On the Cusp of Recovery: Bond Producers Forsee Brighter Future for Surety Market

The road you take to work, the school your children attend and the police and fire stations that protect the subdivision in which you live each very likely have at least one thing in common: surety bonds.

Surety bonds provide the public with the security that the contractors working on construction projects in their community will complete the work and that the local laborers and suppliers will be paid. They are mandated by law to be used on public works projects, and owners may often use surety bonds on privately-owned construction projects, too.

Many economic, business and environmental factors affect the state of the surety marketplace and availability of surety credit for construction contractors, as is borne out by analysis of the surety market in the past fifteen years. The market of the early 1990s reacted to the economic recession of 1990-1991 and contractor failures and surety losses of the 1980s by imposing strict credit policies, making it difficult for contractors to receive surety credit.

During the second half of the 1990s, however, the clouds looming over the surety industry began to lift. Construction activity was on the rise, the number of contractor failures was receding and profit margins were beginning to improve. At the same time, funds from premiums were invested in a very hot stock market, motivating some sureties to pursue expansion of their bonding lines. All signs pointed to a brighter future for the construction industry and increased surety capacity.

Through the mid-to-late 1990s, contractors continued to get surety bonds without much difficulty or restrictions. Indeed, in many cases, contractors were even successful at getting restrictions reduced or eliminated.  But as the millennium neared, clouds soon began to gather again above the surety marketplace as surety companies’ aggressive underwriting policies resulted in record losses. The declining economy and stock market decline of the early 2000s and repercussions from Sept. 11, including property and casualty losses, further exacerbated the surety market.

The end result was a tight market with strict underwriting criteria and higher premiums.

To determine how the surety market has changed and will continue to evolve, Grant Thornton LLP produced the 2005 Surety Credit Survey for Construction Contractors. The first of its kind in nine years, the survey provides perspectives from more then 300 surety bond producers on how the economic and financial picture for the construction industry has changed, what factors bond producers consider important when granting credit and how contractors can improve their ability to obtain credit.

The Competitive and Economic Environment for Contractors

Competition is the name of the game in construction. The construction marketplace, regardless of capacity or available jobs, is a highly competitive environment where companies may be tempted to underbid and over-promise to win contracts.Nearly half (47percent) of the bond producers surveyed describe the construction marketplace’s current competitive environment as “about the same” as a year ago, while 21 percent say it is better. Almost one-third (31 percent), however, characterize the competitive environment as “worse” than the recent past.

While local and state governments are decreasing the number of new projects they undertake, an upswing in opportunities in the private sector should continue to fuel not only the opportunity for growth, but also competitiveness in the construction marketplace.

The quest to use capacity may be stimulating competition for financially stressed contractors. On average, respondents report that 15 percent of contractors are experiencing “unusual financial hardship.” Surety bond producers most often cite “low profit margins” (64 percent) as a major cause of the difficulties faced by financially distressed contractors in today’s market.

Low profit margins were also the leading cause of financial difficulties cited in 1996 (45 percent), but for very different reasons. In the mid-1990s, work was abundant. Contractors tried to get higher margins, but couldn’t because they encountered difficulty in both managing the volume of work and finding qualified laborers and supervisors. Today, the market is coming out of a trench and contractors are bidding low to get enough work to utilize available capacity, thereby intensifying competition.

The Competitive and Economic Environment for Sureties

Regarding their own market, surety bond producers are fairly comfortable that demand for surety bonds will be the same or increase over the next three years. More than one-third (35 percent) see the demand for bonds increasing and 42 percent say demand will stay the same.

The volatile surety market of the past several years has had contractors wondering if capacity is still available. But while the outlook for securing surety bonds may seem gloomy, light may be beginning to show at the end of the tunnel.

With claims working their way through the system, surety bond producers are almost evenly split regarding how much aggregate surety capacity will be available in the next three years. One-third say capacity will increase (32 percent), remain the same (30 percent) or decrease (34 percent).

Capacity has sifted markedly since the 1996 survey, when 42 percent said surety capacity would increase.

