Surety bond business weathers construction industry woes

Experts see opportunities for agents

By Dave Willis

To become more aware of some core issues facing the surety bond business, retail agents and brokers would do well to observe and understand what is happening in the construction business. These days, it takes very little effort to do this. Daily, it seems, newscasts share each little up and down—for the last few years, there have been more downs than ups—in the construction arena.

"As the economy went into recession in 2008, there was a lag before state and local governments started to experience reduced tax receipts, which led to increasing deficits," explains Roland Richter, vice president of marketing at Liberty Mutual Surety. "This ultimately resulted in governments slowing or cancelling a number of construction projects, particularly at the state and local level. At one point, government census data reflected a drop of some $50 billion in annual state and local construction spending."

Spending is off in the private sector, too, says David Byrne III, principal and president of Byrne Bonding & Insurance, a surety agency recently acquired by Starkweather & Shepley, a Rhode Island-based Assurex Global partner. Because fewer jobs are open for bid—public or private—many contractors have had to tighten profit margins just to get work in an increasingly crowded field of competitors.

"This profit squeeze leaves little room for construction error," Byrne notes, "which adds an extra risk factor to each project. In addition, lower profits mean that fewer funds are available for investment in new equipment and personnel. Overcoming these challenges is the primary focus for today's surety bond clients."

An exception to this slowdown exists, and that is in the large construction marketplace. Large construction projects are more complex and, because of the complexity and amount of financing involved, they often carry longer lead times.

"Because of the lead times, once these projects—for example, hospitals and universities and road projects—are put in motion, rarely are they stopped," Richter explains. This bodes well for the largest national and multinational contractors. They have work because they are among the few firms that can actually bid these big jobs.

Another factor benefits these larger contractors. "Federal and state governments have changed how they do road projects," Richter notes. "If they were rebuilding, say, a 25-mile stretch of interstate highway, they used to break it down into five-mile segments. At $10 million a mile, that would be $50 million for each project. But by making it one $250 million project, they have fewer bidders, but save money and make better use of staff because they only need one project manager, not five."

These factors generally lead to healthy profit margins among the larger construction firms. "As a result," Richter comments, "the jumbo contractors are doing rather well, and they have sizable backlogs, good profitability and flexibility in their work."

Surety business

Lack of construction work has started to have a modest effect on the surety arena. For instance, reduced margins have caused smaller contractors to struggle to cover their overhead. "The surety industry is starting to see more losses reported by smaller contractors," notes Richter. "This, in turn, suggests more surety defaults and claims on surety bonds, as contractors run out of money and can no longer finance existing projects." This is likely to lead to an increase in frequency in small contractor losses.

"The good news is that the surety bond business does not go up and down as frequently as the broader P&C industry—it may have one down year after a long run of profitable ones—and the surety capital base is sufficient to cover losses," he adds. "Where sureties usually run into trouble is when they have large severity losses."

Byrne concurs. "In general, the surety industry will have another profitable year in 2011, with only a slight profit fade from the previous year," he says. "Of increasing importance is the continuation of the economic recession. The slowdown in business has reduced the number of bonded construction projects. In addition, miscellaneous surety business, which comes from sources other than construction, is also experiencing a reduction in the number of bonds issued."

Surety companies are trying to balance these marketplace realities with underwriting discipline and the need to maintain premium levels to support their operations. "In addition," Byrne explains, "several sureties have just entered the surety bond business or are ramping up existing facilities to increase market penetration. As a result, we don't expect there to be any significant price increases or shifts in underwriting attitude."

Adds Richter, "As an industry, we have done a good job communicating with our customers and agents, and creating more transparency in the underwriting process. Our customers and agents understand where the business is going, where the underwriting process is going, and what the pricing rationale is."

Opportunity for agents

Retail agents and brokers would do well to consider how surety might fit into their overall portfolio of products. "Agents need to keep in mind that most surety provided is mandated by state and federal law," Byrne explains. In many instances, it is not a discretionary purchase.

"As concerns about the economy continue," he adds, "more owners are requiring bonds to mitigate their risk on everything from new building construction to the purchase of an expensive piece of machinery, and even insistence that a specific delivery schedule be met. This means there are more opportunities for agents and brokers to serve existing clients and prospect for new ones."

According to Richter, agents need to recognize the importance of transparency both ways—from the surety to the client, and then back again. "Agents and brokers can serve their clients well by helping ensure transparency among all parties," he says. "Communicating the underwriting posture of the surety helps clients to better plan and then adapt their operations and business model to help drive stable surety capacity."

By the same token, he notes, customers need to be open and candid with the surety about all of their issues. "If the surety is presented with a financial or operational surprise, that may cause it to rethink the surety capacity being offered to the customer," Richter says. "For example, if a contractor is having difficulty on a project—for instance, the owner is refusing to pay or there's some large dispute going on—the surety should know that."

Byrne offers similar counsel for agents and brokers based on his years of front-line experience in the market. "First, make sure client files are up to date with current financial information," he explains. "This allows for better communication and increased transparency.

"Second, make sure you understand all of the information provided," he says. "If there are any losses or problems revealed, be certain to get an explanation that you understand and can share with the appropriate surety.

"Finally," he says, "make sure that clients provide ample lead time for requests and avoid last-minute surprises. Bonding companies can certainly do a better job for your customer when they are given an appropriate time frame in which to work."