The slumping U.S. economy was created, in large part, by an irrational and overheated credit market. The implications of the credit crisis are now becoming more evident in the surety industry, which is a central source of credit to the construction industry.
Concerned by the current heightened risk environment and exposure to increasing contractor failures, surety companies have not changed underwriting standards, but are more closely scrutinizing contractors to ensure they meet those standards. Underwriters are looking at whether contractors have depleted their cash reserves, rely heavily on the bank, have difficulty right-sizing their company in the down cycle, or are seeking bonding support for projects of greater size or scope than their normal business plan. This level of underwriting scrutiny will remain until the U.S. construction economy demonstrates signs of a real recovery.
The current trend of longer bid lists and declining margins is likely to continue throughout 2010. The efficient management of human resources remains critical to maximizing returns. Solid underwriting requirements will continue, and the most disciplined contractors ultimately will come through this economic cycle as stronger companies with fewer competitors.
Health of Surety Industry
While the surety industry likely will see an uptick in loss ratios in 2009, sureties are well-positioned to mitigate the losses.
In prior underwriting cycles, losses were magnified because the weakened economy was coupled with softer underwriting. Sureties softened their pricing and underwriting to enhance market share. Their books did not consist solely of contractors that were capable of withstanding the downturn.
In the current underwriting cycle, the surety industry has not seen a softening of underwriting. The magnitude of the losses in the early 2000s gave companies an underwriting mantra, and they stuck to the basics. Sureties have remained focused on retaining well-capitalized and well-managed contractors that can face current economic challenges. While losses are likely, they will not be as great due to disciplined underwriting.
Furthermore, the property and casualty insurance industry is well-positioned to withstand these losses. Mortgage-related investments have affected the financial standing of insurance companies, but indications show the property and casualty insurance industry remains well-capitalized to meet its obligations under policies and bonds.
Surety Capacity
Unlike banks, property and casualty insurers have proved financially sound, so sureties are more willing to provide capacity now than banks. Sureties are competing actively for business and generally have strong financials to back their capacity, which is sufficient to meet the needs of customers in all market segments.
Capacity also is adequate due to the reduction in the overall amount of construction being put in place at this time. Most contractors’ backlogs are substantially smaller than in previous years. They are unable to utilize their total surety capacity because sufficient work isn’t available.
On the other hand, sureties have raised the level of examination in terms of credit worthiness to extend this capacity. Today, sureties are looking “under the hood” for signs of weakening balance sheets caused by the negative effects of the recession. Sureties are responding to the changing composition of their clients’ balance sheets and adjusting program commitments as necessary.
Small: Under $10 million
This market has been hit by multiple factors, including fierce competition caused by an increased number of bidders on scarce new work, private sector contractors entering the public market, decreased profit margins, increased claims, growth in geographic territory due to a lack of local work, and bank scrutiny on lines of credit and construction loans.
Capacity in the small market is adequate, but requirements for entry remain high for small contractors seeking to obtain the support of a surety partner for projects exceeding a certain size. Smaller firms must demonstrate a certain level of experience and sophistication, and have access to capital to obtain surety support. Without reasonable levels of committed capital, contractors are unlikely to be extended surety credit based on projected earnings and prospective growth of the balance sheet.
The surety industry is committed to enhancing bonding access for small and emerging contractors. Access is less of a capacity issue than a qualification issue. For example, the public procurement work-force is stretched, and more jobs are being bundled together under much larger contracts. A single contract may be more efficient for the procurement workforce team to administer, but it is not realistic to expect a contractor whose largest project to date is $1 million to qualify to perform a $100 million contract. The surety industry also is seeing projects that are supposed to be small business set-asides carry price tags as large as $50 million to $100 million.
Occasionally, states propose legislation to waive bonds or increase bond thresholds as a way for small and emerging contractors to access jobs, but these practices may do more harm than good. One of the purposes of a surety bond is to protect the states’ and public’s interests by assuring a qualified contractor performs a project. This also ensures that subcontractors and workers get paid. Lack of a bond on a project hurts these subcontractors and workers—most often the small and emerging contractors legislators intend to help.
The industry is working with government procurement agencies, public works owners and legislators to find solutions to contract bundling, bond waivers and bond threshold issues. One way the surety industry is making a difference is through implementation of programs to provide small and emerging contractors with education, mentors and technical assistance to address the qualification issue.
Middle: $10 million–$100 million
Even with the consolidation of carriers that occurred during the past several years, capacity still is sufficient in the middle market. Carriers are employing greater scrutiny in evaluating these contractors in line with their underwriting requirements, but will expand both single and aggregate programs for what they perceive to be valued accounts.
Some surety executives set the mid-market range at $50 million to $150 million. The capital structures, reinsurance arrangements and net retention strategies of many underwriting companies support business plans that focus on developing relationships with construction firms with sales in this range.
Middle market contractors may see some underwriting flexibility from surety companies on issues such as surety rates, geography, capital thresholds and personal guarantees.
Also noteworthy in this market is that some surety carriers that historically have stayed below the $10 million level appear to be increasing limits in order to participate in this market. Carriers may re-evaluate losing accounts to another underwriter simply because those clients have outgrown internal limits set on capacity.
