Surety Capacity Remains Ample and Inexpensive, Despite Construction Downturn

Fiscally fit bond principals with solid management plans—and without losses—are discovering sufficient and inexpensive capacity for surety insurance, say brokers and underwriters.

Despite the extended economic morass that has slowed or swallowed the construction projects of many a contractor in the past several years, the surety market has ample capital due to improved underwriting discipline—and is ready to deploy it judiciously.

THE RATING GAME

Bond principals generally will find sureties offering capacity at attractive rates—though market executives differ as to whether rates will be flat or falling.

Like last year, large construction contractors—those with $150 million or more of annual revenue—can expect flat rates, says Drew Brach, managing director and U.S. surety practice leader for Marsh Inc.

No more than 10 sureties will write bonds or agree to participate as co-sureties for huge contractors—so those underwriters are not under any pressure to cut rates, Brach adds.

However, Brian Carpenter, a senior vice president for Willis North America, sees “some downward pressure” on rates for huge contractors with strong balance sheets—due, in part, to new market entrants in the past 12 to 18 months.

Indeed, in the past 12 to 18 months a few of the largest contractors have negotiated 10 percent or greater rate cuts, says John Welch, president of CNA Surety, a unit of CNA Financial Corp.

Experts also have differing views regarding rates for midsize contractors, those generating $25 million to $150 million in revenue.

For example, Welch says there is some rate-cut pressure, though rates largely are flat. But Brach says that competition can drive down rates for this business class by 10 percent.

Rates for midsize accounts already are 10 to 30 percent lower than they are for jumbo contractors because dozens of sureties compete for this business, which poses a smaller loss-severity risk.

Small contractors can expect a 10 percent rate hike this year, after underwriters last year kept rates flat to 10 percent higher, Brach says.

Mike Bond, the head of surety operations for Zurich North America, says the surety market does “see losses” now among contractors with $50 million or less of revenue. Yet overall, he adds, there is no “significant movement in pricing.”

Huge contractors might have to find additional co-sureties to build ample capacity. Most midsize contractors, however, should not have trouble arranging a performance and payment bond with a single surety, sources say.

And even some troubled contractors can find surety capacity if they are “moving in the right direction,” are in a healthy business segment and “have a good story to tell,” says Bond.

STRONG PERFORMANCE DESPITE WEAK CONSTRUCTION MARKET

The surety market served as its own worst enemy from the late-1990s through the mid-2000s but has significantly tightened underwriting since then, market experts say.

In years past, “underwriters were making subjective decisions” on principals but now are relying on analytics, says Brach.

Indeed, the second half of the past decade was the surety market’s best five-year performance of the last half century.

According to the Surety & Fidelity Association of America, the surety market’s loss ratio from 2000 through 2004 exceeded 60 for three years, hitting a high of 82.5 in 2001. That drove its combined ratio above 100 for all five of those years and above 120 in three.

But the industry reversed that trend in 2005, and its loss ratio fell below 20 for the remainder of the decade—settling at 13.4 in 2010.

Those sharply reduced losses dropped the industry’s combined ratio below 100 in 2005 and below 70 in four of the following five years.

Thus, sureties’ financial wherewithal was “a lot stronger going into the recession” than at the outset of past economic downturns, says CNA’s Welch.

For the first three quarters of 2011, the loss ratio was 12 (it was 16.7 for the same period in 2010).

When the industry’s full-year 2011 figures are totaled, surety-market executives expect the loss ratio still will be less than 20. Zurich’s Bond expects that 2011’s losses will mirror 2010’s or “tick up a point or two.”

FACTORS IN SOLVENCY

That the surety business has continued to see strong results well beyond the onset of the recession isn’t a total surprise. Reversals in surety underwriters’ results typically have trailed economic downturns by 18 months to three years, as contractors work through their backlogs and public entities’ budgeting catches up with reduced tax revenues.

Construction, however, began declining five years ago. The estimated $807.1 billion of seasonally adjusted construction value in place in November 2011 represents a nearly 33 percent drop-off from the construction industry’s record $1.2 trillion total in 2006, according to U.S. Census Bureau figures.

This year looks better than 2011 for contractors—but only marginally, according to construction-management consultant FMI Corp., which forecasts a 6 percent gain in project value in place.

Given that the construction industry’s slide began five years ago, the surety industry traditionally would have segued already from booming to worsening results to the crisis portion of its cycle.

So why hasn’t it?

A few factors have underpinned the surety market’s enduring strong performance—and should continue supporting sustained solid results, says Zurich’s Bond.

Typically, Bond says, the market’s results are driven by the largest sureties, which have geographically diversified their business around the globe and are underwriting major contractors that are growing larger and stronger through acquisitions.

Sureties’ results also have benefitted from the fact that not all contractors nationwide were hurt equally as badly, says Sarah Finn, national surety senior vice president at IMA Inc. in Denver, Colo.

The construction downturn “is very regional,” says Finn, who notes that states such as North Dakota, South Dakota, Texas and Wyoming did not see a drop-off as dramatic as that encountered elsewhere.

TOO GOOD TO LAST?

Still, there are some indications of potentially growing losses. For example, subcontractors’ payment claims against general contractors and the latter group’s claims against project owners are “plentiful and abundant,” notes Willis’ Carpenter.

But will they turn into full-blown non-payment losses? Carpenter says they might reflect only some cash-flow difficulties that have caused payment delays, rather than flat-out defaults.

Subcontractors present the biggest bond-trigger risk, according to market executives. Many of them tend not to manage their overhead well as business is contracting, executives say.

Even so, about 80 percent have done a good job of maneuvering their way through the challenging economy of the past five years, says Marsh’s Brach. The other 20 percent, however, are “just hoping the construction industry is going to rebound, and they’ll get more work,” he adds.

Yet when taken together, all of these factors suggest the surety market might skirt the crisis segment of its traditional market cycle or mitigate it significantly, many brokers and underwriters say.

CNA’s Welch, however, is not as optimistic. “I don’t think we escaped damage,” he says.

There is no disagreement among brokers and executives, however, that market capacity is ample. “If anything, we’ve seen companies come in,” Zurich’s Bond observes.

 IMA’s Finn and Marsh’s Brach note, however, that underwriters are being cautious. For example, they will examine whether a project will provide positive cash flow to a contractor throughout the length of the contractor’s involvement, or whether the contractor will have to incur debt at some point.

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