This shift in available capacity may be a result of surety company consolidation or of surety companies and reinsurers leaving the marketplace. In the late 1990s, many contracting companies had a long-term relationship with their surety company. But due to consolidation in the surety industry and periods of record losses over the past several years, there are fewer surety companies (and reinsurers of surety credit) making bonds available to the construction industry.

This consolidation subsequently caused changes in some long-term relationships. In the past two years, however, some new reinsurers have entered the surety market adding to available capacity and contributing to bond producers’ guardedly optimistic future outlook. This new capacity may enable some construction companies to establish or strengthen their long-term relationships with surety companies.Although bond producers are split on the capacity availability, more than one-third (35 percent) of respondents see the demand for bonds increasing, and 42 percent say demand will stay the same.

Obtaining Surety Credit

While the surety market eases out of a trench and positions for a brighter future, contractors may still find it difficult to acquire the bonds they need. This is due, in part, to the fact that surety companies have become more selective in choosing contractors they will bond or have limited the availability of bonds to existing customers. This selectivity helps to manage risk for the surety and the project owner.

Consistent with the changed marketplace since 1996, 49 percent of surety bond producers say it is difficult for their construction clients to obtain surety credit, compared with 14 percent who said it was difficult in 1996.

More than one-quarter (27 percent) anticipate that it will be easier to obtain credit for their clients next year. Six in ten (58 percent) anticipate that the ease or difficulty of obtaining surety credit will not change next year, while only 12 percent anticipate that it will be more difficult next year.  These responses are a sign of the stabilizing atmosphere in the surety companies.

The ability to obtain surety credit for construction clients may become easier or more difficult depending on the type of project in which the client is engaged. Looking at bonding by project type, 78 percent of survey respondents say it is challenging to obtain bonding for hazardous waste projects. About three in ten say that petrochemical (34 percent), telecommunication (31 percent) and power plant (28 percent) projects are difficult to bond. About half of the bond producers report it is easy today to obtain surety credit for projects in the areas of water/sewer (43 percent), heavy/highway/transportation (45 percent), commercial/industrial (46 percent), and government (50 percent).

Ownership also plays a role in obtaining surety credit. Not surprisingly, more than four in ten (43 percent) bond producers say it is difficult to obtain surety credit for “one-man show” sole proprietorships, while more than half (53 percent) say it is easy to obtain surety credit for C Corporations.

Construction company size is also a factor in obtaining surety credit. As a result of the consolidation of the surety bond market, two-thirds (64 percent) of bond producers say it will be more difficult to obtain bonding for small contractors in the next three years. The same holds true for large contractors: 54 percent say consolidation will make it more difficult for them to obtain bonding.

These findings ring true with the general marketplace perception that smaller and larger construction companies inherently come with more risk. This is because smaller companies can lack established business processes. Larger contractors can generate large claims, or often have a greater appetite for volume than the sureties have tolerance for risk.The outlook is different for medium-size contractors, however. Almost two-thirds (62 percent) say there will be no change to the ease of obtaining bonding. The perception of medium-sized contractors is rosier than those smaller or larger because they typically offer more diversity in the scale and scope of projects-spreading risk = fewer large claims.

Financial Statement Presentation

Properly presented financial statements are integral to obtaining surety bonds. Solid financials show the bond producer and the surety’s underwriter that the construction company is financially qualified to perform the project and presents minimal risk of future claims caused by financial instability.

Surety companies continue to emphasize the three C’s-capital, capacity and character-to develop a thorough understanding of a contractor’s business.

To be assured of a contractor’s financial strength and commitment, sureties are looking at a number of criteria, including contractors that:

•     Manage overhead, including general and administrative expenses
•     Bill, collect and pay subcontractors and suppliers on time
•     Maintain a solid job cost accounting system that is timely and accurate
•     Look for projects that fit the size, skills and location of their company
•     Create an established and effective risk management program

Surety companies are requesting more information and looking at it more closely than during the looser market of the mid-to-late 1990s. To mitigate future risks, underwriters are taking the necessary steps to ensure they bond only contractors that can meet their obligations.

