Surety Market Update 2013 | Aon

Surety Market Update 2013

Table of Contents
Surety Market Update 2013 2
Only a bump in the road . . . 2
The surety market leaders versus the rest of the pack . . . . 2
Construction Economics – 2
Contract Surety Results – 3
Commercial surety market dynamics – 4
Peer Performance – 4
Surety Strategies and Best Practices for 2013 – 5
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Surety Market Update 2013
Only a bump in the road . . .
The construction economy is rebounding, albeit slowly. We are seeing improvements in residential
spending, lower construction unemployment and modest, mid to upper single digit forecasts for 2013
spending levels. However, the current economic recovery is weak when compared to prior, post
recessionary periods. Contractors have won new work but margins are half what they were, or less.
By now, we would have expected to see more contractors default and a noticeable rise in the surety
industry loss ratio. But so far it has only been a small bump in the road and forecasts are suggesting
the bump will not get that bad for surety markets. Contractors on the other hand are finding the market a
challenge with tighter margins, but many have adjusted overhead and cost controls and are doing well.
Several contractors have also developed risk management tools to transfer risk and add to margin. We
do not anticipate a dramatic worsening of the surety loss ratio over the next few years. We expect to see
losses grow, but not to a point of greatly upsetting surety market conditions for capacity, rates and
underwriting standards.
The surety market leaders versus the rest of the pack . . . .
The surety industry remains concentrated with the top five carriers having over 50% market share and the
top 10 making up 67% market share. These larger surety companies tend to get the best opportunities,
participate in the marketplace across all geographies and have diverse client size (including all of the
largest construction companies) and type. They write more large GC’s, primes and civil firms and have
fewer small, specialty contractor firms. The loss ratio performance of the larger sureties continues to
perform better than the rest of the market. For example, for the full year 2011 the top 5 loss ratio was
4.3% while the rest of the market reported 18.4%, still very profitable, but over four times higher. For nine
months 2012, the top 10 surety loss ratio was 12.5% and the rest of the surety companies reported a loss
ratio three times higher at 35%. In addition to the general credit quality of the larger clients and surety
underwriting practices of the top 10, a partial factor is the Subcontractor Default Insurance (SDI)
marketplace. Here many of the largest GC firms run their own SDI programs and have taken premiums
out of the overall surety marketplace, especially for those specialty trades that meet their pre-qualification
requirements. SDI programs often allow the sponsor GC to opt out certain subs and require traditional
surety bonds if they do not pass their internal SDI review standards. This can create some adverse
selection for surety markets whose books of business are oriented to small and middle
tier subcontractors.
Construction Economics –
2012 was overall, an “up year” for the construction numbers. Put in Place Construction Values as
reported by the U.S. Department of Commerce stood at an annual seasonally adjusted rate of $866 billion
which is up 9.1% over the prior 12 months. Construction unemployment fell from 16.4% at year-end 2011
to 13.5% at the end of 2012. That is an improvement, but still double the unemployment rate the
construction industry had in 2006 (6.7%). Residential construction grew a healthy 20% from about $250
billion at year end 2011 to over $300 billion at year end 2012. Several of the public owned home builders
have been recently upgraded by the rating agencies. Private construction led the way with growth of 16%
in 2012 versus a disappointing, but expected 1% decline in public construction. Some notable segments
show Power up nearly 30% along with Manufacturing up 21%. Conversely, Highway, Sewer and Water
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were down 5%. Congress has struggled to pass much of anything but did manage to finally pass the MAP
21 (Moving Ahead for Progress in the 21st Century) bill, which after 33 months of delay, provided
$104 billion for the two year transit reauthorization. It also boosts the TIFIA (Transportation Infrastructure
Finance Improvement Act) loan program which has been a key tool in P3 projects. Aon’s Infrastructure
Solutions group is tracking $17 billion of new P3 (Public Private Partnerships) procurements with a heavy
emphasis on roads, bridges, tunnels and airports (75% of the $17B).This procurement method continues
to evolve in the US. The European, Canadian and Australian models are being modified to better fit the
US political framework (e.g. O+M might be the public responsibility in the U.S., rather than a private
concession as is more common around the world). We expect public funding challenges to propel this
trend and grow as a method of procurement. Often the debt providers in a P3 project are the most vocal
relative to performance security requirements and lean towards liquidity to address any delay in
performance which in turns delays the availability payments (e.g. tolls) to service the debt. Several of the
leading surety companies have developed performance security alternatives to the traditional
Performance and Payment bonds used on public procurements. The new surety product development
adds the liquidity feature, but also provides a much larger performance limit and important payment
protection for labor and material providers. Workers, subcontractors, material providers are often not at
the bargaining table, but are important constituents for the public entity.
