The Surety Bond Industry
Today's good news and tomorrow's concerns
Written by: Ed Heine, Managing Executive, Surety, Payne Financial Group, Inc.
The good news is that the surety industry is profitable and can provide the capacity that its clients require. Predictions that the market would suffer tremendous losses due to the challenging economy have proven to be exaggerated and most industry executives view the future with cautious optimism. Quite a story!
Ten years ago, the surety industry experienced very large levels of loss activity. The impact of the losses was profound: the capacity of the industry decreased as the capital base supporting the business declined. Without exception, those that remained in the business carefully assessed their financial goals, the quality of their business relationships and the types of exposures they bonded - and revised their business plans. Based upon current results, this planning is paying dividends for the surety companies and the constituents they serve. The industry is alive and well.
Ever since the recession began in 2008, surety companies have encouraged their agents and clients to focus on developing strategies to manage the downturn in the construction economy. Backlogs and profits have declined, prospective work has reduced and competition is fierce. Those that had developed a solid financial condition during the stronger economy of the previous decade have been able to secure the bonding credit that is supportive of their plans; those that did not have experienced a more conservative approach from their sureties. A strong balance sheet is not enough - a strategy for controlling expenses and preserving capital is essential. Surety companies continue to place great emphasis on strategic planning. Their reliance on this factor has not only reduced their exposure to loss, but, importantly, has resulted in stability in the industry.
Characterizing the market for the near term are several issues:
- Many surety professionals expect an increase in loss activity but fewer larger losses in 2011 and 2012.
- Contractors should expect an impact to their bond credit if their company's financial strength has weakened. This does not reflect a change in surety underwriting methods; it is merely a reaction to the client's own circumstances.
- ARRA funding, through the federal Recovery Act, has run its course and federal deficit issues will likely hamper critical funding. Most states are either in a financial crisis or must manage carefully to avoid one and that dynamic could hinder construction spending. Private sector funding requires significant equity; lenders are still very cautious. Contraction in construction and surety remains a real possibility if recovery lingers.
- Uncertainty remains on the economic recovery, GDP growth of 2.5 percent to 3 percent will only sustain the current jobs picture; experts believe we need growth of 3.5 percent or higher to reduce unemployment. It is very challenging to plan construction operations in this environment. What will the innovators and the leaders do? Great opportunities for the best planners.
- The banking industry is on the path to recovery, with many willing to extend credit to acceptable risks. The pool of qualified borrowers has shrunk as more stringent credit criteria are applied.
- Larger and more conservative companies are flush with cash, awaiting opportunities. For all players, working capital (liquidity), balanced debt, profitability and solid credit are continually emphasized by surety analysts.
- Sureties are unwilling to extend significant credit without good financial reporting - a very important factor in establishing surety credit.
- The terms and conditions of construction contracts are being reviewed carefully, and surety clients are being asked to work with owners to establish fair terms and conditions. Risk selection, contingency planning and contract administration are a great focus.
- Government set-aside programs for disadvantaged businesses represent significant opportunity for participants in that market. Sureties are insisting that their clients understand all of the rules and regulations of the programs. Failure to abide by the regulations can result in great expense, with potential fines and penalties for violations being significant.
- Surety companies do create solutions for difficult and challenging requests. Using techniques like collateral or funds control, many bonds for contractors representing every segment of the market have been written this way. When using these techniques, review the documents governing the deal carefully, and include your CPA and attorney in that review. Remember to review your bank agreements, which may contain covenants that restrict the use of alternative surety underwriting techniques.
- All stakeholders need to be careful of fraudulent bonds, unlicensed surety companies and with whom they are doing business.
- As bonds are more difficult to secure, owners may propose bond waivers or threshold increases on public work (have not seen this in Montana, but it is happening elsewhere). Such reduces the protection of the tax dollar, the prequalification of bidders and the performance and payment protection provided by the bond. Contractors, sureties and other interested parties need to be mindful of legislative attempts in this regard, and government interpretations that bonds can be waived or thresholds increased. (Remember that there usually is a payment bond in addition to the performance bond. These arrangements don't end when you finish the job, they end when all bills are paid and all warranties and guarantees expire. This could be well beyond the completion date.)
Surety companies expect their clients and agents to communicate in a timely and comprehensive manner, and are very willing to contribute to developing strategies. The contractor who helps facilitate this process should benefit greatly, and will understand how to secure the surety's prequalification of his business. Without question, the ability of a contractor to honestly state that he has surety credit to support the projects is a critical part of his success, particularly in challenging economic times.
Contributors to this article include the management and several members of The National Association of Surety Bond Producers; Berkley Surety Group, Travelers Casualty and Surety Company of America, and members of Payne Financial Group's (PFG) surety bond department. PFG is a regional firm, providing Business and Personal Insurance, Employee Benefits and Surety Bond services through 10 offices located in Montana, Boise and Spokane. Ed Heine can be reached at 406.532.5911 or eheine@pfg-insurance.com.
