was audited and reviewed by independent risk experts. Since the insurance renews annually, the Certificate of Insurance Audit should be updated annually as well.

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