The biggest problem with the 2013 economic outlook is the uncertainty around fiscal policy. Therefore the
confidence level of consumers, bankers, public and private owners, etc. remains cautious. This continues
to suppress investment preventing robust economic recovery. However, we also believe this is building
pent up demand, particularly for infrastructure projects where needed improvements are being delayed,
but eventually will need to be addressed. A rapid up-turn in the economy will create a potential increase
in default risk as contractors will need to shift from a slower cash flow environment to an accelerated
need for cash to expand backlog. In fact, some sureties and bankers feel a significant factor in the
relatively modest amount of defaults in the last few years can be attributed to the negligible rate of
economic growth and therefore less strain on cash flow.
Contract Surety Results –
Just when you thought it might be easy to predict the direction of the surety loss ratio, we saw the
3rd quarter industry loss ratio drop from 24.4% in June 2012 to 19.8% at September 2012. This is still an
increase over year end 2011 which closed out at 13.7%. However, the industry remains highly profitable
having reported $8.4 billion in underwriting gains for the five year period 2007 through 2011. Assuming a
surplus ratio requirement of a conservative $1 of surplus for every $1 of premium written, the industry has
a five year ROE of 32.1%. This is why we have seen the growth in capacity offered by individual markets,
new market entrants, larger single bond amounts, rate reductions and in general a competitive surety
marketplace, in spite of the severe downward trends in construction economic measures since 2007.
It is also important to understand that the direct loss ratio reported by individual companies is masked by
reserve releases from prior years to off-set current year losses. For example, Travelers reported negative
losses in 2011 of $131 million and therefore a -15.4% loss ratio in 2011. Through 3Q 2012 they are
reporting negative losses of $9.1 million and a -1.5% loss ratio. Liberty is also reflecting fewer losses as
a likely result from prior year reserve releases. They reported losses of $76.6 million at September 2012
which is down from $131.6 million in losses 90 days prior at June 2012. This simply reflects that the
surety companies anticipated worse loss development than has occurred and therefore accounting rules
require them to release redundant reserves. This reserve release off-sets other losses in their book.
Therefore it is important that contractors concerned about the risk of subcontractor defaults recognize that
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the true loss picture from defaulting contractors is likely higher by as much as a couple $100 million in
losses than shown in the Surety industry loss results.
The contract surety top line peaked in 2007at $3.47 billion and has fallen modestly each year since. The
last full year of contract surety premiums reported was for 2010 and was $3.18 billion. The other major
component of the surety industry results is the commercial surety business which stood at $1.24 billion
in 2007 and has grown to $1.35 billion at 2010. The commercial surety business has also been quite
profitable and is experiencing the same trends of new entrants, capacity increases and competitive terms
and conditions.
Commercial surety market dynamics –
Basel III, the global bank regulatory standard for capital and liquidity is moving into its next phase. It will
increase the capital requirements on a number of banking activities, one of which is letters of credit
(LC’s). We have seen an increase interest from global companies to explore surety product alternatives
to letters of credit. We also expect global construction companies who have traditionally relied on LC’s
outside of the US for performance security (particularly in the P3 space), to re-visit the surety alternative.
In general, we expect Basel III will increase demand for surety by construction and non-construction
companies. Commercial surety is even more profitable than contract surety over the last several years
and has attracted new capital and markets. Competition is expected to remain keen.
