A role for agents in a competitive contract surety market
Losses are growing, but competition remains a factor in keeping rates down
By Dave Willis
As the construction market goes, so goes the surety market—for the most part. And the construction market has seen some tough times. "The operating environment for contractors remains very competitive," explains Robert Thomas, president of Hanover Surety. "That is forcing many good contractors to survive on a low backlog of work.
"The large number of contractors competing for the same jobs is driving down pricing and eliminating the margin of error that can be tolerated," he adds. "The fittest are surviving and there is a slow stream of work returning so many are hopeful the outlook will improve."
"Contract surety is competitive," says Susan Sallada, CIC, president of Universal Service Agency. "Large contractors are competing on projects that, in the past, would have only been bid on by small to medium-sized contractors. Economic pressures have forced all contractors to look for work wherever they can find it."
Roland Richter, vice president of marketing of Liberty Mutual Surety, says that weak demand and increased competition is reducing margins and resulting in more contractors showing losses on their balance sheets. "This has an impact on surety," he explains. "Increased contractor losses lead to more defaults on bonded projects, increasing surety losses."
"The contract surety loss ratio is up from 2011," notes Lynn Schubert, president of The Surety & Fidelity Association of America, "but it's still very good. Part of the cause of increase in the ratio comes from the fact that premium remains down because of the lack of construction money."
Schubert says 2012 loss ratios may not yet be wholly reflective of the fact that sureties are paying a lot of claims. Increased claims activity seems to be occurring more in the subcontractor level than with general contractors, she adds, and is higher in certain specialty lines. According to Sallada, "Obligees and owners have been quicker to turn in claims to the surety, rather than try to mediate or resolve the contract differences."
According to Richter, sureties have exercised responsible underwriting and pricing over the last decade. "That is mitigating some of the negative economic effects of the current construction recession," he explains. In addition, he notes, marketplace competition is strong. "With seven years of very positive results, interest in the surety business is up," he says.
Adds Sallada, "There is rate competition and capacity for the most creditworthy accounts. Recent entry of a number of new sureties into the marketplace has increased competition. It remains to be seen how they will impact the marketplace in the coming years.
"Given the profitability of surety over the past seven years, some companies might like to see more surety volume," Richter notes. New entrants, particularly in the smaller end of the market, coupled with increased capacity in the middle market and for large accounts have had some impact on underwriting conditions and pricing.
Sallada doesn't expect to see relaxed underwriting standards in 2013. "Increased losses caused by the economic decline of the last few years have led to a tightening of underwriting. Most sureties say they plan on maintaining these standards going forward."
Losses may make some classes of business more difficult to write. "Developers reentering the marketplace with new projects have few alternatives for site improvement bonds," Sallada explains. "Municipality bond language has become more onerous, due to past losses."
More surety companies are running personal credit checks on principals, not just business credit reports, she adds. "These personal reports are affected by things individuals may be unaware of, such as medical bills not paid by health insurance companies, restructuring of bank debt on real estate, payment history by divorcing couples, payment history on co-signed loans, and more," she adds.
"Certain bond types, such as union wage and welfare bonds, have become very difficult to obtain," Sallada notes. "That's due to losses suffered by sureties and unions' lack of willingness to work with contractors on benefit payments versus filing payment demands to surety companies on these bonds."
Contract surety bonds
While financial statements of many contractors have shown decreases in working capital and stockholder equity over the past few years, things are changing. "As contractors look to undertake bonded projects, the question remains, 'Will their financial statements support their bond requests?'" says Sallada.
A growing number of surety companies are looking at alternate means to increase their willingness to support contract bonds. "In the past we rarely saw sureties use funds control/administration," she explains. "A number of surety companies have either partnered with independent funds control companies or have taken on this function internally."
More sureties are accepting collateral in support of bonds than in the past, as well, Sallada adds. "A number of surety companies have filed debts and credits, as well as completely separate contract rates based upon credit scores and financial capacity of the principal, thus allowing them to write, at a higher premium, bonds they might not have written in the past," she says.
Now is a good time for retail agents and brokers to prepare their contracting accounts for potential bonding opportunities. "Alert those contractors using small surety programs based on personal credit of their bonding capacity limitations," Sallada advises. "To qualify for larger surety lines, these contractors must have their CPAs prepare reviewed percentage-of-completion-based, year-end financial statements." Surety companies expect these statements to be issued within 90 days of the contractor's fiscal year end.
