Smooth sailing so far, but uncharted waters ahead
One could say that today’s surety business is like a ship slowly cruising after having passed through turbulent waters, but heading into new waters that may hold either promise or peril.
A little more than a decade ago, surety business was convulsed by huge loss ratios and massive consolidation. An industry accustomed to loss ratios at or below 25% saw the number climb to 70% in 2004. Of the top 15 surety writers in 1994, only five remained among the top 15 in 2007, while the share of overall surety premium written by the top 10 writers rose from 53% to 66% from 1997 to 2007.
In recent years, surety premium has remained well below its mid-2000s peak; a buyer’s market persists, thanks to an abundance of capital competing for construction business (the principal source of surety writings) that has just recently emerged following a severe recession.
Profitability in surety remains strong, or at least satisfactory, as loss ratios have come in at less than 20% in seven of the past 10 years. Virtually without exception, surety writers express determination to maintain underwriting discipline and avoid a repeat of the recent past.
“Profitability has been good for the overall surety industry for at least the past 10 years,” says Matt Sternat, vice president for insurance research at Conning, Inc., a firm specializing in research and asset management for insurers.
Looking ahead, Sternat says that “[contractor] default rates appear to be down, but contractor margins are getting tighter, which could lead to more losses.”
Nonetheless, he adds, the soft market continues to suppress pricing. “Even with some big losses, mainly from large international contractors, there doesn’t appear to be too much momentum to harden the market just yet.”
“The surety market in general remains very healthy and is returning adequate levels of capital,” says Robert Staples, senior vice president of the surety division for Allied World. “The more established sureties continue to remain true to their underwriting criteria.”
Staples adds that “there will not be a hardening of the market until such time as capacity is taken away, either through excessive losses or a consolidation of surety markets. Consolidation is a possibility for 2017, as growing market share organically continues to be difficult.”
“All sections of the market are very competitive,” observes Susan Sallada, owner of Universal Service Agency, Ft. Washington, Pennsylvania. “Rates remain soft and capacity is strong, and we are constantly reminding underwriters to maintain course and not lower their underwriting standards to chase business.”
“We have to be careful in this soft market,” says Scott Paice, vice president of surety for Sarasota, Florida-based FCCI. “We have tried to be flexible and creative while at the same time staying true to our core values and underwriting basics.
“Like many of our competitors,” he adds, “we have particularly tried to be more flexible in underwriting small contractor accounts. Most sureties now have ‘express’ programs primarily driven by credit worthiness and/or limited financial reporting and a simplified application process.”
Bracing for good times
By now, construction has almost completely recovered from the real estate crash of 2007. After falling from a peak of around $1.15 trillion of value put in place in 2006 to less than$800 billion in 2011, construction value put in place again exceeded$1 trillion in 2015.
This recovering market is poised for a surge in growth if federal and state governments follow through on much-discussed proposals for substantial infrastructure spending, a rare topic of general consensus among members of both major political parties.
“Agents can “(h)elp contractors and other surety principals be in a better position to qualify for and increase their surety credit.”
Universal Service Agency
In particular, President Trump has proposed a $1 trillion infrastructure improvement plan that has met with guarded approval, and some hesitation, from members of Congress across the partisan aisle.
“Recent political events have created some optimism for the future not seen for quite a while in the marketplace,” says Sallada. “Increased spending by federal and state governments would mean more jobs and, in turn, more bonds.”
“Infrastructure improvement is long overdue and would be a welcome boost to the construction market,” says Staples. “That said, the private construction market continues to grow, even without an infrastructure stimulus program. Infrastructure construction would be a welcome addition but should not be viewed as a panacea.”
Indeed, there are serious doubts whether the construction industry itself is prepared for a surge in demand, as contractors face a critical shortage of skilled labor and supervisory personnel. In all, there are an estimated 6.5 million construction workers in the United States today, down from around eight million in 2006, and many of those remaining are approaching retirement age.
According to a report from Aon Risk Solutions, the number of young people enrolling in construction trade apprenticeships fell to fewer than 300,000 between 2009 and 2011, less than half the number over a similar period four years earlier, while many skilled workers left construction altogether during the recession.
As a result, the report states, “the pipeline of new people has a hiring gap of roughly six to seven years and now, when talent is needed for staff growth, there is a formidable hole.”
As it is, boom times can be bad times for surety writers, as their clients are tempted to reach for more work than they can handle. “Contractors don’t starve to death; they die from gluttony,” says Hugh Rice, senior chairman of FMI Capital Advisors, in a recent report on the surety market done in conjunction with the Associated General Contractors of America (AGC). “They get too much work, too fast, with inadequate resources, and then they get into financial trouble and run out of cash.”
This recurrent problem can be all the more acute with a severe labor shortage. “The [construction] industry is struggling to attract younger workers into this difficult and cyclical business,” says Paice. “This just means that contract defaults will become more costly, as it will be more difficult to keep up with any increased workload.”
