Hidden Risks: Surety Relationships

Although the economy is showing modest signs of improvement, many observers believe that the construction industry is years away from full recovery. Construction business owners should be aware that even as the economy improves, developments could occur that adversely affect their surety relationships and capacity. Construction companies and their surety brokers should take precautionary measures as the construction economy regains its health.

Historical Context
Even with a recession that has lasted four-plus years and devastated private-sector and residential construction, surety underwriters and brokers have noticed that surety industry losses relating to contractor failures have remained remarkably modest. Surprisingly, profitability and capacity have been robust across the broader surety industry.
Much of that surety-industry profitability can be attributed to contractors having strong balance sheets and financial resources prior to the recession, as a result of healthy profits accumulated during the decade prior to 2008. Contractors also had significant backlogs of work with healthy margins entering the downturn, and many reacted quickly to the signs of a recession by reducing overhead and disposing of nonessential assets and related debt. 

However, as those legacy backlogs have been exhausted, contractors have seen resources drained. Margins on new work have dropped substantially as greater industry revenues have shrunk. Contractors have had to cope with more marginal jobs and slower payments from owners. Less-favorable resolution of change orders and claims has also been common, due to financing constraints, limited resources and tightened budgets.

The concern for construction business owners has now shifted. If the construction economy gains momentum in its recovery, contractors taking on additional work with tight margins will have to ask themselves whether they have adequate organizational depth and talent, strong financial resources and reliable surety and banking relationships. All of these elements of the business will be necessary to support prosecution of the work and to manage operating cash flow as backlogs spike upward. The reductions in staff, equipment and nonessentials that these business owners made during the deepest periods of the recession might come back to haunt them if they do not have proper planning for the upturn.

Surety Providers
One of the most critical assessments that a construction business owner should make is that of the company’s relationship with its surety provider. Since the construction economy is not yet “out of the woods,” contractors and their brokers need to know how their surety companies have fared during the recession and how their underwriting has been impacted as a result. Just as important, contractors should have a plan for a backup surety provider in case the primary provider experiences adverse loss and claim activity and, thus, tightens underwriting criteria.
 
Any construction company that has a relationship with a smaller or regional surety company should be especially aware that several of those types of organizations are experiencing deteriorating loss ratios. Those sureties’ loss ratios have risen to the 40- to 50-percent range in 2011 and 2012, compared to less than 30 percent during the deepest part of the recession, 2008 to 2010.  Add operating expenses of 50 percent-plus, and the result is red ink.

While a few of the larger surety companies have experienced an upward trend in loss frequency and severity, most have done quite well throughout the recession. It’s simple math: A $5 million claim will have a much greater impact on the bottom line of a smaller or regional entity—and its willingness to extend credit—than on the bottom line of a major national provider. 

Banking Relationships
The same advice extends to contractors, especially electrical and other specialty subcontractors with high levels of self-performing payroll, that are dependent on banks for lines of credit to fund their operating cash-flow needs. They should perform exhaustive analysis to ensure that they’re working with healthy and reliable bank partners and that their projects are adequately funded or financed to avoid non-payment on change orders or claims.

It’s not news that the credit market is vastly different than it was prior to the start of the current recession. Banks are much more conservative and more likely to balk at lending money to a contractor who runs into a problem. The best safeguard for a construction business owner—in addition to closely reviewing the health of the bank they’re working with—is to ensure that credit covenants are reasonable and compatible with the business plan and operating requirements and, if necessary, make a change before problems occur. 

On the Horizon
Of course, no one knows when the construction industry will make a full recovery. One issue impeding recovery is the fact that many public entities, from the federal government to the local level, are reducing their construction budgets as their tax revenues have declined. If a budget deal is not reached and automatic budget cuts are implemented, federal construction spending could be devastated. Defense contractors alone might have to lay off tens of thousands of workers.

The best piece of advice: better to be safe than sorry. As the economy recovers throughout 2013 into 2014, be aware of the health of your surety and banking relationships, and make changes or establish formalized alternatives as needed. To use a well-worn phrase, there certainly is a “light at the end of the tunnel,” but that tunnel might be longer, deeper and darker than expected.  Taking precautions now, even as the economy appears to be improving, is the best protection.