In the 1990s, Surety companies were making a lot of money thanks to a booming economy that kept contractors busy and solvent. Insurers flooded the Surety marketplace to take advantage, prices dropped, and excess capacity built up. Predictably, when the recession of the early 2000s hit, contractor defaults led to record Surety losses—with loss ratios climbing from 20 percent in 1998 to 75 percent in 2004—and insurers exited the market in droves.
The Surety market has since recovered, and the line has been a very profitable business for insurers over the last several years. As a result, capacity is increasing in both Contract and Commercial Surety.
“Carriers are looking at the Surety market as a line of business they can enter and make underwriting profits because of the last several years of good returns on the line,” says Geoffrey Heekin, managing director of Aon Risk Solutions’ Construction Services Group.
Aspen U.S. Insurance, Philadelphia Insurance Cos., OneBeacon and Main Street America are among companies that have entered the market or created new divisions in the past year.
“There is significant capacity in the market right now,” says Sean McGroarty, national Surety leader in Willis’ North America Construction Practice. “We are seeing some sureties aggressively target large contractors with significant bonding needs in order to win new business.”
THE PRICING PICTURE
As more sureties compete for the same piece of the pie, pricing favors the buyers of Contract Surety bonds.
“Particularly for good contractors in the middle market, rates are very competitive,” says Drew Brach, Marsh’s U.S. Surety practice leader. The exception is the “jumbo” account sector—typically companies with more than $500 million in revenue—that are seeing stable pricing. Pricing has also been aggressive in the Commercial Surety marketplace.
“The market is hyper-competitive,” Heekin says. “Pricing is soft—it could even be questioned if it’s sustainable.”
Surety premiums decreased from their all-time high of more than $5.5 billion in 2008 to $5.15 billion in 2011, according to NAIC data. From the second quarter of 2011 to the second quarter of 2012, the Top 10 Surety writers’ premium was down about 7 percent, according to the Surety and Fidelity Association of America (SFAA).
Yet despite apparent similarities with the market at the turn of the century, today’s Surety market feels much different to those who earn a living providing commercial and contract bonds. “Because of the large losses seen in the 2001 to 2004 period, the industry became more careful in its underwriting and sustained that [discipline] through the current downturn,” says Roland Richter, vice president of Surety marketing at Liberty Mutual Insurance.
Before the 2001-2004 crash, companies were offering non-traditional Surety products that gave financial guarantees beyond what the market had typically provided. “That generated significant losses as companies defaulted,” McGroarty says. “Today, companies are sticking with their knitting. They are providing more capacity, but it’s to companies and contractors that have better credit ratings and stronger balance sheets.”
Part of the industry’s premium decline is due to decreased pricing, but part is also due to lower demand. Surety is a lagging indicator: Growth in Surety was sustained in the late 2000s even as the Great Recession set in because construction projects were already under way or approved in the private sector and because of the economic stimulus that funded projects in the public sector.
“Contractors had big backlogs,” says Richter. “Larger projects stayed in the pipeline for a while because the design and permitting was already in place—the momentum was there. When a recession occurs, there is a lag before defaults occur.”
According to Census Bureau data, private-sector commercial construction peaked in January 2008 at $414 billion before plunging to $244 billion in 2011. As of July 2012, it stood at $294 billion. Public construction peaked in July 2009 at $323 billion and has since decreased to about $270 billion.
“We are seeing more contractors shut down and others not doing well that are trying to reorganize, reduce their overhead and deal with less cash flow,” says Brach. “However, we believe things have bottomed out, and we’ll see slow recovery in the construction work available.”
Yet the construction industry is shaping up to look different than before as the market recovers. “Total dollars being spent [on construction projects] isn’t the only measurement; it’s the way those dollars are spent. And on the municipal side, jobs are larger, so there are fewer contractors that can apply for them,” observes Carl Dohn, president of the National Association of Surety Bond Producers.
There is also a growing trend in the use of public-private partnerships (PPPs). “With public entities having all kinds of financial difficulties, there are a lot of alternative construction deliveries being explored,” says John Welch, president of CNA Surety.
The U.S. DOT encourages the consideration of PPPs, with states such as Texas, Virginia, Florida and Maryland leading the charge. “That will be a continued trend that will create some different dynamics in Surety. The type of bond and the wording will change, and these projects will be big jobs that need a larger Surety,” says Welch.
“As PPP partnerships increase, sureties will also be asked to provide bonds that are a little more liquid if they want to write business,” Heekin observes.
Indeed, sureties are watching for an increase in requests for liquidated damages in contracts. Traditionally, sureties would guarantee that contractors would complete the job and pay the bills and subcontractors. If a contractor failed, the guarantor would satisfy outstanding liabilities and find another contractor to complete the job. With liquidated damages, owners require a percentage of the bond to be an “on-demand” payment when contractors default.
In a depressed construction environment, property owners and developers have more power—and they are well aware of that fact.
“Owners are trying to shift more exposure and liability to contractors, such as design responsibility; they’re having contractors starting work with uncompleted design specs or putting in onerous wording that could lead to quicker defaults,” Richter observes.
Gary Rispoli, Chubb’s U.S. Surety field operations officer, says he is seeing an increase in contracts that include very broad indemnity terms and unreasonable damage provisions.
“We’ve seen municipalities asking for liquidated damages of $100,000 a day for every day the contract was uncompleted beyond the original completion date,” he says. “Unfortunately, because the volume of new construction projects is down, some contractors are willing to accept those terms, greatly increasing the risk factor.”
Today, sureties and brokers are feeling the pricing pinch, although some are eking out growth. CNA saw no growth in 2011 but was up about 4 percent in 2012. Marsh has achieved about a 10-percent revenue increase year-to-date, but Aon is seeing flat results.
“It’s a zero-sum game,’ says Heekin. “We’re handling more clients, but because of the pricing dynamics we get paid less to do the same amount of work. It’s not a growing line of business for us.”
Rispoli believes that the best long-term growth strategy is to build and capitalize on a consultative relationship. “This is definitely a market where sureties and brokers that have strong expertise in business and can be an advisor to their customer can be extremely valuable,” he says. “Opportunities will come as the market evolves, and those sureties that committed to the line will be positioned to capitalize.”
Unfortunately, that consultation may not ultimately lead to growth in business. Dohn at the National Association of Surety Bond Producers says that brokers need to reconcile themselves to the fact that, in a shaky recovery and changing marketplace, there may be nothing they can do to help clients avoid the inevitable.
“Sometimes as a producer you may be doing your client the best service by figuring out how to shut down their business,” he says. “You don’t make money doing that, but you sure do sleep better at night.”