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Surety Market Overview: How Is the Economy Affecting Contractors?

The nation’s slowly dropping unemployment rate may be a sign that the economy is on the road to recovery. But surety executives still expect the next year to be tough for the construction industry as the impact of the recession and depleted backlogs continue to take a toll on contractors’ balance sheets. “Contractors at all levels face significant challenges in acquiring work and getting adequate margins, while dealing with owners who are having budget and staffing issues themselves,” says Rod Williams, chief underwriting officer for Liberty Mutual Surety.

Some sectors of the industry have fared better than others. Specialty trade contractors have been hit the hardest, especially those in nonresidential construction, which lost 6,400 jobs in August 2012. There is better news for residential specialty trade contractors—a job increase of 8,200 in August and a 1.3 percent increase compared to the previous year. Heavy and civil engineering construction grew 2.1 percent since August 2011.

The unemployment rate for construction rose from 11.3 percent in August to 11.9 percent in September, confirming the industry is one of the country’s slowest to recover. According to Bizminer, more than 20 percent of all general contractors and operative builders, heavy construction contractors and specialty/trade contractors operating in 2009 were out of business by the end of 2011.

Because of the surety industry’s adherence to strict underwriting standards prior to and during the recession, losses are not as severe as they could be. In the small and middle markets, surety executives say this year brought an increase in loss frequency. “It seems like there are fewer qualified contractors due to economic issues, so the base of bond clients has decreased; therefore, competition for bondable contractors has increased,” says Jeff Booth, senior vice president and chief underwriting officer of Allstar Financial Group.

Small
“Small contractors are showing the most obvious signs of distress, and sureties are underwriting this segment accordingly,” says Doug Irvin, vice president and surety unit manager for Lockton. “If the contractor has established a good rapport with its surety, the underwriters are generally trying to provide controlled levels of support to give the client a chance to manage through this cycle.”

Adds Michael Cifone, senior vice president of surety for American Safety Insurance: “Cash flow problems usually arise much quicker with the smaller contractors, as they are usually squeezed between slow-paying owners and having to meet payroll each week.”

However, ample surety is available for qualified contractors with strong balance sheets. “Capacity in the small market is adequate, but smaller firms must demonstrate a certain level of experience and sophistication and have access to capital to obtain surety support. Poor quality financial presentations often are a major limitation for access to surety credit,” says Mike Foster, executive vice president of underwriting for Merchants Bonding Company.

Loss activity in this segment has prompted sureties to implement stricter underwriting standards. “Almost all of the sureties are doing some degree of reviewing or re-underwriting for this line of business due to the impact the sustained and deep downturn in economic activity in the construction industry has had on companies in the arena,” says Carl E. Dohn, Jr., president of Dohn & Maher Associates and the National Association of Surety Bond Producers.

Well-managed small firms benefitted from set-aside programs through various government agencies and obtained bonding. These programs facilitate the participation of small, minority- and women-owned businesses on major federal construction projects that they otherwise would not be able to bid on or win. “As a result of increased activity within various Small Business Administration programs, it has been our experience that set-aside contractors have experienced an easier time obtaining bonding for projects. This is partially due to the fact that large contractors are seeking opportunities to engage with these smaller firms in an appropriate structure in order to participate in the projects themselves,” says Jim Tressel, vice president and senior contract underwriting officer for Liberty Mutual Surety.

While financially sound contractors may find surety bonds available to them, many contractors pursuing set-aside projects are in the same boat as other struggling small contractors. “Many of these companies are new and show limited experience and capital. Most of these cases can only be handled with the support of outside indemnitors or mentor-teaming relationships. In spite of more limited competition for this work, many set-aside contractors are still unable to translate this into higher margin work,” Foster says.

Another challenge is each agency with a set-aside program has different rules regarding the arrangements small contractors may enter into with larger contractors. “Until there is consensus, transparency of the bonding arrangement is critical,” Dohn says.

Middle
With backlogs being depleted for mid-size contractors, an increase in the frequency and severity of claims occurred, especially at the lower end. Surety executives say this segment remains the most competitive with sufficient surety for qualified contractors.

“Contractors of this size have generally done a good job of managing through the down economy and are weathering the storm better than the smaller contractors; however, they too have felt the pains from the limited projects and long bid lists that persist in the marketplace,” says Mike Noe, executive vice president of construction services for Travelers Bond & Financial Products.

