Surety Update

What a difference 12 months make! In the late spring of 2000, the news was the continued profitability of the surety business with expectations that, as long as the construction economy continued to grow, conditions in the surety market would continue

to be favorable for most contractors. By the fourth quarter of last year, the market was in transition; loss frequency and severity were increasing, and surety reinsurers
were in the midst of their second consecutive losing year. And, the market has changed considerably during the past six months. The following is an explanation of why this
is happening, what can be expected over the next 6-18 months, and the implications for contractors.

2000 Surety Industry Results
According to the Surety Association of America (SAA), total direct written surety premiums were about $3.5 billion in the U.S. last year. The industry incurred direct losses of $1.5 billion in 2000, an increase of more than 100 percent from 1999. The direct loss ratio for primary surety companies as a group was 45 percent. In addition to losses, the industry had underwriting (including reinsurance), acquisition, and loss expense ratios
that averaged about 60 percent. As a result, the industry had a combined ratio of 105 percent – that
is, for every $1 of earned premium, the industry lost five cents. (These results do not include investment income.)

The top 20 underwriters of surety bonds in the U.S. (based on 2000 direct written premium volume) wrote just over $2.6 billion in premiums, or 75 percent of the total written. Using an estimated expense ratio of 60 percent, 6 of the top 10 – and 9 of the top 20 – had losing years. 2000 was the first losing year for the industry since 1987, and the worst (in terms of dollar volume of losses) in at least two decades. A number of factors caused this dramatic turn. Discussions with the leading surety companies indicate the following:

• The drive for premium growth in recent years resulted in a lack of focus on fundamental underwriting practices; this led to inappropriate levels of credit being offered.

• Merger & acquisition activity in the industry in the past five years did little to reduce overall market capacity.

• The strong construction economy, combined with overabundant surety capacity, allowed contractors to become overextended. Also, even though contractors should have
been generating increased profit margins (due to the strength of the economy), this has not necessarily been the case.

These factors, together with shortages of qualified labor, have only exacerbated the financial pressure some contractors are facing. In addition to the problems in the contract surety market, the historically profitable commercial surety market had serious loss activity (estimated at $284 million) in 2000. The slowing economy was the chief culprit here. Self-insured workers’ comp and certain types of financial guarantee bonds were
among the obligations experiencing the most significant loss activity. These factors combined to produce record losses for the industry in 2000. Meanwhile, surety reinsurance companies lost money in 1999 and 2000 – and 2001 is also shaping up to be a losing year.

Surety Reinsurance
Almost all primary surety companies reinsure a portion of the bonds they write to professional surety reinsurers. The amount of reinsurance purchased depends on the individual company’s risk philosophy, as well as the terms, conditions, and cost of the
reinsurance. Surety reinsurers are a relatively small group, but their support
and profitability are vital, allowing primary sureties to provide capacity to the construction and commercial community that use surety bonds in the U.S. and elsewhere.

Historically, many reinsurance contracts involved “quota share” treaties, which provide for an agreed-upon participation percentage that is applicable to bonds written. The participation level can vary, depending on the size of bond, aggregate amount of work program, and type of bond. In addition, a portion of the bond liability and premium are
allocated directly to the reinsurers. This approach provides for an equitable distribution of premium and liability between the parties involved.

In the mid-to-late ’90s, excess-of-loss treaties were negotiated, which meant that the primary underwriters would pay a predetermined amount for reinsurance coverage, in excess of an agreed-upon retention of loss. For example, a primary surety may want to take the first $5 million of loss, with any amount in excess of that limit being the responsibility of the reinsurance companies. This approach can be profitable for all parties if the frequency of losses is low, but detrimental to the reinsurers if a number of losses exceed the $5-million threshold. Surety reinsurers have had losses in excess of $900 million during the past two years while earning just $600 million in premiums. The end result? The soft surety market of the ’90s is gone. Some primary sureties have left the business, and some longstanding surety reinsurers have left the industry. Those remaining have dramatically changed the costs, terms, and conditions of the reinsurance contracts, forcing primary sureties to refocus on underwriting and not on premium growth.

