The U.S. surety Industry will continue to realize growth in overall premiums, and likely experience a modest increase in loss activity in 2017.
With clear skies overhead, most contractors are enjoying healthy backlogs and a return of acceptable profit margins–the “telltale” sign of a true economic recovery. However, there are gathering clouds on the horizon. While times are good but not great, prudent contractors are studying the elements, properly manning and provisioning, and regularly charting their destinations to be disciplined and stay on course.
Both the U.S. economy and surety industry remain resilient and strong headed into 2017. However, dynamic factors in both will affect the future and should be considered when making business decisions.
- Although the U.S. economy is slower than most may like, it continues to experience one of the lengthiest recoveries in its history (seven years). Current low inventories will be a key factor in fueling future growth.
- Based on the Architecture Billings Index (ABI), which serves as a leading indicator for nonresidential construction activity, demand at A&E firms reached its highest level in more than two years in the first half of 2016. Although recently there has been a slight slowdown in some regions, the current ABI still shows continued positive growth in most states, including local demand in major metropolitan cities.
- The American Institute of Architects’ (AIA) Consensus Forecast for 2016 and 2017 predicts an overall slowing of growth in construction spending during the year ahead. Despite growth in the U.S. economic, employment and consumer spending rates, various factors might slow the pace of the future economic expansion.
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Although the Feds have adopted an interest rate strategy of “lower for longer,” and there has been a further emergence of global central banks, new domestic banking regulations have lenders tightening up on lending practices. Additionally, more strategic approaches to construction investments are being taken until the results of the 2016 election are known. Geopolitical and terrorism risks also will persist.
In the meantime, materials prices will continue to drop as the economy slows for overseas materials manufacturers. Wages will continue to drive construction costs, with a shortage of trained workers. As there will be an easing of construction spending in the future, once again competition and margins will be tested for local contractors. Although an overall slower economic expansion is imminent, a slowdown does not translate to negative results. It simply reflects a stabilization of the market and a decreased rate of growth.
The surety industry has charted a similar course as the economy grows steadily through the current cycle. The 2015 results showed the most profitable year in the history of the industry. The estimated total industry direct-written premium for the 2015 calendar year was $5.62 billion, with an 18.3 percent loss ratio (the U.S. Surety Industry breakeven loss ratio is generally 34 percent). This record-breaking pace continued through the second quarter of 2016, with more than $2.98 billion in total direct premium written and an 18.4 percent loss ratio–slightly higher compared to the second quarter 2015.
With market capacity growing, a surprising number of new players entering the industry and more competing products, such as subcontractor default insurance (SDI) and letters of credit, the supply of surety bonds continues to outgrow the demand. There has been an increase in the number of carriers, with the lion’s share of premium remaining with the top five largest surety companies: Travelers, Liberty Mutual, Zurich, CNA and Chubb (recently acquired by ACE LTD Group). These top carriers write 50.3 percent of all premiums. In fact, the top 10 surety companies control 63.7 percent of the overall surety market. Despite the current top-heavy profile of the market, the U.S. surety industry remains very competitive. There are now clear signs of softening underwriting terms and conditions for sureties that are committed to acquiring market share and retaining good, solid contractors.
Recent years also have shown a continued acquisition/consolidation trend, with the acquisition of Chubb & Son Inc. Group by ACE LTD Group and HCC Surety Group by Tokio Marine Holdings. Three years after being acquired by Tokio Marine Holdings, Philadelphia Insurance Companies launched a surety operation. More concerning is the recent trend of many “non-contract” surety companies entering the contract underwriting arena.
This new “arms race” for premium has exposed many of these new players that have brought with them the very loose interpretation of underwriting standards that they have been accustomed to in facilitating commercial (non-contract) bonds. Naturally, as demand increases to meet the current supply and these new companies increase their market share, expect to see a continued increase in loss frequency in 2017 and 2018, and potential market adjustment as some of these firms are forced to leave the market.
A new development in the market has been the expansion of the number of insurers and dramatic increase in losses in SDI. As a competing product to surety bonds, SDI continues to take surety premiums away from the contract surety market. Now with significant apparent losses in the SDI market, SDI placements are being re-underwritten on a much more conservative basis, with many of the providers tightening the terms and conditions. SDI will still take its share of premium from the surety industry, but for how long remains unknown.
The future of the surety market will remain bright if public spending continues to increase based on the new administration funneling funds into infrastructure, specifically in the transportation, education and military sectors. The concern that remains is whether these public funds will be enough to finance the increase in demand for infrastructure projects. Many believe public funding will not be adequate and the United States will begin to see an increase in public-private partnerships (P3s). P3s are an alternate procurement method where project financing is obtained through both public funds (tax payers) and private investors (often from foreign entities).
P3s began to pick up traction in the last two decades on larger capital improvement projects and have been proven to be a successful method for infrastructure financing in Europe and Canada. With the mounting federal, state and certain local budget deficits, the United States is poised to see an acceleration of P3s as an alternate procurement method. As P3s become more prevalent in the U.S. construction market, disputes over P3 contract terms and bonding requirements will emerge as a key issue in the upcoming years. Contractors competing in the P3 market will need new skill sets, supporting financial partners and stronger balance sheets.
Part II of this series will address manning and provisioning and staying the course. Successful contractors will have the best people, the right mix of backlog, maximize technology, maintain cash reserves, follow a business plan and surround themselves with a circle of trusted advisers.