Chapter 25 Quiz: Surety Bonds

Twenty questions — fifteen multiple choice and five short answer — to check your grasp of the chapter's core: that surety is a three-party guarantee of performance, underwritten as credit toward a near-zero expected loss. Answers and brief explanations are in the collapsed key at the bottom; try the whole quiz before opening it.

Multiple choice

1. The single feature that most fundamentally distinguishes a surety bond from an insurance policy is that:

• A. surety bonds are sold only by specialized companies
• B. after a loss, the surety expects to be reimbursed by the principal, whereas an insurer absorbs the loss
• C. surety bonds always cost more than insurance policies
• D. surety bonds cover only construction risks

2. In a surety relationship, the obligee is:

• A. the party whose performance is guaranteed
• B. the party that guarantees performance
• C. the party that is protected by the bond and receives the obligation
• D. the broker who places the bond

3. In a surety relationship, the party that pays the premium is the:

• A. obligee
• B. principal
• C. surety
• D. reinsurer

4. A surety line that runs a 60% loss ratio in a normal year is best described as:

• A. healthy and profitable, like a property line at the same ratio
• B. a catastrophe, because surety is structured to run a loss ratio near zero
• C. exactly at break-even
• D. impossible to evaluate without the expense ratio

5. A bid bond guarantees that:

• A. the subcontractors will be paid
• B. the completed work will be free of defects for one year
• C. if awarded the contract, the contractor will enter into it at the bid price and furnish the required performance and payment bonds
• D. the contractor's license will remain valid

6. On a public construction project, a payment bond exists primarily because:

• A. the owner wants the work completed on time
• B. public property generally cannot be liened, so the payment bond is the subcontractors' main recourse if the contractor fails to pay them
• C. the law forbids performance bonds on public work
• D. it lowers the contractor's bond premium

7. A performance bond's penal sum is most commonly set at:

• A. 5% of the contract price
• B. 10% of the contract price
• C. 100% of the contract price
• D. an amount chosen freely by the contractor

8. Which of the following is a commercial surety bond rather than a contract surety bond?

• A. a performance bond on a highway project
• B. a payment bond on a school construction contract
• C. a motor-vehicle dealer license bond
• D. a bid bond on a water-treatment plant

9. The three C's of surety underwriting are:

• A. cash, collateral, and coverage
• B. character, capacity, and capital
• C. contract, claims, and credit
• D. construction, completion, and cost

10. Many experienced contract-surety underwriters weight the three C's, in order of decisiveness, as:

• A. capital first, then capacity, then character
• B. capacity first, then capital, then character
• C. character first, then capacity, then capital
• D. they are always weighted exactly equally

11. Working capital, the most-watched figure in contract surety, is defined as:

• A. total assets minus total liabilities
• B. current assets minus current liabilities
• C. annual revenue minus annual expenses
• D. the contractor's bank line plus its cash

12. When a surety reviews a contractor's balance sheet, a receivable from another company the same owner controls would typically be:

• A. counted at full value as a liquid current asset
• B. disallowed or heavily discounted when computing adjusted working capital
• C. treated as net worth rather than working capital
• D. added to the bank line

13. A contractor whose backlog has roughly doubled relative to its historical annual volume, while its working capital has barely changed, is showing the classic warning sign of:

• A. excellent financial management
• B. overreach — taking on more work than its capital and management can safely carry
• C. a strong bank relationship
• D. conservative bidding

14. The document under which a principal and its owners agree, typically personally, to reimburse the surety for any loss it incurs is the:

• A. performance bond
• B. statement of values
• C. General Indemnity Agreement (GIA)
• D. certificate of insurance

15. When a performance bond is called, the surety's options do not include:

• A. financing the original contractor to completion
• B. taking over and completing the work itself
• C. tendering a replacement contractor to the obligee
• D. cancelling the contractor's underlying property insurance

Short answer

16. In two or three sentences, explain why surety is properly described as credit rather than insurance. Use the words guarantee and reimbursement.

17. Explain why a surety cannot simply "price for the risk" of a marginal contractor by charging a higher bond fee, and state what the surety relies on instead to protect itself.

18. A contractor's reported working capital looks healthy, but the surety's adjusted working capital is far lower. Name two specific quality adjustments a surety might make, and explain why the gap between the two figures is itself a signal.

19. Walk through, at a high level, what happens to a surety's money when a contractor defaults on a half-finished bonded job: name the major components of the gross loss, what reduces it, and why the net loss typically dwarfs the bond fees ever collected. Use the term salvage.

20. Surety is described in the chapter as the line where "judgment is genuinely irreplaceable." Explain why analytics and models help less in surety than in auto or property insurance, and what the one decisive, unmodellable variable is.