As with all segments of the market, underwriting remains disciplined, and sureties report that more emphasis is being placed on mitigating subcontractor risk

“Contractors with subpar results are experiencing more problems than others, but certain sureties have stepped forward to provide solutions that include collateral and other methods to mitigate risk,” says Mike Bond, head of surety for Zurich Surety.

Large
Large contractors have not experienced as many significant losses, and surety credit will remain available to financially secure contractors. “While the economy has negatively affected many large contractors, they generally have greater staying power than smaller companies,” says Doug Hinkle, chief underwriting officer of CNA Surety. “We have seen little change to underwriting standards, and there is adequate surety capacity and availability, particularly with the weak construction market that is presenting far fewer work opportunities.”

Because of this staying power, sureties are willing to meet the bond needs of their large clients. “Project size has proliferated in recent years, as has the use of joint ventures, so large customers find themselves working with multiple sureties and multiple partners to compete for the large project work for owners,” Bond says.

Mega
Mega-contractors had larger backlogs going into the recession and the financial capability to absorb losses better than smaller contractors during the last few years. However, many of the jobs that carried mega-contractors through the recession are wrapping up.

“The backlogs are starting to be reduced, and new work may have significantly lower profit levels. It would not be surprising to see some of these accounts get to a position of significantly reducing their operations,” Dohn says.

Overall, the poor economy did not have a major impact on contractors in this market segment. “Consolidation of the customer base has caused sureties to look at their aggregation exposure to these mega construction companies, but to date this segment has received sufficient capacity and underwriting attention to manage through the complex mega-project bond exposures, particularly in the sophisticated infrastructure marketplace,” Bond says.

Most sureties serving this market currently focus on retaining existing customers and attracting new ones.

Surety Outlook
Surety executives expect loss frequency and severity to increase in 2013, especially in the smaller end of the market. “We anticipate a higher-than-average claim count as subcontractors and suppliers seek to preserve their rights and more aggressively pursue collection of accounts receivable,” Foster says.

Adds Hinkle: “I would expect the severity of loss activity to grow as more middle-market contractors struggle with competition and the long duration of this weak market.”

Despite anticipated increases, executives say losses currently are in line with historical norms. “The industry in general has remained rational, and there remains plenty of bond capacity, especially for contractors that have responded appropriately to the financial crisis and adjusted their business plans accordingly,” Williams says.

Adds Bob Cave, chief underwriting officer of SureTec: “It is ironic that we probably have the greatest amount of surety capacity in memory at the same time that contractors face the most difficulty in obtaining work.”

Irvin notes another major concern for contractors is managing the exposure to contractor default and/or underperformance. “Healthy contractors can quickly become infected by one sick subcontractor,” he says. “The intense competitive environment often makes it difficult to bond every subcontractor, so it is important for general contractors to have a thorough prequalificiation and management process.”

Adds Williams: “Contractors should be very selective in underwriting owners and subcontractors, and be mindful of a trend toward transferring more risk to the contractor. Transparent and frequent communication between a contractor and its surety, as well as other financial partners, is essential.”

Businesses that reduced overhead and kept their finances in order during the last few years should be well-prepared to handle the recovering economy. “The hope is that after the election, money will shake loose for construction activity,” Booth says.

Yet, Cifone believes it is “unrealistic to expect that we will see any significant improvement in the construction economy in the foreseeable future as the federal and state governments attempt to deal with their runaway budgets. We do not expect to see an increase in public funds allocated toward construction projects, and private funds are slow to invest in new projects,” he says. “The low cost of borrowing has been unable to entice a significant amount of private investments in construction-related projects.”

Only time will tell if investments in construction—public or private—will pick up and increase contractors’ job opportunities. “Firms whose balance sheets have been negatively impacted during the downturn need to be even more thoughtful in their pursuit of new opportunities,” Noe says. “Putting work in place is important coming out of the down cycle, but ensuring it is profitable work at adequate margins is even more critical.”

Many contractors will be tempted to downsize or reduce overhead too much in the near future and—when the economy improves—add overhead too quickly, expand their geographic reach and the type of work they do, and take on bigger jobs. “All of this can be challenging in good times,” Dohn says, “let alone amid the tight economic conditions plaguing today’s construction markets.”

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