According to the survey, nearly all bond producers agree that a contractor’s financial statement should be prepared using the percentage-of-completion accounting method (98 percent) and contain a contracts-in-progress schedule (97 percent) and adequate financial disclosures or footnotes (94 percent). Nearly nine in ten agree the presentation should contain a completed contract schedule (86 percent) and related-party disclosures (86 percent).

Contractors that are able to provide a history of successful operations not only show that they can successfully complete the construction project, but also build a balance sheet that is a foundation for continued success.

Contractors without solid financials or past relationships in the surety bonding market can find assistance through programs like the Small Business Association Surety Bond Guarantee (SBG) program.The SBG guarantees bid, performance and bonds issued by surety companies to small and emerging contractors and reimburses the surety a percentage of loss, if the contractor defaults. This government guarantee provides contractors that would not otherwise meet surety companies’ minimum standards with contracting opportunities.

Improving Credit Standing

As intermediaries between contractors and surety companies, bond producers can often recommend ways for contractors to become more creditworthy. To help guide construction companies through the process, surety bond producers are doing more legwork and advising contractors on steps to become more bondable. More than nine in ten frequently advise their construction clients of the importance of proper financial presentations (95 percent), to produce interim financial statements (94 percent) or use certified public accountants that are familiar with the industry (92 percent).

Eight in ten of the bond producers frequently advise their clients to communicate their potential problems early in the process (82 percent) and generally improve the quality of their job status reporting (78 percent).

Two-thirds (66 percent) of the bond producers advise their clients to use bonded subcontractors, while only half (50 percent) made such recommendations in 1996.

S Corporations and Limited Liability Companies (LLC) are among the fiscally responsible contractors that are attractive to sureties. While S Corporation and LLC tax strategies are desirable for estate planning and other long-term tax strategies, they also provide owners the unrestricted (no double taxation on dividends) ability to remove accumulated profits from the company. The popularity of these tax strategies and the ease with which owners are able to remove equity from the company is likely why 33 percent of the bond producers report that sureties are placing restrictions on dividends and distributions.

Three-fourths of surety bond producers also report that sureties required personal guarantees in the past year. This is further reinforced by the seven in ten (72 percent) respondents who say more than 80 percent of bonding arrangements require personal indemnification. In the next three years, 58 percent anticipate personal indemnification requirements will remain at current levels, while 35 percent expect requirements will become more restrictive.

Requiring personal indemnification provides the underwriter with a level of assurance that the construction company’s ownership group is committed to the business and will do everything possible to finish their contracts.

In addition, size appears to affect the requirement for personal indemnification. Bond producers who have a larger percentage of small clients more often report that personal indemnification is required. On the flip side, when a major portion of their clients are larger contractors, these agents are less likely to report that sureties require personal indemnification.

2006-Cusp of Recovery

During the surety market of the mid-to-late1990s, contractors were able to obtain surety bonds without much difficulty. In 2006, the surety marketplace is on the cusp of recovery. As a result, surety bond producers are guardedly optimistic about future bond capacity and demand and foresee a future that will continue to be challenging for contractors. To position themselves as attractive candidates in a still tight bonding market, sureties are urging construction companies to achieve internal efficiencies, report consistent profitability and create an environment of effective project management.
Most importantly, construction companies must produce solid, complete and properly presented financial statements to even be considered for surety bonds. Contractor’s annual financial statements are their chance to make a good first impression with a new surety or the underwriter looking at the file for annual renewal.

Although some clouds of uncertainty continue to hover over the surety market, many surety bond producers foresee a brighter future ahead.

About the survey

Members of the National Association of Surety Bond Producers (NASBP) were invited to participate in the online survey between Dec. 8, 2004, and Jan. 13, 2005.
NASBP members provide surety bonds for the construction industry, an important element in the success of the construction process. A total of 308 completed surveys were submitted, resulting in a margin of error of ±5.5percent.
To order a complimentary copy of the survey, please visit http://surveys.gt.com/formprocess/surety.asp.

Construction Business Owner, April 2006