This has been another tough year for the U.S. construction industry. Work availability is down and the housing market is sluggish. Consumer confidence is low, with the national unemployment rate exceeding 9 percent, a fluctuating stock market and a recently downgraded credit rating. Congress’ bickering over the budget deficit did not help. Reduced consumer and government spending further contribute to the economic decline.
During election years, the federal government usually increases its spending on public projects to boost the economy. That seemed highly unlikely with a congressional “super committee” assigned the task of recommending another $1.8 trillion in budget cuts.
In the construction industry, owners turned to the use of new project delivery methods, each of which comes with its own set of risks for the surety market to address.
“CM at-risk has been a very popular delivery method during the last few years. Owners like the ability to choose the contractor they feel is best qualified,” says John Rindt, president of the National Association of Surety Bond Producers (
NASBP) and executive vice president of
JDW Insurance. This method can be abused on both ends, Rindt warns. “Some public boards are not sophisticated enough to make the correct decision about which contractor is best qualified, and contractors use any and all means at their disposal to secure work.”
Regardless of the delivery method, Michael Bond, head of surety at
Zurich North America, says the most important way to ensure a successful project is to hire the right contractors. “Surety continues to be the best way to prequalify those contractors and guarantee performance,” Bond says.
Well-capitalized contractors with a proven record of successful projects will find significant bonding capacity in their respective market segments. Struggling contractors that are in debt and have a record of losses, however, will be afforded fewer opportunities. “Surety underwriters will disengage pretty quickly from an account when company losses or debt leverage become issues,” says Daniel Young, senior vice president and chief underwriting officer of
The Insco Dico Group.
To weather this economic downturn, contractors must reduce and manage overhead and budget expected revenues realistically. One of the most important things contractors can do is keep an open and honest line of communication with their sureties and bond producers so all parties can work together through any issues that arise.
Small Contractors
The economy hit this market segment hardest, which has led to an increase in defaults and losses. “As a small surety, underwriting has tightened up to ensure we are bonding qualified contractors,” says Jeff Booth, senior vice president and chief underwriting officer of Allstar Financial Group.
However, there is an abundance of surety capacity for financially sound small contractors that can find work. “More small contractors are gravitating to the specialty markets and putting up collateral for their surety credit,” Young says.
Furthermore, the
Small Business Administration’s Surety Bond Guarantee Program, which provides capacity for small contractors, is expanding. The
Bonding Education Program—a joint effort between the
U.S. Department of Transportation and the surety industry—educates small businesses about, and assists them in obtaining, surety bonds (see related
article).
“There is a substantial amount of capacity for contractors in this category with new surety companies entering the marketplace and providing additional capacity. Expansion of the SBA bond guarantee program has provided increased capacity for small contractors, and there are several markets supporting small contractors with collateral or ‘funds disbursement’ requirements in place,” says Larry Taylor, president of
Merchants Bonding Company.
Mid-Sized Contractors
“This market segment appears to be one of the most competitive,” says Michael Noe, executive vice president of construction services for
Travelers Bond & Financial Products. “As with the small market, terms are very competitive due to the pressure of reduced writings as a result of the economic downturn in construction and continued favorable financial performance of surety carriers.”
Larger contractors dropped into this market with the hope of maintaining their backlogs by taking on smaller projects. The good news is that “many smaller sureties are now trying to move up to service mid-market customers in addition to the traditional service from the large sureties,” Bond says. “The effect is that mid-market contractors now have access to a wider range of sureties and their capacity and services.”
Large Contractors
Many large contractors have begun to feel the effects of reduced backlogs and limited job opportunities. “Sureties were willing to step up to support the large contractors, as they are an efficient segment of the market. As backlogs have run off, the terms and conditions for maintaining the aggregate backlog have become more flexible,” says David Finkelstein, executive vice president of surety at
Arch Insurance Group.
As with the other market segments, contractors that are not financially sound will have difficulty obtaining bonds. Strong accounts with proven track records, however, will find the surety market is still highly competitive on terms.
Mega Contractors
“The mega end of the large segment has seen increased capacity due to new entrants in this segment of the surety market,” Noe says. Executives agree very large contractors and multinational construction companies endured the last few years most successfully.
“Owners continue to move forward with large-dollar projects that, due to size and complexity, attract only a handful of bidders. A select group of the largest contractors are maintaining significant backlogs and remain very profitable,” says Tim Mikolajewski, president of
Liberty Mutual Surety.
