Payment and performance failures among small and midsize construction contractors were mostly responsible for the substantial increase in surety losses in 2012, and they are expected to continue driving claims through the remainder of 2013.

While U.S. surety insurers did not sustain the tidal wave of contractor defaults that many predicted last year, the industry's aggregate loss ratio rose to 22% in 2012, an increase of 8 percentage points over results from 2011, according to a report released July 2 by the Surety and Fidelity Association of America.

Much of the increase in losses, the SFAA report said, has been driven by contractor failures in the small and middle markets, as prolonged stagnation in certain construction segments — particularly publicly funded projects — has intensified competition for new projects among local and regional contractors.

Though the construction industry has shown modest economic improvement in the past 18 months, it has been driven almost entirely by privately funded projects, providing little relief for smaller contractors and surety companies that depend largely on federal, state and local government contracts.

“Governments, whether it's city, state or federal, really aren't putting out the amount of infrastructure work that they should be,” said William Maroney, a New York-based surety practice leader at Wells Fargo Insurance Services USA Inc. “Overall, what we're seeing is a lack of projects for the small to medium-size contractors. They're still hurting for work, and it's a feeding frenzy at those lower levels.”

To gain a competitive edge in pursuit of the limited number of new contracts available to them, small and midsize construction firms have been bidding projects at dramatically lower profit margins than they would under normal economic conditions, leaving them with less cash on hand to cover the cost of even routine work stoppages, project design changes or increased materials and labor expenses.

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“There's also been a fair amount of creep among contractors into areas beyond their expertise when their core competencies have dried up,” said Alan Murray, a senior vice president at New York-based Moody's Investors Service Inc. “The question for sureties is whether the contractor actually has the wherewithal to complete a project that isn't necessarily within the bounds of their traditional expertise.”

With contractor defaults and project disputes largely occurring at the smaller end of the construction industry in 2012, the attendant surety losses were similarly concentrated among small and midsize insurers, experts say.

A report published in February by Kansas City, Mo.-based Lockton Cos. L.L.C. indicated that the aggregate direct loss ratio among the top 10 U.S.-based sureties — representing nearly 65% of total direct written surety premiums — stood at 12.7% through the first three quarters of 2012, while the remainder of the marketplace reflected a loss ratio nearly three times as high, at 34% for the same time period.

For the most part, experts said surety losses in 2012 appear to have been weighted toward payment bond claims against contractors that, while financially solvent, fell behind on payments to suppliers and subcontractors.

Despite the uptick in surety losses, experts say midsize contractors with strong financial and project performance histories — as well as portfolios of current and pending projects that are within their capabilities — are still likely to find ample capacity and competitive rates in the surety market.

According to a market report published in January by Marsh Inc., surety bond rates for qualified mid-market contractors at the end of 2012 were generally flat or reduced by as much as 10% compared with rates from the prior year.

However, while the industry's loss experience in 2012 has not substantively affected capacity or pricing, experts said mid-market contractors should expect and prepare for increasingly thorough examinations of their businesses — and in most cases, of their subcontractors — when pursuing surety bonding.

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“When it really gets down to it in today's marketplace, the more interaction contractors have with the surety, the more comfortable the people making the underwriting decisions are going to feel about the account,” said Drew Brach, Marsh USA Inc.'s U.S. surety practice leader in Grand Rapids, Mich.

Aside from standard indicators of financial health such as cash flow, credit scoring and access to future capital, experts said surety underwriters likely will factor the size, scope, location, cost and duration of the project to be bonded against a contractor's portfolio of previously completed projects to determine the contractor's realistic likelihood of completing the project as contracted.

“The level of scrutiny has absolutely ticked up. The whole surety industry over the past few years has relearned a few lessons about partnering with contractors with overly ambitious plans or who aren't adjusting their overhead to reflect their current situation,” said Michael Bond, a Washington-based executive vice president and head of surety at Zurich Financial Services Inc. “For a lot of sureties, those were expensive lessons, so it's top of mind for them now to look at everything they can.”