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Sureties In Thinned-Out Contract Market Eye Better Times After Punishing Years

With more work ahead, contractors can be more selective, improving outlook for sureties

After years of mounting losses, contract surety carriers now look for some more profitable years to come as a growing economy and Katrina rebuilding fuel construction activity.

Henry W. Nozko Jr., president of ACSTAR Insurance in New Britain, Conn., sees the demand for bonds increasing in the next three years, with the recent losses only reinforcing the fact that "the cost of a surety [bond] compared to the guaranty provided remains...an inexplicable bargain."

There is nothing like some serious losses to wring some capital out of a line of business, experts say, noting that that is what has been happening with surety in the past few years.

The line, which theoretically should operate at 0 percent loss ratio, has been well above 60 percent in recent years, according to Geoff Heekin, Los Angeles-based vice president for Aon Construction Services, Surety.

Mr. Heekin said sureties used to factor a 20 percent payout as their probable maximum loss. "Now it is somewhere around 40," Mr. Heekin said.

James Maloney, deputy chairman, Willis National Construction Practice in Columbia, S.C., said that "unprecedented losses" in contract surety in the past few years have led to consolidation along with executive management turnover, "further exacerbating unsettled conditions." He said that losses since 1999 for the entire surety industry amounted to over $11 billion.

While surety (including commercial and fidelity) generates about 1 percent of U.S. property-casualty industry revenues, "it holds the potential for any single loss to impact the insurer's quarterly earnings-per-share," Mr. Maloney said.

Or as Mr. Heekin puts it, "these are pretty big bets."

Mr. Nozko sees the losses of the past few years stemming from "a rapidly increasing materials price environment, which has put a lot of contractors on fixed-price contracts with no ability to recoup these costs."

Relaxed underwriting standards that included waiving personal indemnity from contractors and certified financial statements also contributed to the red ink, market participants say.

"I put a lot of blame on the contractors," Mr. Nozko said. "But I also put it on the surety companies. They just did things they should not have done. A lot of those losses would not have been caused had the surety industry done better underwriting."

The sharp losses also had a winnowing effect on the number of sureties.

Among the players exiting the market recently are Kemper and Fireman's Fund. (Fireman's Fund exited the line for strategic reasons, selling the renewal rights to its surety book to St. Paul in 2001.)

"Since surety is a small part of their business, many of the companies just decided to remove themselves from the surety business because of the losses. And some of the smaller companies literally disappeared and went out of business," Mr. Nozko said.

As a result of consolidation over the past 15 years, the top 10 sureties now write 64 percent of all surety business (including commercial and fidelity), compared to 47 percent 15 years ago., according to the Washington-based Surety Association of America. The group pegs the contract share of the entire pie at 67 percent.

After a series of strategic acquisitions, St. Paul Travelers is by far the largest player, writing 21.5 percent of the market, followed by CNA at 8.3 percent, according to figures provided by the Washington-based Surety Information Office. (The accompanying table, based on data from National Underwriter Insurance Data Services, confirms these figures, which are for the entire surety market, not just the contract portion.)

But even the No. 1 player found itself contributing to some of those losses, particularly in the second quarter of 2003, when it took a $56 million after-tax loss as a result of a contract surety exposure.

In the second quarter of the following year, the company announced over $400 million in after-tax reserve charges related to surety.

Last June, the company reported a significant contract surety loss in connection with the Boston "Big Dig" project that it co-wrote with Chicago area-based Kemper. A company spokesman did not elaborate on that loss or whether it was related to the 2004 charge.

St. Paul Travelers Bond Executive Vice President Terry Lukow said he does not comment on loss ratios. But, he did say, as for market conditions today, "We mirror the construction industry."

And that should bode well for the surety industry as contractors no longer have to offer bids based on razor-thin margins that leave very little room for error.

As a percentage of Gross Domestic Product, the construction industry's peak was in 1998, at nearly 8.5 percent, dropping to a low, in late 2002, of just below 7 percent, according to the SIO. It is expect to slowly rise for the next couple of years.

"There is not a lot of excess, but there is an adequate amount of capital to satisfy demands," Mr. Heekin said. "As a result, the pricing is moving up and the risk-reward quotient for those who have stayed in the business is getting a little more balanced."

Respondents to a 2005 Grant Thornton Surety Credit Survey agreed. While 56 percent said that, in 2004, economic conditions improved, 66 percent said the environment will improve through this year.

The passage of the mammoth $284 billion federal highway bill along with homeland security needs should keep contractors busy in the next few years, experts say.

And then there is the Katrina factor and what effect such a sudden infusion of federal cash will have on the construction business.

Lenore Marema, vice president for the SAA, said the Katrina rebuilding activities could raise a lot of regulatory and legislative issues touching on surety.

"There will be pressure to waive bond protections, suspend competitive bidding and eliminate retainage, among other protections and requirements, just to get the work done," she said.

Thomas Kunkel, chief executive officer for St. Paul Travelers Bond, said any waiving of bonding requirements seems unlikely if history is any guide. That is not what we have seen in the past, he said.

"In similar situations, the best companies in the surety industry have prepared to respond to urgent requests to provide capacity for their construction clients," Mr. Kunkel noted.

Mr. Heekin agrees that there could be certain pressure for regulatory change, but feels that bond requirements will remain. And thus, a lot of new work will need bonding.

But where the federal government will play a role in the surety market in terms of Katrina is in the Small Business Administration bond guarantee program, which can help small and emerging contractors obtain bonding and take part in the rebuilding effort.

SAA President Lynn Schubert said that a proposed 60 percent fee hike could make the program unattractive to many sureties.

According to information on the SBA Web site, the SBA can guarantee bonds for contracts up to $2 million (providing guarantees ranging from 70-to-90 percent of losses incurred). The SBA charges a guarantee fee to both the contractor and to the surety. For the surety, the fee is a percentage of the bond premium.

"Without participating sureties, the SBA will not be there to help small and local businesses when they need the SBA the most," she said.

But no matter how you slice it, Katrina plus highways equals a lot more work in the coming years, which in turn could ease some of the pressures that sent losses soaring early in the decade.

"When there is a lot of work, contractors can become more selective and can put less pressure on their margins," Mr. Heekin said.

But even a significant upswing in construction activity will not attract all that much new capital to the market.

"Even with this increase on the Katrina front, I don't see any opportunistic capital coming in," Mr. Heekin said. "The players that are there now have an adequate amount of capital to respond."

Mr. Maloney said that capacity will remain an issue for aggregate programs over $250 million, noting there are only four sureties that will write aggregate programs of more than $500 million without a co-surety partner.

In addition, sureties may impose single bond size limitations on contractors that do not have a joint venture partner. "This requirement is driven by a surety's desire for its client to obtain a spread of risk for any large single project as well as its own desire to maintain single credit risk aggregate exposures on any single risk within its current credit model," Mr. Maloney said.

Reinsurance shortages have arisen as a result of the sharp losses in recent years. Mr. Maloney attributed this factor to underwriters imposing more discipline manifested through more adherence to traditional underwriting ratios and maintaining the quality of submissions.

With the sureties retaining more of the risk, they will, by necessity, seek more collateral from clients and limit aggregate exposure to any one client, Mr. Maloney asserted.

Pullquote for Schubert

SAA President Lynn Schubert said that a proposed 60 percent fee hike could make the SBA program unattractive to many sureties, which would limit the ability for small contractors to participate in Katrina rebuilding.

Special Reports /

Sureties In Thinned-Out Contract Market Eye Better Times After Punishing Years

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