Chapter 25 Exercises

Work these with the chapter's central reorientation in front of you: surety is credit, not insurance. Ask of every bond who guarantees whom, to whom, and who gets paid back if it goes wrong, and of every principal will they perform, and are they good for the money if they don't. Items marked with a dagger (†) have worked solutions in Appendix: Answers to Selected Exercises; the rest are for discussion or self-test. Section references like (§25.4) point you back to the relevant part of the chapter.

A. Recall and definitions

  1. † Define a surety bond in one sentence, and name the three parties it involves and what each one does. (§25.1)
  2. Name the three parties in a surety relationship. For each, state (a) what role it plays and (b) whether it is the party that pays the premium, the party that is protected, or the party whose performance is guaranteed. (§25.1)
  3. State, in one sentence each, what a bid bond, a performance bond, and a payment bond guarantee. (§25.2)
  4. † Distinguish contract surety from commercial surety, and give two examples of bonds in each family. (§25.2, §25.3)
  5. List the three C's of surety underwriting and say, in a phrase, what question each one answers. (§25.4)
  6. Define the penal sum of a bond and explain why a performance bond's penal sum is commonly set at 100% of the contract price. (§25.2)
  7. What is a General Indemnity Agreement (GIA), and why is it called the spine of the surety business? (§25.7)
  8. Explain what it means for a bond to be called, and name the four options a surety has when a performance bond is called. (§25.7)

B. The structure: surety vs. insurance

  1. † A colleague who underwrites property insurance says, "A bond is just insurance for the project owner against the contractor failing." Correct the statement precisely, using the idea of reimbursement and the three-party structure. (§25.1)
  2. Explain why, in surety, "the party who pays the premium is not the party who is protected." Why does this disorient an insurance professional crossing into surety? (§25.1)
  3. † A surety line and an auto-insurance line both wrote \$5 million of premium last year. The auto line ran a 62% loss ratio and made money; the surety line ran a 62% loss ratio. Explain why the same loss ratio is a healthy result for one and a catastrophe for the other. (§25.1)
  4. Explain the sentence "a surety underwrites toward zero expected loss." What about the line's structure makes near-zero loss the expectation rather than merely the hope? (§25.1, §25.4)
  5. Why does a project owner (or a state) often require a bond as much for prequalification as for protection? What is the social function of that gatekeeping? (§25.1)

C. The bond types

  1. † A contractor submits a bid on a public project and is the low bidder, then refuses to sign the contract because it realizes it bid \$400,000 too low. The owner awards to the next bidder at \$300,000 more than the original bid. Which bond responds, what does it pay, and up to what limit (if the bid bond was 10% of a \$5 million bid)? (§25.2)
  2. On a public project, the contractor collects progress payments from the owner but fails to pay its steel supplier \$200,000. Which bond protects the supplier, and why can't the supplier simply lien the public building instead? (§25.2)
  3. A contractor defaults on a half-finished \$8 million job. Explain the four options the surety must choose among, and give one circumstance in which each option would be the right choice. (§25.7)
  4. † Match each bond to its obligee: (a) a contractor's license bond; (b) an executor's fiduciary bond; (c) an appeal/supersedeas bond; (d) a performance bond on a city water project. Obligees to choose from: a probate court; a state licensing agency; a project owner (the city); an appellate court / the judgment creditor. (§25.2, §25.3)
  5. Explain the difference between a judicial court bond and a fiduciary court bond, with one example of each. (§25.3)

D. Underwrite this submission (the three C's and the credit decision)

  1. † Underwrite the program. A general contractor requests a \$4M single-job / \$10M aggregate bonding program. Its financials show \$1.2M adjusted working capital, \$2.8M net worth, an unused \$1.5M bank line, 18 years in business, a clean payment record, and a steady backlog around its historical \$16M annual volume. Its largest completed job to date is \$3.5M. Walk through the three C's, then state whether you would approve the program as requested, approve it with a modification, or decline — and defend your decision. (§25.4, §25.5, §25.6)
  2. Underwrite the contrast. A second contractor requests the same \$4M/\$10M program. It shows \$1.4M reported working capital (but \$0.7M is a receivable from another company the same owner controls), \$1.9M net worth, a fully-drawn \$1M bank line, 5 years in business, two supplier liens resolved late, and a backlog of \$13M after years around \$7M. Its largest completed job is \$2.0M. Underwrite it against the three C's and decide. How does this account differ from the one in Exercise 19, and which C is the binding constraint? (§25.4, §25.5, §25.6)
  3. † For the contractor in Exercise 20, a junior underwriter proposes to "approve the program but charge a much higher bond fee to cover the extra risk." Explain why this is the wrong tool, and what the right response is. (§25.4)
  4. A contractor of modest financials but a 25-year flawless track record and excellent references requests a program slightly above what its working capital would formulaically support. A contractor of strong financials but a thin, recent record and a history of late-paid subs requests the same program. Which is the better surety risk, and what does your answer reveal about the weighting of the three C's? (§25.4, §25.6)