Peer Performance –
Many of the surety companies have been building their financial data bases and are in a better position
today to measure credit quality of their book of business and to make relative comparisons across their
portfolio. Many firms have substantially increased their capital base through retained earnings in the past
five years. As a result, there are many stronger construction companies competing in the marketplace
today on larger jobs. While many firms are still doing well, they are not as profitable as their record years
in the mid to late 2000’s. From a surety perspective however, they are less risky credits because they
have stronger net worth positions which is essentially the buffer any surety company has from loss – the
contractors net worth is depleted first. Many have also built up impressive cash balances as there has
been less demand to fund new work. This is particularly true of some of the largest firms who have also
been looking at this market place with strong cash and lower organic returns as an opportunity to grow
through acquisitions. They see now as the time to position themselves for the upturn in geographies and
specialty skill sets they do not currently have.
As project size has grown in general, we are seeing increased joint venture activity. This also lowers
surety risk as the joint and several nature of JV’s put’s multiple contractor balance sheets ahead of surety
default involvement. In the process of partners underwriting their partners, many firms have exchanged
financial statements. Some larger national contracting firms are surprised at the size of retained earnings
and cash balances at some firms traditionally considered smaller, local contractors. This will likely make
margin improvement slow to achieve as more firms are qualified on larger projects than once thought.
However, many firms are reporting their best margin work is on larger JV projects where the competition
is more rationale and it is less likely for a JV team to be overly aggressive in taking on new work to keep
crews and equipment busy. Major JV’s also have fewer bidders in general, as more firms team up and
often need to go through a pre-qualification process and short listing.
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Surety Strategies and Best Practices for 2013 –
At a recent industry event we discussed the surety market with several senior surety company executives.
All commented on the concerns related to the prolonged market conditions, fiscal funding challenges and
subcontractor default risk. However, none of them had major concerns about their own portfolio and none
felt the surety industry loss ratio would exceed the upper 30’s in the next few years. As a result, we do not
forecast any sudden change in surety availability, pricing or capacity in the next 24 to 36 months. This
does not however mean that individual surety companies might not experience higher losses than the rest
of the industry resulting in changes in their responsiveness, management or competitiveness. We have
already seen this trend over the last 24 months.
As a result of the expected market conditions we recommend surety best practices as follows:
1. Continue to stay in close touch with your senior surety partners. You get a carrier specific perspective
from the company people and a broader marketplace perspective from your Aon surety broker.
2. Meet new potential JV partners as the best relationships open up new opportunities for both.
3. Develop a solid understanding of the P3 and DBF (Design Build Finance) procurement methods and
related performance security issues.
4. Be in tune to acquisition opportunities as some firms are not willing to re-invest equity (including
sweat equity!) in today’s market, whereas other firms are looking to make efficient uses of
excess capital.
5. Explore project insurance opportunities as they can add to the construction margin as well as bring
consistency to coverage and increase buying power.
6. Benchmark best practices as the bar keeps moving. Standing still, means being left behind.
7. Consider the pros and cons of surety default work.
8. Be sure to review the quality of your subs bonding company and take the right steps in the event
of a bonded subs default.
9. Review and update subcontractor pre-qualification practices and compliance with those standards.
Also review steps required when award will be made to a non-qualifying sub.
10. Be diligent in contract review as owners and their legal representatives are pushing risk transfer even
more aggressively to contractors.
Aon Construction Services Group has over 100 surety professionals ready to discuss the marketplace
and opportunities with you more broadly. We will even buy you lunch!
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Contact Information
Paul Healy, CPCU
National Practice Leader – Contract Surety
paul.healy@aon.com
617.457.7719
www.aon.com/construction
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About Aon
Aon Corporation (NYSE: AON) is the leading global provider of risk management services, insurance
and reinsurance brokerage, and human capital consulting. Through its more than 36,000 colleagues
worldwide, Aon delivers distinctive client value via innovative and effective risk management and
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