Since the economic downturn in 2008, attention in the surety market has been highly focused on the potential for increased claims activity and the resulting losses.
As of 2013, the industry appears to have returned to average loss performance. However, there is still a fair amount of variability among the sureties, which adds to the notion that there may be some bumpy roads ahead.
Anecdotally, it appears that the frequency of claims is beginning to trend downward, but the severity of individual claims is increasing. Several medium and large contractors filed for bankruptcy or simply closed their doors in 2014, and there is a concern that more may follow. The shortage of craft labor, exacerbated by a growing labor demand in the oil and gas industry and the overhead cuts that occurred during the recession, will have an impact. Coupling this with fewer public projects, and an increase in the number of mega-projects, may result in the potential for severe claims.
Be Bond Worthy
A contractor who has a strong balance sheet, best-in-class estimating processes and a track record of successful project completions will enjoy a surety relationship with favorable terms and conditions. All contractors seeking surety credit in this slowly recovering economic environment must continue to focus on the following business fundamentals to be bond worthy:
- maintain consistent financial statements and accounting practices;
- have strong working capital and net;
- manage free cash flow consisting of money in the bank, good borrowing ability and an understanding that interest-bearing debt is a liability;
- reflect accurate work-in-progress estimates listed in the WIP schedule;
- manage project billings (be in an over-billed position, if possible, and do not let under-billings reach 25 percent of working capital, as this is a red flag for sureties);
- demonstrate a pattern of consistent job selection;
- track margin performance (bid vs. completed);
- implement a clear business strategy that leverages strengths;
- do not grow backlog beyond cash-flow capacity (cash management skills are critical);
- formalize and follow subcontractor selection and management processes;
- create strong partnerships with the surety and surety broker; build a strong three-party relationship;
- communicate any issues to partners immediately (no surprises);
- understand contractual obligations; and
- maintain healthy banking relationships.
The surety industry is profitable with more than adequate capacity, but it is operating cautiously with the sense that the other shoe has yet to drop. The combination of a relatively anemic public sector construction market, the abundance of surety underwriting capacity, the perpetual re-underwriting of existing surety portfolios and the need for the surety companies to grow is resulting in favorable terms, conditions and pricing for high-quality construction companies.
Excerpted from FMI’s U.S. Markets Construction Overview 2015.