The surety industry faces some of the same human capacity issues as the construction industry. According to the Aon report, “The severe contraction of training programs and college campus recruiting in the recession years means that there are just fewer experts right now to manage complex [surety] placements and financial analysis.”
This skill shortfall comes at a time when sureties face substantially greater complexity in the line.
If there are significant public infrastructure initiatives, many of them will be as “public-private partnerships (P3s),” contracting arrangements where private companies undertake the construction, operation, and/or maintenance of infrastructure in exchange for service fees or proceeds from a designated revenue stream, such as tolls. Already widely used in other countries, the use of P3s is emerging in the United States.
“P3s tend to be used for large projects and generally add complexity to the process,” says Sternat. “They require different bond forms, more documentation, and more complicated requests for proposals.”
“Sureties who serve larger contractors can often extend more surety credit because a well-implemented SDI program can make a contractor a better business, and therefore a better surety risk.”
Chief Operating Officer
Long-term maintenance provisions in some P3s make it unattractive for sureties to guarantee performance. “There are not many sureties that could or would want to be on the hook for 7-10 years,” Sternat adds.
“P3s represent simply another source of work for contractors, much like any privately funded development project,” says Rick Ciullo, chief operating officer of Hartford Bond. “P3s are usually complex transactions, though, with contracts that pass risk to a number of parties, including the contractor. In some cases, the contractor chooses to invest in the project itself.
“These are significant risks that only a handful of contractors are strong enough and sophisticated enough to understand and manage,” Ciullo adds.
Knowledgeable, seasoned surety underwriters are needed to manage the risk of subcontractor default, cited as one of the top three construction performance risks in the AGC-FMI report.
In this regard, surety underwriters and producers have to understand and respond to the growth of alternatives to surety bonds, particularly subcontractor default insurance (SDI), which was introduced in the mid-1990s.
In contrast to performance and payment bonds traditionally sold by sureties to guarantee contracted work performance and supplier/laborer payment, SDI works more like other types of insurance, paying losses above a deductible to an insured general contractor for a performance or payment loss by a subcontractor enrolled in the SDI program.
Proponents of SDI say it generally costs less than surety bonding of subcontractors and lets the insured general contractor respond more quickly to losses, and thus meet project timelines. Critics say an SDI insured has to take on the administrative work of qualifying its enrolled subcontractors, and they often have to be “bondable” anyway.
“SDI has improved risk management for the many general contractors who use it,” says Ciullo. “In fact, sureties who serve larger contractors can often extend more surety credit because a well-implemented SDI program can make a contractor a better business, and therefore a better surety risk.
“SDI has also forced the surety industry to take a hard look at its claims-paying reputation and develop new processes and products to improve our usefulness to obligees,” he adds. “That said, none of these alternatives generally satisfy the high standards that surety bonds offer.”
Others agree that SDI does not offer the full level of protection traditionally provided through surety bonds. “We have been frustrated with bond requirements being waived as a result of increased use of SDI,” says Paice. “While SDI may be in the best interest of some large national construction firms, it does not offer the protection of performance and payment guarantees down to the subcontractor level, and it poses significant adverse selection issues for the surety industry.
“Without a surety involved,” he adds, “you lose an important intermediary that has proved to add value and expertise when confronted with a default.”
For agents and brokers
What are agents and brokers who sell surety bonds to make of a stable market with prospects for a growth surge that may also bring a surge in losses? “Agents and brokers can add value by enabling a relationship between the customer and its surety team,” says Ciullo. “Surety credit is extended only in part on the basis of financial statements.
“The bigger part of the equation is the contractor’s business plan, its organizational muscle and experience to execute that plan, and the commitment of leaders to work in the business every day and make course corrections as needed,” he adds.
“Help contractors and other surety principals be in a better position to qualify for and increase their surety credit,” Sallada advises. “Credit-based programs may be acceptable at the outset of a relationship, but most contractors grow and want to bid larger jobs. If the agent hasn’t prepared a contractor and its CPA for the required quality of the financial presentation, problems may arise with the working capital and stockholder equity requirements of a larger bonding program.”
Paice urges surety producers to go the extra mile and monitor jobs coming to bid, help their clients obtain that work, help them identify suppliers and subcontractors, and establish backup surety options for them. He says contractors, especially small ones, often need support in interpreting, managing, and—where possible—resisting onerous contract language that increasingly shifts risk from project owners to contractors and subcontractors.
“Small contractors are good at their respective trades,” he says, “but often over their heads when reading contract language written by teams of lawyers who have only their customers’ interests in mind.”
“Brokers should realize that the surety has the contractor’s long-term business interest in mind when tough decisions need to be made, no matter how unpopular those decisions,” says Staples. “This understanding is necessary to maintain strong underwriting results and provide maximum capacity to the most deserving contractors.”
For more information:
FMI Capital Advisors
Universal Service Agency
Joseph S. Harrington, CPCU, is an independent business writer specializing in property and casualty insurance coverages and operations. For 21 years, Joe was the communications director for the American Association of Insurance Services (AAIS), a P-C advisory organization. Prior to that, Joe worked in journalism and as a reporter and editor in financial services.