In the 1990s, Surety companies were making a lot of money thanksto a booming economy that kept contractors busy and solvent.Insurers flooded the Surety marketplace to take advantage, pricesdropped, and excess capacity built up. Predictably, when therecession of the early 2000s hit, contractor defaults led to recordSurety losses—with loss ratios climbing from 20 percent in 1998 to75 percent in 2004—and insurers exited the market indroves. 

The Surety market has since recovered, and theline has been a very profitable business for insurers over the lastseveral years. As a result, capacity is increasing in both Contractand Commercial Surety. 

“Carriers are looking at the Surety market as a line of businessthey can enter and make underwriting profits because of the lastseveral years of good returns on the line,” says Geoffrey Heekin,managing director of Aon Risk Solutions' Construction ServicesGroup.

Aspen U.S. Insurance, Philadelphia Insurance Cos., OneBeacon andMain Street America are among companies that have entered themarket or created new divisions in the past year. 

“There is significant capacity in the market right now,” saysSean McGroarty, national Surety leader in Willis' North AmericaConstruction Practice. “We are seeing some sureties aggressivelytarget large contractors with significant bonding needs in order towin new business.”

THE PRICING PICTURE

As more sureties compete for the same piece of the pie, pricingfavors the buyers of Contract Surety bonds. 

“Particularly for good contractors in the middle market, ratesare very competitive,” says Drew Brach, Marsh's U.S. Suretypractice leader. The exception is the “jumbo” accountsector—typically companies with more than $500 million inrevenue—that are seeing stable pricing. Pricing has also beenaggressive in the Commercial Surety marketplace.  

“The market is hyper-competitive,” Heekin says. “Pricing issoft—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 NAICdata. From the second quarter of 2011 to the second quarter of2012, 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 ofthe century, today's Surety market feels much different to thosewho earn a living providing commercial and contract bonds. “Becauseof the large losses seen in the 2001 to 2004 period, the industrybecame 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 offeringnon-traditional Surety products that gave financial guaranteesbeyond what the market had typically provided. “That generatedsignificant losses as companies defaulted,” McGroarty says. “Today,companies are sticking with their knitting. They are providing morecapacity, but it's to companies and contractors that have bettercredit ratings and stronger balance sheets.” 

CONSTRUCTION TRENDS

Part of the industry's premium decline is due to decreasedpricing, but part is also due to lower demand. Surety is a laggingindicator: Growth in Surety was sustained in the late 2000s even asthe Great Recession set in because construction projects werealready under way or approved in the private sector and because ofthe economic stimulus that funded projects in the publicsector. 

“Contractors had big backlogs,” says Richter. “Larger projectsstayed in the pipeline for a while because the design andpermitting was already in place—the momentum was there. When arecession occurs, there is a lag before defaultsoccur.” 

According to Census Bureau data, private-sector commercialconstruction peaked in January 2008 at $414 billion before plungingto $244 billion in 2011. As of July 2012, it stood at $294 billion.Public construction peaked in July 2009 at $323 billion and hassince decreased to about $270 billion. 

“We are seeing more contractors shut down and others not doingwell that are trying to reorganize, reduce their overhead and dealwith less cash flow,” says Brach. “However, we believethings have bottomed out, and we'll see slow recovery in theconstruction work available.”

Yet the construction industry is shaping up tolook different than before as the market recovers. “Total dollarsbeing 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 forthem,” observes Carl Dohn, president of the National Association ofSurety Bond Producers. 

PPPs LEAD TO NEW DEMANDS

There is also a growing trend in the use ofpublic-private partnerships (PPPs). “With public entities havingall kinds of financial difficulties, there are a lot of alternativeconstruction deliveries being explored,” says John Welch, presidentof CNA Surety.

The U.S. DOT encourages the consideration of PPPs, with statessuch as Texas, Virginia, Florida and Maryland leading the charge.“That will be a continued trend that will create some differentdynamics 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 toprovide bonds that are a little more liquid if they want to writebusiness,” Heekin observes. 

Indeed, sureties are watching for an increase in requests forliquidated damages in contracts. Traditionally, sureties wouldguarantee that contractors would complete the job and pay the billsand subcontractors. If a contractor failed, the guarantor wouldsatisfy outstanding liabilities and find another contractor tocomplete the job. With liquidated damages, owners require apercentage of the bond to be an “on-demand” payment whencontractors default. 

In a depressed construction environment, property owners anddevelopers have more power—and they are well aware of thatfact. 

“Owners are trying to shift more exposure and liability tocontractors, such as design responsibility; they're havingcontractors starting work with uncompleted design specs or puttingin onerous wording that could lead to quicker defaults,” Richterobserves. 

Gary Rispoli, Chubb's U.S. Surety field operations officer, sayshe is seeing an increase in contracts that include very broadindemnity 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 beyondthe original completion date,” he says. “Unfortunately, because thevolume of new construction projects is down, some contractors arewilling to accept those terms, greatly increasing the riskfactor.” 

“ZERO-SUM GAME”

Today, sureties and brokers are feeling thepricing pinch, although some are eking out growth. CNA saw nogrowth in 2011 but was up about 4 percent in 2012. Marsh hasachieved about a 10-percent revenue increase year-to-date, but Aonis seeing flat results. 

“It's a zero-sum game,' says Heekin. “We're handling moreclients, but because of the pricing dynamics we get paid less to dothe same amount of work. It's not a growing line of business forus.” 

Rispoli believes that the best long-term growth strategy is tobuild and capitalize on a consultative relationship. “This isdefinitely a market where sureties and brokers that have strongexpertise in business and can be an advisor to their customer canbe extremely valuable,” he says. “Opportunities will come as themarket evolves, and those sureties that committed to the line willbe positioned to capitalize.”

Unfortunately, that consultation may not ultimately lead togrowth in business. Dohn at the National Association of Surety BondProducers says that brokers need to reconcile themselves to thefact that, in a shaky recovery and changing marketplace, there maybe nothing they can do to help clients avoid theinevitable. 

“Sometimes as a producer you may be doing your client the bestservice by figuring out how to shut down their business,” he says.“You don't make money doing that, but you sure do sleep better atnight.”