Large: $100 million–$250 million
Although surety competition has increased, the large market has many of the same characteristics as the middle market except at the high end.
Consolidation continues to affect the large construction market, as a recent merger left the surety industry with only a handful of participants. Underwriting continues to be disciplined, and more pressure has been placed on contractors in this market to show how they mitigate risk with their subcontractors.
Financial institutions also have had an effect on credit availability in this market segment. Contractors’ profit margins continue to decrease. Because of a lack of work in this area, some large contractors are increasing their territory in search of smaller projects.
Mega: More than $250 million
Prior to the recent economic change in the construction market, mega-contractors experienced a strong track record of earnings, growing balance sheets and expanding backlogs. The stronger balance sheets and healthier backlogs will help drive mega-firms through the down cycle and enable these companies to maintain staff and be properly positioned for the recovery. In this market, all contractors are experiencing difficulty securing new work, but the declining backlogs have not yet affected the balance sheets of the nation’s largest construction companies.
Five major surety companies appear to be the only consistent players in the mega-construction market. Competition does exist, however, as these sureties look to retain their existing customers and attract new customers.
At this size, risk is as much a factor as available surety capacity. Currently, $750 million appears to be the largest single project that one surety is willing to bond. However, most sureties in this category do not exceed the $500 million level. Sureties will look for co-surety arrangements on these mega projects exceeding $500 million to spread their risk and support the bond needs of mega-contractors.
Subcontractor Bonding
The current economic climate has affected the amount of work available, increased price volatility of labor and materials, stretched contractors’ cash positions, changed their balance sheets and reduced their ability to turn a profit. Surety executives expect the subcontractor market to be hit hardest by the economic downturn. Defaults already are evident in the subcontractor community, creating significant challenges for general contractors and construction managers.
A healthy subcontracting community is a prerequisite to a healthy general contracting community. Now more than ever, a solid approach to risk management is necessary. There is no substitute for having an independent, financially sound surety company to research and prequalify subcontractors. They know their clients and can determine the health of other projects and previous work far better than a contractor.
Subcontractor performance and payment bonds ensure a surety has prequalified a subcontractor for a particular scope of work and size of project. The surety’s guarantee of performance and payment ensures the job will be completed in accordance with all contractual terms and conditions and that all legitimate covered sub-subcontractors, vendors and material suppliers will be paid for work performed or material provided.
General contractors place their own working capital and net worth at risk on every job, and subcontractor default is a risk that must be managed. Surety bonds provide the single best method for most general contractors to protect their balance sheets. They are an inexpensive method of risk transfer that all general contractors and construction managers should consider on all major subcontractor work packages.
Surety Outlook
How the surety industry performs in the coming months largely will depend on how the construction industry performs. In turn, how the construction industry performs will depend on the recovery of the U.S. economy—and that is difficult to predict.
A number of factors and considerations, such as the federal stimulus package, may help advance some public works projects and other large jobs that are on the drawing board, as well as improve the conditions of state treasuries, available financing and private owner demand for buildings, plants and equipment. All are experiencing an instability that hasn’t been seen in decades.
Cycles dictate that there will be recovery, but because of the lag time that preceded the downturn in the construction industry, it could take some time to restore demand. The recovery will require an upturn in consumer confidence and a more stable, predictable credit market.
Surety executives are beginning to see signs of stability in the economic outlook, but the longer range durability of these conditions remains uncertain. Most surety executives expect limited growth in the U.S. economy through the first half of 2010. The housing market will be a leading indicator as to when the economy will recover, and some predict that is still at least a year away.
The impact of the slowing economy and credit crisis will lead to an increase in contractor defaults in the second half of 2009. Contractor failures are expected to accelerate in 2010 due to declining backlogs, increased competition for fewer new projects, more onerous contracts, compressed margins and higher overhead expenses as a percentage of sales.
Some surety executives say improvement in construction may not be evident until the second half of 2010. Others say that because commercial construction tends to lag behind residential construction by about 18 months, things may not pick up until mid-2011. Others say it could be well into 2011 before the turnaround in construction becomes apparent, noting the private commercial market may not have bottomed out yet.
Despite the current recession and crises in the mortgage and credit industries, the surety industry has proved financially sound and stands ready to support qualified contractors and help them meet the challenges of tomorrow.
| Company | Direct Premium Written (Millions $) |
| Travelers Bond | $991.6 |
| Liberty Mutual Insurance Group | $832.8 |
| Zurich Insurance Group | $482.3 |
| CNA Insurance Group | $434.3 |
| Chubb & Son Inc. | $297.3 |
| Hartford Fire & Casualty Group | $210.6 |
| HCC Surety Group | $148.8 |
| International Fidelity Insurance Co. | $118.8 |
| ACE Ltd. Group | $109.1 |
| Arch Capital Group | $105.9 |
* Includes contract and commercial surety.
Source: The Surety & Fidelity Association of America, "Top 100 Writers of Surety Bonds--Unlimited States & Territories & Canada," 2008 (Preliminary). Additional information and reports are available for purchase at www.surety.org.