E. Price / size this risk (the financial analysis)

  1. † A contractor reports current assets of \$4.0M and current liabilities of \$2.6M. Of the current assets, \$0.5M is a related-party receivable a surety would disallow and \$0.3M is receivables aged past 120 days that the surety discounts to zero. (a) What is the reported working capital? (b) What is the adjusted working capital after the surety's quality adjustments? (c) If this surety uses a rough aggregate ceiling of ten times adjusted working capital, what aggregate program does that imply — and why is that a starting point rather than the decision? (§25.5)
  2. A contractor's revenue and net profit have both grown every year, yet its surety is increasingly nervous. Its backlog has gone from roughly \$8M (its historical annual volume) to \$22M in eighteen months, and its working capital has barely moved. Explain, using backlog and working capital, why profitable growth can be a warning sign in surety, and what the surety should do. (§25.5, §25.6)
  3. † Explain what the bank line tells a surety that the financial statements alone cannot, and why a contractor that is fully drawn on its line and has no other liquidity is a worse risk than its balance sheet might suggest. (§25.5)
  4. Rank these three forms of contractor financial statement from least to most assurance, and state when a surety would require the highest level: reviewed, audited, compiled. Why does a surety prefer statements prepared on the percentage-of-completion method? (§25.5)

F. Find the red flag

  1. † A contractor's submission for a large new bonding program contains all of the following. Identify the three that should most worry a surety underwriter, and say why each is a red flag: (a) 20 years in business; (b) a requested single-job limit nearly triple its largest completed job; (c) a backlog roughly double its historical annual volume; (d) audited percentage-of-completion statements; (e) a bank line that is fully drawn with no unused capacity; (f) an unused bank line of \$2M; (g) a clean lien and judgment history. (§25.5, §25.6)
  2. A surety is reviewing a contractor it has bonded for years and notices, in the quarterly work-in-process schedule, that the estimated cost to complete on the contractor's two largest jobs keeps rising while the billings lag. What is this telling the surety, and why might it act before any bond is formally called? (§25.6, §25.7)
  3. A commercial-surety file crosses your desk: a \$25,000 fiduciary bond for the executor of an estate. The penal sum is small, so a colleague suggests issuing it on the credit score alone. What about the exposure (as opposed to the penal sum) should give you pause, and what would you check? (§25.3)

G. Memo and communication

  1. † Write the decline (memo form). You are declining the requested \$4M/\$10M program for the contractor in Exercise 20. Draft a short internal file memo (150–250 words) stating the decision, the three-C basis for it (cite the specific financial and track-record facts), what smaller program — if any — you would consider instead, and the indemnity you would require. Keep it defensible to your manager and the broker. (§25.4, §25.5, §25.6, §25.7)
  2. A long-standing contractor's owner is frustrated that you will not raise its aggregate program to let it chase a job 50% larger than anything it has built. Draft three or four sentences you would actually say to the contractor that hold the line on capacity discipline without damaging the relationship. (§25.6)

H. Ethics and judgment

  1. † A contractor you have bonded for a decade — strong character, loyal, fair to its subs — is in a genuine cash squeeze after one bad job and asks you to approve a bond it needs to keep working through the rough patch. The financials, read strictly, no longer support the program. Lay out the competing considerations (the relationship and the contractor's character versus the credit discipline and your own portfolio's tail risk) and explain how a disciplined surety underwriter might thread them — for instance, what conditions, collateral, or program reduction could let you help without abandoning the discipline. (§25.4, §25.6, §25.7)
  2. A broker pressures you to drop the requirement that the contractor's owner sign the General Indemnity Agreement personally, arguing the corporate indemnity should be enough and a competitor will waive it. Explain what you would be giving up, why it strikes at the core of the line, and how you would respond. (§25.7)

I. The Underwriting File

  1. † Extend the file. Harbor Steel is weighing a bid on a piece of public structural-steel work. List the three bonds it would likely be required to furnish and what each guarantees, then name the four pieces of information a surety would most want from Harbor Steel to underwrite it as a principal — and explain how each of those differs from what its property underwriter cared about. (The Underwriting File; §25.2, §25.4, §25.5)
  2. Explain, in three or four sentences, why the surety underwriting of Harbor Steel as a bond principal is "a different decision, by a different underwriter, on different evidence" from the property-casualty package being assembled in this part — and why adding a surety relationship would not change the account's insurance disposition. (The Underwriting File; §25.1)