Surety Market Update

In early fall 2009 the National Association of Surety Bond Producers (NASBP) held it national seminar in Washington DC and, as you might imagine, the mood was less than cheery.

The association released its mid-year and 2009 projected results, which showed a 28.9% loss ratio, more than double the loss ratio for 2008. Beyond the negative results, the prevailing feeling that losses will continue to mount throughout the coming year influenced the mood. After five straight years of significant profits the surety industry is bracing for a difficult year in 2010; and it’s making the kinds of adjustments that usually accompany a recessionary cycle.

Surety company executives are concerned about the potential problems looming on the horizon, like a shortage of new profitable work, low backlog, shaky project financing, a conservative banking industry, and unresponsive contractor business strategies. Contractors who work to address these concerns will be best positioned to expand their surety programs in 2010.

A principle difference between today’s market conditions and those of the last business cycle is the relative calm before the downturn. In the late 1990’s the surety industry was marked by increased competitors, a surprising number of who took an aggressive approach to gaining market share as the growth period wound down in 2000. During that growth cycle contractors were offered bonding programs that often exceeded their historical capacity, and the financial strength of the contractors was overlooked in favor of taking share.

When the dot com bubble popped, setting off a string of economic problems that ultimately peaked around the time of the September 11th attacks, surety losses were at record high levels of almost 83%. One positive result of that time was that underwriting common sense stayed in control of things as the latest bubble expanded, and the response to the declining economy may be more measured, particularly in western PA.

“Zurich's underwriting standards have remained consistent over the years, so customers have a better understanding of what to expect in terms of surety capacity,” says Regis McKaveney, who leads underwriter in Zurich NA’s Pittsburgh office.

Kevin Waldron, a vice president and the director of construction for Chubb Surety, echoes that feeling. “We have no plans to change our underwriting approach throughout the cycle, whether it’s a soft or hard market. Our customers look to us for stable, consistent and predictable capacity.”

Even though most surety companies would agree that their underwriting didn’t loosen as it did in the late 1990’s, few would argue that the current recession isn’t going to bring about some changes in how they view their customer’s programs.

“We saw some tightening already in the fourth quarter of 2009 as the sureties started to see some red ink,” observes Jim Bly, vice president at insurance broker Marsh. “There will certainly be some belt tightening by underwriting. I think that means more qualifications and requirements for the insured. This kind of environment brings more requirements for leaving liquidity in the company and a greater focus on the company’s bank debt and more personal guarantees from the business owners.”

Of course the surety industry is built upon risk management. At risk on each and every project for which it insures successful completion is the ability of all parties to perform. While contractors can suffer lapses in technical competence, the mother’s milk of performance is profitability. And it is profit that suffers in a recession.

Nick Tropiano of HDH Group says shrinking profits are his company’s highest priority concern in a down market. “We’re probably most sensitive to our contractors’ ability to get profitable work and to maintain profitability on jobs they have,” he says. “Once the profits shrink or disappear it affects all aspects of the contractor’s business. Their clients will pay more slowly and there aren’t profits to cover the slowdown. The big problem then becomes cash flow.”

Tropiano sees the current environment as ripe for what can be the ‘perfect storm’ of bad cash flow. If cash flow slows, the banking industry isn’t in a position to extend as much credit and contractors will discover they have a limited ability to finance all their projects.

One seemingly unavoidable result of the slower economy is slower pay, which starts the strain on cash flow, and ultimately a tough market tends to increase the chance that a ‘slow pay’ account will become a ‘no pay’ account. Contractors, understandably, will tend to keep the slow paying accounts on the books for longer periods, and human nature kicks in, making it difficult for many business owners to write off a debt which still has a glimmer of hope. In those kinds of situations the surety company will be more proactive in 2010.

“We’ll look at assets that are questionable, like very old receivables, and remove them from the equation in working up a debt-to-equity ratio,” explains Regis McKaveney. “Accounts receivable may be discounted or removed in this kind of market to see what the ratio is like without them. We want to see more cash than credit, rapid receivable turnover, no extremes in overbilling or under billing, all signs that a contractor has been proactive in strengthening his balance sheet.”

For most contractors, the change they are likely to feel most in 2010 is the increased reporting and oversight. This is where strategies for coping with a recession are expected to show up. Surety companies will look to see measures taken to increase the amount of cash in the business (or see more put back in), and to see that a higher percentage of the business’s profits are being used to pay down debt, especially if there are lower margins on the work to justify paying interest. Reporting will be more frequent and the surety company will be more likely to require audited statements.

“Our expectation for any account is an annual review, which involves a personal meeting and open communication, and obviously our preference is for an audit with supporting schedules,” says Kevin Waldron. “For customers where we have larger exposures we will want to meet more frequently than that.” Waldron clarified that more exposure may mean either higher capacity or simply more risk in a customer’s business.

Most observers expect to see more conservative ratios in 2010. “For a general contractor the benchmark is a five percent working capital position for the total work to be completed – the backlog – but that will probably rise to seven-and-a-half percent,” predicts Jim Bly. “For specialty trade contractors the standard is higher because of the higher risk or labor overruns and variable profits. Their ratios may go to ten percent this year”

In addition to tighter scrutiny of financial results, the surety companies have higher expectations of their customers for developing strategies to ride out the recession. They will want to see realistic plans, strategies that anticipate a “U” shape recession that may cause break-even results for a couple of years. And they will want to see a strategy that reduces unnecessary risk, and overhead, to a bare minimum.

“Contractors are naturally optimistic so they are apt to wait a little longer before they pull the trigger on cutting back staff,” explains Jay Black, managing partner of surety at agency Seubert & Associates. “It is especially difficult when it involves crews that have been with the company a long time. A lot of employers are still feeling bad about their 401-K’s becoming 201-K’s last year.”

Black sees the surety company dampening that natural optimism when it comes to evaluating what to bid during the short term. The predominant tendency among contractors is to err on the side of volume rather than profitability, feeling more comfortable with normal backlogs, even when the competitive environment dictates getting the work on very thin margins. The dangerous thinking in this kind of market is that the profit can be found somewhere later in the job, or worse, on the next job.

“There are going to be contractors who honestly believe that everything will be OK if they can just get that next big job that’s out to bid,” says Nick Tropiano. “But I expect to see the sureties run from that way of thinking, and they should.”

It’s important to remember that the driving force behind this additional caution in the surety industry is the rising losses. While the insurance side of the transaction is looking to tighten up controls to prevent contractors from being their own worst enemies, the reality is that some portion of the increased losses stems from the surety industry extending its standards too far, even if the business didn’t get carried away.

“I wouldn’t discourage a contractor from having a relationship with a backup surety, in case their capacity decreases because the surety isn’t doing well,” says Tropiano.

“There are really only four things we can do to grab more share: we can offer more capacity; we can reduce or release personal indemnity; we can lower rate; or we can relax the financial reporting requirements,” notes Jim Bly. “Some of the companies took a more aggressive stance than others and so their losses will be worse. Contractors should ask the surety about its performance too. A company that isn’t performing well could limit the contractor’s performance, even if the contractor is doing OK.”

2009 marked the reversal in a five-year trend of lower loss ratios for the issuers of construction bonds (Source NASBP)