She recommends that agents not link bonding programs to property/casualty programs. "While there are situations where a strong P&C account can help bonding capacity with the same company, there are many more situations where the P&C agent has jeopardized the P&C account because of bonding," she explains. "The financial capacity and financial presentation of an account is the key driver in bonding. Retail agents should keep a clear distinction between P&C and bonding programs in the mind of contracting accounts."
Thomas encourages agents to assess their performance and skills in order to grow their business. "In a tough economy, it's more important than ever to retain customers and generate new ones," he says. "With this in mind, agents must make sure they're meeting their clients' present and future needs.
"Agents must be ahead of the process," he adds, "and make sure they have secured the best surety relationship for their clients. This will help contractors remain competitive for new business opportunities and keep their operations running smoothly."
Richter says agents should look at the stability of their surety markets. "Don't just look at one-year results, but over the longer term," he notes. "Look at the staying capacity of your markets and at the critical mass needed to manage a down cycle. Critical mass—the ability to withstand a large loss—is starting to become more important."
Developing new business
Finding new business could be a challenge in the current market. "Customers experiencing financial stress are less likely to make changes," explains Richter. "They're not looking to add risk by shifting to another surety or agent. That said, if an agent can add value, a contractor that may have stress and is not able to get bonded may be looking for new sureties or agents that can access them."
Thomas agrees. "Agents that sell value, not price, will win," he explains. He encourages agents to source new sales by leveraging their best assets—existing satisfied customers who will give referrals and/or recommendations. His company is helping agents add value, through development of a Risk Mitigation Unit that he says offers construction, legal and accounting expertise, as well as problem-solving skills needed to successfully resolve disputes and pursue affirmative claims.
According to Richter, transparency is key. "In difficult markets, where contractors experience more losses, underwriters need to ask more questions and need to better understand the risk. Agents who provide information quickly and candidly, and who maintain an open dialogue between all parties, have a better chance of maintaining underwriting stability and bonding capacity for customers."
Rob Duke, director of underwriting and counsel at The Surety & Fidelity Association of America, concurs. "Good communication goes a long way," he says. "Underwriters have started to see financial statements with more red ink than black. If an agent can provide information regarding the financial situation—reasons behind it and what strategies might be in place to come out of it—the underwriter needs that information. And the more, the better."
He also encourages agents to communicate with sureties in advance of claims. "The agent or broker should enter into a conversation with his or her company or companies to find out what the surety expects if a claim does occur," he notes. "Too often, the agent may not know what to do, how involved to be, or how much information to provide.
"It's likely the surety will encourage the agent to share information on potential claims or performance issues early on," Duke adds. "There is a tendency to want to withhold information when there's a problem, but by addressing it up front, bigger problems can be avoided."
Transparency and communication goes beyond the agent-carrier relationships. "Agents need to maintain a high visibility with customers," explains Richter. "They should give clients regular updates on where the sureties are and what they're thinking. Strong relationships require more face time."
Agents and brokers should understand that special circumstances or opportunities may exist that can help them build their bond business. "We see increased frequency of performance and payment bonds when banks are involved with financing a project," says Sallada. "Also, large general contractors and owners are using surety bid bonds and consent of surety letters to pre-qualify contractors and waiving final performance and payment bonds to save money."
She warns contractors to be cautious of contracts that indicate a bond is required. "The contractor may never be asked to produce the performance and payment bonds, and they may assume they were waived, only to find out they can't receive project payments until the required bonds are submitted," she notes.
Duke says agents and brokers should look for new opportunities with government entities. "As local and state governments get tighter, we're seeing them start to outsource certain activities they did themselves in the past," he explains. "These outsourced services, whether they're janitorial services or accounting or bookkeeping services, are resulting in contracts; a bond could secure the performance of that contract."
Certain contractor types may also yield new opportunities. "As government contracts pick up, small and emerging contractors or disadvantaged businesses will have more opportunities," Schubert explains. "It can be tough to find enough of these firms. We've been working hard as an industry to educate small and emerging contractors on what it takes to become a bondable contractor."
Agents can help in this process. "There are national programs they can take part in, and there are local programs, as well," she says.
Surety professionals are optimistic about the business and about the opportunities for retailers. Agents and brokers who heed their advice, who understand the business, and who build strong carrier and client relationships stand to prosper over the long run. As Thomas says, "Surety customers who appreciate professional advice will be willing to pay for the value the agent can bring, and they'll be loyal for years to come."