The reinsurance treaty renewal process has become more time-consuming, and at least one of the top 10 sureties still has not completed its reinsurance renewal from January 1, 2001. Surety companies that don’t show improvement will have difficulty as the July 1, 2001 and the January 1, 2002 treaty renewals are negotiated. As a result, the surety industry is in for a very tight market for the next 12-18 months – longer if loss activity continues. Following is a rundown of capacity availability and other restrictions:

1) Capacity restrictions for larger accounts, with profitable and financially strong operations, have been only marginally impacted. However, if reinsurance contracts start
to include co-surety diminution clauses, capacity will be a problem for larger accounts as well. This clause automatically limits a reinsurer’s capacity for joint ventures and other large projects. Primary sureties may have to obtain additional approvals from their reinsurers or use more facultative reinsurance (capacity from other primary surety companies) to provide for capacity for these projects.

2) Capacity for environmental projects has been reduced, and will remain tight for small and large firms alike.

3) Capacity and underwriting for financial guarantees has become more restrictive. Insurance company deductible bonds/loss-guarantee bonds have become difficult to
write for firms with marginal financial performance.

4) Capacity for large international surety users will also be affected, as the types and size of credit extensions are being closely scrutinized.

5) Rate pressure is already mounting as primary underwriters find it necessary to pass on higher reinsurance costs. This is particularly true for environmental and international
obligations.

6) In addition, financial guarantees (such as insurance company retro/deductible loss bonds, self-insured workers’ comp obligations, etc.) are seeing significant cost
increases. For most (if not all) companies, the days of the $1-2 rate for these bonds are gone for now.

7) Underwriting will become more focused, with the emphasis on high-quality data and detailed information. Expect to see more consistent underwriting, as well.

Damage Control
The implications of this changing market for contractors that need surety bonds can be assessed only on a case-by-case basis. Therefore, it is particularly important to build and maintain a good relationship with your surety underwriters. Surety is a relationship business, and one that applies a fair degree of subjectivity to the final outcome. So, whether you have had the same relationship for many years, or you changed sureties during the soft market, the following recommendations should help to maintain this valuable credit source for your company:

1) Approach the renewal of your surety facility as though you are approaching a new market. The quality of the submission is critical, so make sure it includes all appropriate
disclosures. Discuss the high and low points, and be sure to include your business plans for both upcoming and following years. Benchmark your financial performance against
peer companies to determine points of comparable strengths and weaknesses.

2) Annual audits must be provided on a timely basis. The typical time frame is 90 days after year-end. Also, be sure the necessary supplemental schedules (work-inprocess
and closed jobs) are included in the CPA financial statements being provided.

3) Make sure your surety is comfortable with the quarterly or semi-annual financial updates you provide. Again, more is better, so provide a written summary of the
results, giving detailed explanations for variations to the plan.

4) Plan for more lead time than you needed in the past. Local surety underwriters are being required to review more information and provide more detailed analyses. In many cases these underwriters may not have the same authority they once had. In addition, many local (and some home-office) underwriters have not experienced a hard surety market. These changes will affect their turnaround time so, if there are large projects being contemplated or joint venture bids on the schedule, be sure to provide information early in the process.

5) Above all, communicate frequently with your broker and underwriter. Surprises in the surety business are rarely welcome, and this will be especially true with the market
changes underway. Don’t take these relationships for granted; alert appropriate parties to organizational, financial, or operational changes in your company when they occur, not when you need a bond.

6) Continue to underwrite your surety. Ask questions about their reinsurance treaty, how it is organized, and what the implications are for your firm.

7) Remember: In the surety transaction, your surety broker is both your consultant and advisor (assisting with problem solving and developing solutions), as well as your
advocate with the surety markets to “get the deal done.” Make sure you have the right broker working on your behalf.

Summary
Surety bonding is a valuable credit source – one that is vital to most contractors’ very existence. During the height of the soft market, anyone could get a bond, and the fact that your company had a surety line wasn’t a distinguishing feature. But, the market is changing. This is not the first hard surety market, and it won’t be the last. Following these recommended strategies will help maintain and grow the surety facility
your company needs.

About the Author: DAVID C. MOYLAN is a Managing Director of Marsh USA, Inc., and the Construction Practice Leader for their Baltimore and Washington, D.C.
offices. He has 23 years’ experience in surety/construction risk management. He may be reached at Phone: 202-263-7626; E-Mail: david.c.moylan@marshmc.com;
Web Site: www.marshmc.com. This article was originally published by the Construction Financial Management Association (CFMA), Sep./Oct. 2001, and is reproduced here with permission.

ConstructionRisk.com Report, Vol. 4, No. 4 (Apr 2002)