Whose Line is it Anyway? Surety Casualty Actuarial Society Seminar on Ratemaking The Tampa Marriott Waterside Tampa, Florida March 7-8, 2002 James Elicker, ACAS Zurich North America Surety

Surety Introduction What or who is a Surety? one who has become legally liable for the debt, default, or failure in duty of another What is a Surety Bond? a bond guaranteeing performance of a contract or obligation

Three-party agreement ObligeePrincipal Surety

Surety vs. Insurance Risk transfer Premium determination Cancellation rights

Types Court / Fiduciary Public Official Bonds License, Permit, and Miscellaneous Commercial Bonds

Contract Bonds Types Bid Performance Payment Maintenance

Example: PennDOT awards Bridgebuilders, Inc. a $25,000,000 contract to construct a new bridge across the Allegheny River. Surety Bonding Company bonds Bridgebuilders by issuing a $25,000,000 performance bond. Bond guarantees that the bridge will be built according to the contract specifications. Contract Surety

Why have contract bonds? Required by law –Federal Miller Act of 1935 –State and local “Little Miller Acts” Relieve owners from risk of financial loss Ensure satisfaction of contract provisions Provide owners a pool of qualified bidders

Surety Underwriting Prequalification - takes the job owner out of the business of contractor evaluation –contractor’s financials –credit history –business operations –company history –past performance –other current projects –necessary experience/equipment

Surety: Unique Characteristics Theoretically possible to underwrite to a zero loss ratio Indemnity is generally available to the Surety Importance of exposure per principal, not per bond Bond forms are generally statutory

Surety: Pricing Considerations Premium earning pattern –Many P&C information systems require earnings pro-rata between coverage effective and expiration dates. –Earn premium over period estimated at bond issuance. –Take down any unearned premium reserve remaining when the bonded obligation is met.

Surety: Pricing Considerations Assignment of “accident” date –When does a contractor fail to meet an obligation? –Information systems often constrain accident dates to be within coverage effective dates. Therefore, there may be a “massing” of losses assigned to the last day of coverage. –Losses on multiple contracts for a single principal should carry the same accident date.

Surety: Pricing Considerations Exposures are inflation sensitive or immune –Many contract bonds use “contract price” as the basis of rating. As inflation raises contract prices, exposures keep pace. –Many non-contract bonds have defined “penalty” amounts that are used for pricing. These penalties do not change as a function of the CPI but are typically mandated by statute or regulation.

Surety: Pricing Considerations Payment patterns are long-tailed and often go “negative” –In contract cases, at times it is in the best interest of all parties for the surety to provide assistance to the principal. The surety may provide financing, for example. –Assuming the contractor gets back “on its feet”, indemnity agreements can come into play and the surety collects over a number of months or years until it becomes whole. –Litigation to recover funds from third parties (including job owners) also leads to money coming in to offset payments made earlier.

Surety: Pricing Considerations Booking of “contract balances” –In contract, not all funds are dispersed from the job owners to the principals at the inception of the work. Often contracts call for several payments coincident with certain contract milestones. –These funds are generally available to the surety once the job has become a claim situation.

Surety: Pricing Considerations Macroeconomic issues –The general economic cycle, through its impact on the business cycle, affects the frequency of contract surety claim situations. –Start of recession in spring of 2001 resulted in decreased construction volume. –Marginally operating firms may fail to meet obligations. –Subsequent poor results trigger industry consolidation.

Enron Enron entered into pre-paid forward contracts to deliver natural gas and oil to Mahonia Ltd., an energy-trading business created by J.P. Morgan & Company. Surety bonds were written to guarantee the deliveries. Contracts were entered into at year-end. Earnings from the contracts would offset Enron’s other losses, in effect deferring losses to future period. Through use of complex derivative transactions, deliveries of natural gas and oil were often sold right back to Enron.

Enron Initially a tool for managing tax liabilities, over time, as the size of the transactions and prepayment periods grew, the contracts became a major source of financing for Enron After Enron filed Chapter 11, J.P. Morgan sued 11 insurers who did not make payment on $1.1 billion worth of guarantees. Insurers are denying the claim alleging that Mahonia was a fabrication meant to disguise loans in the forms of commodity trades. Therefore, there was never an intent to make delivery.

K-Mart Enron losses and the economy in recession lead to shrinking surety bond capacity. With a self-insured workers comp plan, K-Mart was required by regulators to post surety bonds guaranteeing payment of benefits. K-Mart identifies high bond prices as a contributing factor leading to bankruptcy.