The fortunes of the surety sector are, naturally, directlylinked to those of the construction industry.

After reaching a high mark of more than $5.5 billion in premiumin 2008, that number decreased as the recession took hold and tookconstruction activity down with it. Then, surety premiums reboundedas the economy improved and construction activity increased, and in2015, finally surpassed the $5.5 billion mark again.

Yet one doesn't have to examine statistics to know that theconstruction market has rebounded.

“One way I measure what's going on in the construction industryis how many tower cranes I can count on my drive to work everyday,” says Susan Hecker, director of national contract surety andarea executive vice president at Arthur J. Gallagher & Co. “Over the past few yearsin the San Francisco area, it has gone from a handful to more than50.”

More bonds are being issued on private projects as well, whichis good news for sureties. There has been a trend of lendinginstitutions requiring bonds in more instances to finance projectson the private sector, notes Bill Minderjahn, vice president ofsurety for RT Specialty LLC.

Public project spending has not quite seen the same level ofrecovery: Peaking in July 2009 at $323 billion, public constructionin July 2016 was $278 billion. “The drop in spending reflects thelack of funds that state and local governments have,” says DavidHewett, U.S. contract surety leader at Marsh.“However, the demand for projects is there, and governments arefinding creative ways to meet infrastructure needs.”

One way is through public-private partnerships, or P3s.

“We're seeing more interest in P3 projects than ever before,which is driving discussion on the surety side about how to be mostrelevant in the space by offering bonds that are more liquid,” saysPatrick Pribyl, senior vice president and surety team leader atLockton Cos.

Shortage in skilled workers

However, strong growth in construction can be a mixed blessing.On one hand, the construction rebound has driven bonding demand.However, there is growing concern over the availability of skilledworkers.

Maintaining a qualified workforce is one of the top concerns forconstruction company executives, says Jack Gibson, president andCEO of the International Risk Management Institute, which hostedits Construction Risk Conference in Orlando,Florida, early in November.

“We're seeing more and more baby boomers retiring,” he says, “alot of institutional knowledge leaving at the trade level andsupervisor level. You have to fill that void.”

“The unemployment rate for construction nationally is the lowestit has been in 10 years, which is positive, but it has constrainedavailable labor,” says Ed Titus, senior vice president of suretyfor Philadelphia InsuranceCos. “We see the Texas, California and Florida constructionmarkets struggling with not having enough of an available trained,skilled workforce for contractors to start bidding on newprojects,”

With the labor shortage, sureties are watching a rise in claims.“Without enough workers, it's hard to finish on time, and thattriggers damages,” says Larry Taylor, chairman of the board andpresident of MerchantsBonding Co.

“The flow of money from owners down to the sub-trades is alsoslower than it has been,” he adds. “If the owner pays the general[contractor] slowly, and the general pays the subcontractor slowly,and the sub pays suppliers slowly, that can trigger a claim becauseour bonds guarantee that labor and material providers arepaid.”

Energy sector

Another area of potential concern for sureties is the energysector. Law firm Haynes andBoone, which tracks bankruptcy filings, reports that more than100 North American oil and gas producers have declared bankruptcysince the start of 2015, with 58 filing as of September 2016 andmore expected this year. “We don't anticipate there being manyfull-bond penalty losses, but I know that sureties have takenreserves toward losses in the energy sector,” Pribyl says. “Thebonds tied to that space, such as well plugging bonds andreclamation bonds, are becoming a bit harder to place, althoughthere hasn't yet been real hardening.”

“You have to remember that the biggest surety loss ever wasEnron,” adds Hecker. “When you see so many energy companies filefor bankruptcy, it's a concern because a lot of bonds are writtenin that sector. The coal sector is really concerning.”

Related: Construction contract bonds: 5 things you need tounderstand

Downward pricing has kept growth in the surety sectormodest, but capacity remains plentiful. (Photo:Shutterstock)

Appetite for business

The surety market's current strength is perhaps best illustratedby what happened when XL Catlin left the primary market in March2016, taking more than $1 billion in capacity with it.

“It had no impact,” says Hewett. “It would take the exit of twoor three mid-size carriers to have an impact.”

Several sureties have entered the market over the last fewyears, including both new capital and property and casualtycarriers looking to expand their revenue by writing an additionalline of business. “We have heard from many different insurancecompanies that are not in the market of their desire to get in,particularly in the middle-market sector,” Hewett adds.

Existing sureties have been working to increase their businessas well. “Surety underwriters are under pressure to grow,” saysTaylor. “Most sureties are public-stock companies, so they need toshow their shareholders earnings growth.”

With the profit being earned in the surety business, theappetite for business is not surprising. According to the Surety & FidelityAssociation of America, for seven of the past 10 years theindustry's loss ratio has been below 20 percent. For the first halfof 2016, it was just higher than 18 percent.

Contract surety, commercial surety

The market divides into two sectors: contract surety forconstruction (“sticks and bricks”) and commercial surety, whichcovers other bonding needs. Competition is tough in both areas, andis particularly keen in commercial.

“Where we see severe competition to the point where rates aresignificantly impacted or underwriters are complaining about othercompanies doing things that are 'hypercompetitive,' it's typicallyin the commercial surety space. That's also where we see most ofthe new entrants as well,” Hecker says.

On the commercial surety side, pricing is being reduced tolevels “that concern us,” says Titus, adding that he has seen somecompanies undercutting the incumbent surety by up to 20percent.

In contract surety, underwriters are increasingly lenient onpersonal indemnity and other requirements, and are willing toaccept lesser quality in the financial presentation thatcontractors are normally required to have.

“Sureties are not getting the double-digit growth that most wantto see, so companies are willing to 'color outside the lines' towrite business. They are doing things they don't want to do, whichis scary because those debts will come due two to three years fromnow,” says Pribyl.

Disciplined underwriting

“A highly competitive contract surety market has definitelyimpacted underwriting,” says Carl G. Castellano, surety chief riskofficer and vice president of contract security at PhiladelphiaInsurance Cos. “We must remain disciplined while also beingsomewhat creative in our underwriting approach.” Philadelphiaitself is a relatively new entrant to the bonding business, havingstarted writing in 2011, but has grown to become the 15th largestwriter of surety in the nation.

Despite increased demand for bonding created by an improvingeconomy, downward pricing pressure has kept growth in the suretysector modest. The SFAA reports a 2.7 percent increase in directwritten premium in 2015 compared to 2014. In their desire to growbusiness, companies are also competing among each other forunderwriting talent. “Headhunters are much more aggressive andcompensation is going up,” says Taylor. “It's very specializedbusiness that requires experience and expertise.”

Overall, surety capacity remains plentiful. Well-managedcompanies that control expenses and debt will find an extremelycompetitive environment, and even companies that have weakerbalance sheets can find a home.

As long as current loss experience holds, premiums are expectedto remain equally competitive. Although surety has higher claimsexpenses than other lines of business, even a jump of severalpoints in the industry's loss ratio should continue to produce aprofitable combined ratio. “It will take some severe losses orsignificant economic changes for the industry as a whole to seesome tightening,” adds Hewett.

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