Many contractors in this segment have agreed to joint ventures to meet the needs of mega project owners, who expect high Standard & Poor ratings for a surety’s financial strength. “These projects require detailed analysis and risk assessment with regard to contract language, bond forms and other risk factors, such as public-private partnerships and gap financing,” Bond says. “Leading sureties have responded with strong levels of capacity at favorable terms and conditions.”
Surety Outlook
Overall, sureties avoided high levels of losses in 2011, and surety executives generally are optimistic about the future of the industry. However, certain segments of the industry fared worse than others this year. “We have seen an increase in frequency of loss in the small contractor segment of the industry, but it has had little impact on our overall profitability,” says Doug Hinkle, senior vice president and chief underwriting officer at
CNA Surety. “We are clearly seeing deterioration in operating results for many contractors, but particularly so in the sub trades and utility contractor segments.”
An increase in losses has been particularly noticeable in trades that require a lot of equipment to perform their jobs. “The equipment often is financed by debt or a high reliance on lines of credit. Fortunately, because the construction industry is so competitive, the sureties have been able to find replacement subcontracts with minimal financial loss,” says Patrick Pribyl, senior vice president and surety team leader at
Lockton.
“Reports point to a continued expectation of a depressed outlook for new work, which will present ongoing challenges for construction companies,” Noe adds. Looking ahead to 2012, surety executives anticipate an increase in loss activity but not on a catastrophic level because most contractors went into the recession with healthy backlogs to carry them through the last few years. That, along with government stimulus, responsible surety underwriting, and increased collaboration among contractors and their agents and underwriters, has staved off an industry “armageddon” (see related
article).
“During the last three years, the surety industry reported its lowest loss ratios in decades. While we are not seeing a meaningful increase in losses, it is likely losses will revert to the historical normal range given the poor construction market and contractors’ greatly reduced backlogs and margins,” Mikolajewski says.
Despite the expected increase in losses, there is still plenty of flexible bonding capacity for financially sound accounts. “If loss ratios remain reasonable, capacity should remain the same,” says David Hewett, executive vice president of
XL Insurance. “The wild card is if losses go higher than sureties anticipate.”
Most sureties remain disciplined in following the conservative underwriting standards implemented a number of years ago. “Sureties cannot protect their contractors from losses,” Booth says. “We can only adhere to our underwriting guidelines and terms and conditions to deliver acceptable underwriting results.”
Additionally, to protect themselves and their contractor partners, sureties pay considerably more attention to terms and conditions in contracts and bond forms.
“There is more of a risk in the current environment where owners have many firms anxious for work, allowing owners to believe they can place more risk on contractors. There needs to be a balanced set of risks and rewards between the owner and the contractor,” Bond says.
“We need to be especially vigilant on LEED projects,” Rindt says, as liquidated damages may be tied to the LEED certification (see related
article).
Executives agree it is important for contractors to walk away from work with onerous contract terms. “Big losses usually stem from bad documents, not bad work,” says Henry W. Nozko, Jr., president of
ACSTAR Insurance Company.
While managing the challenges of today’s market, contractors need to plan for the future. “A significant risk to contractors during the recovery is talent availability,” Mikolajewski says. “Having downsized their organizations, contractors may have fewer trusted project managers necessary to support a return to full backlogs.”
There also are financial concerns, such as constraints in cash flow and working capital. “When bottom lines are impacted negatively, balance sheets and liquidity positions can become strained. Without enough profitable work to go around, firms may have a difficult time repairing their financial positions to a sufficient level in time to take advantage of the turning market,” Noe says.
Some executives say contractors may be tempted to overextend already strained balance sheets to take on new work, but others are not as convinced. “With the severe pain most contractors have experienced to reduce overhead and survive this economy, we don’t believe we will see a rush to spend,” Taylor says.
Adds Rindt: “I do not foresee a scenario where the economy heats up and contractors, especially subcontractors, are not in a position to respond. I see a slow, methodical recovery that will never stretch the resources of our contractor clients.”
- A bond shows an owner the contractor is better qualified for the job than contractors that are not bonded because the firm has undergone a rigorous prequalification process.
- Owners can pay the contractor in accordance with the contract terms without concern because the work is being guaranteed.
- Bonding capacity can increase a contractor’s project opportunities.
- If problems arise on a project, the surety company may be able to offer the contractor financial, technical or managerial support.
- Bonded contractors are more likely to obtain loans from financial lending institutions.
- Subcontractors and suppliers are likely to offer better prices when they know they are protected by a payment bond, and therefore are guaranteed payment for their work.