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Surety losses likely to rise as economic problems continue

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The surety industry remains healthy despite a downturn in government-backed construction projects, according to industry observers.

But experts say they expect losses may begin to rise as the economy remains in the doldrums. And smaller and midsize contractors—and their subcontractors—are feeling the pinch harder than their national or global competitors.

Nevertheless, capacity is no problem, as the industry is better capitalized than it was when it hit a rough patch a decade ago.

The bulk of the surety business involves government contracts, according to market observers. Underwriter loss ratios have been favorable so far, with the Washington-based Surety and Fidelity Assn. of America reporting that as of June 30 of this year, the loss ratio stood at 11.8%. But financially strapped state and local governments have been cutting back on projects, cutting into contactor balance sheets.

“The way we look at it, the surety industry is a cyclical business,” said Drew Brach, Marsh USA Inc.'s U.S. surety practice leader in Grand Rapids, Mich. He said the cycle historically goes through four stages: crisis, recovery, boom and worsening.

“Right now, we are in the worsening stage, which typically leads to an increase in construction defaults,” he said. “While we haven't seen significant increases in defaults yet, we're seeing some early warning signs. There's a tremendous amount of stress on financial statements, less work, and many contractors haven't reduced their overhead enough to compensate for the changes.”

“When that happens, they have losses and they have cash flow issues,” said Mr. Brach. He said the surety industry is bracing for losses in 2012 and 2013. “Contractor balance sheets are going to reflect reduced revenues and, in some cases, we're seeing reductions of up to 60%” over a two-year period, he said.

“Contract surety underwriting is conservative given the economy,” said Mark Baechle, senior vp and surety leader-Chicago for Willis Group Holdings P.L.C. “There's been a precipitous drop in construction spending over the past three to three and a half years. That has led to fewer opportunities for contractors,” he said, adding that, even so, the first half of this year has been highly profitable for surety underwriters.

The construction market is in a difficult time, said Roland Richter, Philadelphia-based marketing vp for Liberty Mutual Insurance Group Inc.'s Liberty Mutual Surety unit.

“Government spending is down fairly significantly this year,” he said. “If they're not building, the contractors aren't working and fewer bonds are being written,” said Mr. Richter.

He noted that in any economic cycle, there is a lag before its impact is felt. After the economy turns into recession, tax revenues flowing into state and local governments have a six-to-12-month period before they feel the impact on their revenue streams, Mr. Richter said.

The surety industry is in “challenging times,” said Mike Bond, head of surety for Zurich North America in Owings Mills, Md.

“Construction spending is down 20% from its peak in 2008, which puts construction spending at about the same level as it was in 2000,” he said. “In spite of that, the surety industry continues to show extremely robust results. The losses at midyear reported by the Surety and Fidelity Assn. of America were actually down from the same time the prior year” at this year's midyear, he said.

But the expectation is that will change next year and in 2013 unless the construction industry picks up, said Mr. Bond.

Sufficient capacity is “absolutely” available, said Zurich's Mr. Bond. “As long as the results in the overall surety market remain as strong as they are, there will be sufficient capacity in the market.”

“There is capacity available for contractors who happen to have work these days,” said Rick Ciullo, chief operating officer for Chubb Corp.'s surety operations in Warren, N.J.

“Right now, the industry is flush with capital,” said Geoff Heekin, managing director of Aon Risk Solutions' construction services group in Chicago. “We're entering into (2012) with more capital around contract surety than we've seen in a decade.”

“We are going to have more defaults but plenty of capital to support the business, unlike in the early 2000s,” he said.

Demand is down, but supply of surety is at least available, said Chubb's Mr. Ciullo. From an underwriting perspective, surety underwriters are concerned with the health of their customer base. When contractors have built up organizations to do a certain amount of work, and if there is less work, contractors either have to cut their overhead to match the available work or they have to be prepared to take work at substantially lower margins, Mr. Ciullo said.

As public construction has dropped, there's been a slight uptick in demand for surety by private owners, said Willis' Mr. Baechle.

“We are seeing more private owners requiring bonds, often driven by lender requirements,” he said. Developers of shopping centers, distribution centers and other projects are requiring surety bonds, and also asking them of subcontractors more often, he said.