The 2002 surety market was one of the most challenging ever. Loss activity, the impact of Sept. 11, 2001, corporate governance issues and an uncertain economy all have played a part in bringing about this environment. On top of this, more discouraging news roared in at the start of 2003, so the industry really can’t answer the question: Have we hit bottom yet? The Surety Association of America has released nine-month 2002 results for surety, including:
- Direct written premium of $2.8 billion (up 7 percent over prior period, reflecting price increases put through by many sureties in 2002).
- Direct earned premiums of $2.5 billion.
- Direct losses incurred of $1.4 billion, for a loss ratio of 55 percent (14 percent more than during the same period in 2001).
- Estimating underwriting expenses at 60 percent for each dollar of earned premium, the industry has a combined ratio of 115 percent.
Although a breakdown of contract surety vs. commercial surety results is not available, the overall trend is not encouraging. Indeed, many surety companies have indicated experiencing increased loss frequency in their subcontractors’ books of business. Other significant events occurring at the end of 2002 through early 2003 were:
- An SAA top five surety announced it will limit capacity for all international surety accounts to $150 million, a significant reduction. In addition, it announced the intention to limit the number of sureties with which it will issue co-surety bonds. This change affects both domestic and international clients.
- Another major surety was downgraded by A.M. Best & Company to B+, and the parent company announced that surety was no longer a continuing line of business.
- The Enron litigation involving a major financial institution vs. 11 surety/insurance companies was settled out of court. The sureties agreed to pay the bank $526 million, or more than half of the amount claimed. The specific amounts for each surety range from $160 million to $12 million.
- Another major surety announced a major restructuring, closing 10 offices and eliminating about 45 positions. The good news is that this surety renewed its treaty with no major changes in contract surety capacity, and it continues to be a major player in the construction industry.
More changes coming?
Given the surety industry’s poor results since the end of 1999, there may be additional changes on the horizon. Much has been written during the past two years about the reasons for the surety industry’s poor results, so we need not repeat them here. However, it should be noted that an uncertain economy, combined with existing loss frequency, is likely to continue to result in a cautious underwriting environment. The good news for many leading sureties is that reinsurance treaties were renewed without drastic changes in capacity, although cost of reinsurance continued to increase. The surety industry may be looking at a very tight market for the next 12-24 months; many sureties have indicated that normal conditions may not return until 2005. Following is a rundown of capacity availability and other restrictions:
- Capacity for small and mid-sized subcontractors should not be a problem; this is a segment of the market that is drawing the attention of most of the primary underwriters. In fact, this segment of the contractor population may be the only group that experiences competition for its surety business. This is particularly true for firms that have been profitable, have solid balance sheets and produce the complete underwriting information sureties now require. This includes high-quality financial exhibits, complete work-in-progress reports, etc.
- Capacity restrictions for larger accounts, even those with profitable and financially strong operations, have become commonplace. It now takes two or three sureties to arrange capacity in excess of $500 million for well-run construction firms. This is a direct result of escalating reinsurance costs and the use of co-surety diminution clauses. These clauses automatically limit a reinsurer’s capacity for joint ventures and other large projects. Primary sureties may have to obtain additional approvals from their reinsurers or use more facultative reinsurance (capacity from other primary surety companies) to provide for capacity for these projects.
- Capacity for subcontractors in the environmental business has been reduced, as only the main sureties and a handful of smaller ones have capacity supporting this segment of the market.
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Capacity for large international surety users also is being affected, as the type and size of credit extensions are being closely scrutinized.
- Most contract surety underwriters put through at least one rate increase in 2002, finding it necessary to pass along higher reinsurance costs. Additional rate increases may be on the horizon, depending on a primary surety’s reinsurance renewal and current loss activity. However, some subcontractors may not see rate increases, as sureties don’t want to lose strong middle-market construction business.
- Underwriting has become more focused, with the emphasis on high-quality data and detailed information. Expect to see more consistent underwriting, as well.
The implications of this difficult market for subcontractors can be assessed only on a case-by-case basis. Therefore, it is particularly important to build and maintain a good relationship with your surety underwriters. Surety is a relationship business, and one that applies a fair degree of subjectivity to the final outcome. Surety bonding is a valuable credit source – one that is vital to most contractors’ very existence. This is the most difficult surety market ever, with little opportunity for any improvement in the near term. Having a stable surety relationship has now become a competitive advantage, so guard it wisely. David C. Moylan is a managing director at Marsh Inc. and is the construction practice leader for the firm’s Washington, D.C., and Baltimore offices. Moylan has 24 years of contract surety experience. Contact him by email. This article is reprinted with permission from The Contractor’s Compass Second Quarter 2003, an educational journal of the American Subcontractors Association. The next ASA chapter meeting is April 22 and features a general contractor forum with the D.G. Beyer Construction Company.