Construction surety bonds ride
the economic cycle

Agents advised to maintain close communication with sureties

By Dave Willis

The construction surety industry follows the fortunes—and misfortunes—of the construction business. Beginning in the 1990s, the United States experienced what Roland Richter, vice president of marketing for Liberty Mutual Surety, describes as "one of the longest positive runs for construction that the industry had seen for a long time. That continued to just after the sub-prime fiasco of a couple of years ago—in 2008."

In addition to strong building activity, the construction surety market benefited from factors in the non-construction side of the business. Stung by large corporate bond losses—think Enron and other high-visibility bankruptcies in the early 2000s—underwriters became more conservative, Richter explains. "They were more careful in their underwriting and more realistic in their pricing," he says. "That led to the surety industry having its best results in a long time, in terms of loss ratio. We had the right situation—where sureties were careful, contractors were busy and the economy supported it."

The situation has changed. With today's depressed construction market, surety premiums are down. At the same time, thinner profit margins and a lack of available credit have affected contractors' ability to withstand the economic turmoil, which has led to an increase in surety losses. Henry Nozko Jr., chairman, president and CEO of ACSTAR Insurance Company, calls it a perfect storm.

That storm is having an impact. "While the last few years have been pretty good for the surety industry," says Nozko, "the loss ratio is rising. Talk in the industry says 2010 may wind up being about break even. Results for 2011 may deteriorate more if losses continue to climb and revenues remain weak."

Prospects for an economic turnaround aren't particularly bright. "The commercial construction market really dried up over the last few years," says Richter. "Now we're facing huge state deficits across the nation, so public construction is also dropping off."

Over the past several years, the surety marketplace has changed. Travelers Insurance bought up some providers and Liberty Mutual purchased regional carriers with surety operations. "We acquired Safeco and Ohio Casualty and created Liberty SuretyFirst, which specializes in bonds for small to mid-sized businesses," says Richter. "That facility supplements Liberty Mutual Surety's traditional focus on larger capacity business." RLI has announced plans to buy Construction Bonding Insurance Company and CNA Financial is buying back CNA Surety, Nozko adds.

"This means there are fewer places for contractors to go," he says. "It doesn't necessarily mean the underwriting terms and conditions will change, but the fewer markets there are, the less opportunity a contractor has to shop for his surety credit."

Future prospects aren't especially bright, but they are, perhaps, less grim than the last couple of years. "For the first time in four years, the U.S. Census Bureau is predicting a marginal increase in construction for 2011," says Nozko. "It's just 2%, so it's basically flat. But we believe that may lead to some renewed growth in 2012."

Agent opportunities

Regardless of underwriting results, the surety bond business can be lucrative for independent agents. Commission rates generally start at 30% and drop as account size increases. Of course, agents earn the higher commissions. "They do a lot of work on behalf of the sureties when managing an account or a piece of business," Richter notes.

"When we underwrite an account, we need all of their financial statements, all of their work in progress—the schedules of all projects underway, bank statements, tax forms, anything that will help us evaluate the financial viability of the customer," he adds. Such data helps underwriters judge not only the current fiscal soundness of the contractor, but future viability as well.

"When we write a bond, we're looking to when the contract is supposed to be completed," Richter says. "The owner wants the project done and on time. So we need to forecast that the firm will last the lifetime of the obligation and will be able to deal with anything asked of him during that time. The term is prequalification."

Agent legwork plays a big role in this. "A good agent has the ability to go out and know what the surety wants, get that information and match the customer to the right surety, because most sureties have slightly different niches in which they operate," Richter says.

A good agent also sticks close to his client—and the surety. "Agents need to keep their surety markets and their contractor clients as close together as possible," says Nozko. "For instance, instead of conducting annual reviews, make it biannual—maybe quarterly." Such work minimizes surprises—something that can doom a relationship.

"If a contractor is having a tough year financially, even if he doesn't have any surety claims, the surety should be brought in as soon as possible," Nozko explains. "The worst thing for a surety today is to let the contractor operate for a year and then get a year-end statement, without any advance warning, that shows a loss or revenue drop." When this happens, sureties can stop giving credit—something Nozko is seeing more and more these days.

His other advice: Stay the course. "Now is probably the worst time on earth for an agent to market an account and change it from one surety to another, just for, perhaps, a marginally better rate or program size," he says. "What they should be looking for is history and relationship. That's money in the bank."

Agents and brokers without a surety book may want to consider adding the line, "In some places, there is an aging demographic in the surety agency world," says Richter. Surety agencies without continuity plans are sometimes looking to sell. "If an agency has the ability, they should consider buying an operation that is strong in surety."

Growing a surety business is also possible. "If agencies want to develop staff knowledge in surety, they should reach out to sureties," Richter notes. "For instance, we have a new-hire training program, which we've opened up to our agents." This not only benefits agents, but company staff, as well. "It helps our people get the agents' perspective," he says.

Agencies looking to grow the business at, perhaps, a more controlled pace can build construction bonds into a broader surety approach. "Small commercial is a great way for an independent agent to get into the surety business," Richter notes. "Write some probate bonds, some miscellaneous bonds, some license and permit bonds for small artisan contractors. Start small. And from there, start moving into some of the larger construction surety bonds."

The author

Dave Willis is a New Hampshire-based insurance freelance writer and regular Rough Notes magazine contributor.