Surety – Insurance or Assurance? CAS Ratemaking Seminar Philadelphia, Pennsylvania March 2004 Gary Shook, FCAS Zurich North America

Surety 101 Surety bonds guarantee performance Surety bonds are 3 party agreements –Surety –Surety guarantees that –Principal –Principal will perform for the benefit of –Obligee (Miller Act and Little Miller Acts)Obligee no longer needs to ask “Can you do it?” only “For how much will you do it?” (Miller Act and Little Miller Acts)

Surety 101 Contract Surety - The Miller Act –federal contracts over $100,000 –performance and payment (labor and materials) –first and second tier subcontractors protected –bonds not required for military contracts –many states passed “Little Miller Acts”

Surety 101 Surety underwriters are professional “capability evaluators”. Target loss ratio is 0% –do not bond principals that will not perform –u/w must know a great deal about the principal and the obligation

Surety 101 Traditional industry segments include –contract Surety –commercial Surety court fiduciary official license and permit miscellaneous

Surety 101 Contract Surety –bid –performance –payment –maintenance –supply U.S. infrastructure construction runs at about 10% of GDP

Surety 101 Commercial Surety –court generally protect opposing litigant coverage is statutory, bond forms must comply w/ statute –appeal - to stay execution of court order pending appeal from the judgment –bail bonds –mechanics lien (discharges a lien against real estate)

Surety 101 Commercial Surety –fiduciary fiduciaries administer property held in trust bond guarantees faithful performance of duties as ordered by the courts with jurisdiction also includes conservators and liquidators coverage is statutory any and all parties with interest can file claim against the bond (obligee is usually the state or the U.S.A.)

Surety 101 Commercial Surety –fiduciary (cont’d) protects against embezzlement, improper disbursements, loss on investments –executors of estates of deceased persons (or those presumed dead) –estates of incompetents –estates of minors (guardian bonds) –bankruptcy proceedings

Surety 101 Commercial Surety –official covers loss of public funds –faithful performance of duties –failure of depository institution –burglary, robbery, forgery federal and non-federal treasurers, tax collectors, sheriffs and deputies, agents(fishing and hunting license sales), notaries

Surety 101 Commercial Surety –license and permit: bonds are often required prior to obtaining a license or permit properly collect and remit duties, taxes –customs duties –sales and excise tax collection properly discharge obligations under the law –return of illegally imported merchandise –statutory penalty for failure to comply with laws governing the business or activity

Surety 101 Commercial Surety –miscellaneous statutory bonds that do not clearly fall into one of the other categories U.S. immigrant bonds –payment of fines imposed under Immigration Act –maintenance of status and departure of non-immigrant alien –alien will not become dependent upon the state voluntary bonds

Surety 101 Commercial Surety - Miscellaneous Bonds –depository bonds –financial guarantees - traditional –financial guarantees - credit enhancement –income tax bonds –lease bonds –lost securities bonds –workers compensation bonds

Surety 101 Commercial Surety –compliance cigarette tax notary public official, court fiduciary, court guarantee –financial WC Self-insurance insurance premium payment bonds sale and delivery of raw materials

Loss Costs Surety Association of America Contract Surety –bonds classified by type of contract primarily a function of complexity and duration –large building construction, dams, subways –bridge construction, curbs and gutters, elevators –fire escapes, guard rails, paving, mosquito control supply, maintenance, completion, miscellaneous bid –classification codes are also supported but loss costs are based more so on type of contract

Loss Costs Commercial Surety –primarily segmented using classification codes –myriad types of bonds are grouped by relative risk into a manageable number of loss cost classifications (i.e. risk groups) –separately done for court and fiduciary, official, license, etc. Many surety loss costs are structured to support waning average loss/exposure ratios

Individual Risk Considerations Commercial Accounts –3 Cs character capital capacity –collateral - amount and quality –financial health –expected volume of bonds

Individual Risk Considerations Commercial Accounts –credit rating (e.g. Moody’s, S&P) –experience of management –time in business –stability of earnings firm industry segment

Individual Risk Considerations Contract Accounts –3 Cs character capital capacity - experience, expertise, hardware –financial well-being quality of financial statements (e.g. CPA reviewed) net worth (value and volatility) –geographic spread –bonded work vs. unbonded work

The Three Party Agreement This ain’t your father’s HO liability cover Surety bonds principal in favor of obligee –the target loss ratio is zero –principals usually must execute general indemnity agreements in favor of the surety –often includes personal indemnity –after payment is made by surety to obligee, then surety seeks recovery from principal (read customer)

Contract Surety Claims Options for Surety –capital infusion –takeover the contracts –litigate (deny coverage) –allow owner to complete –provide for others to complete (tender the contracts) Early intervention can save $$$$$$

Contract Surety Claims Performance –completion costs in excess of job funds –delay damages –marginal fees (engineers, lawyers, architects) Payment –labor and materials –extra work Case Reserving is very complicated and therefore volatile

Contract Surety Claims Accident date? –loss is not typically “fortuitous” –claim files can open before a claim is made –can be outside the “policy period” Multiple jobs typically affected –bonded and unbonded –various stages of job completion

Contract Surety Claims Probable Maximum Loss (PML) –possible to incur a loss in excess of the “limit” of the bond –typically a function of “work on hand” Offsets include contract balances, indemnity, salvage, and subrogation –personal indemnity is not uncommon –recovery can extend for years

Work on Hand

PML

Surety Reinsurance Cosurety is not surety reinsurance Quota share vs. excess of loss Typically on a losses discovered trigger (XS) Aggregation Cash flow International issues Total risk includes capital market exposure

Surety Reinsurance Many P&C company information systems do not support some of the important surety statistics –post expiration “accident date” –collateral –contract balances –credit rating –net worth

Surety Reinsurance Many P&C company information systems do not support some of the important surety statistics –claim counting can be different –true exposure is difficult to maintain –contract prices will change –recoveries come in many forms

Surety Reinsurance Many P&C company information systems do not support some of the important surety statistics –work on hand (high maintenance stat) –customer number (aggregation issues) exposure incurred losses contract and commercial –exposure (e.g. performance vs. payment)

Enron Bonds guaranteed delivery of oil and natural gas $2B loss to insurance industry (includes asset write downs) Enron loss amount –$1.1 billion in bonds Payback Pricing implications?

Enron Mahonia pays $200 to Enron today for $210 of gas to be delivered in 1 year Mahonia buys a surety bond guaranteeing delivery on the paid-forward contract Enron (secretly) contracts to buy $210 of gas from Mahonia in 1 year. Enron has $200 cash, Mahonia has a guaranteed payment of $210 in a year

Enron Mahonia had no terminals, no storage tanks –contracts back-and-forth usually executed the same day –bond underwriters argue there was never intent or ability to use gas One effect of the loss was many surety writers dramatically reducing capacity –e.g. from $250 million to $25 million per principal

J. P. Morgan Chase vs. Continental Casualty (CNA) Federal Insurance (Chubb) Fireman’s Fund (Allianz) Hartford Liberty Mutual Lumbermens Mutual (Kemper) National Fire (CNA) Safeco St. Paul Travelers (2)

J.P. Morgan Chase Settlement Principal$965million Settlement654 -Rights Purchase86 = Net Payments568(60%ish)

Enron For the record –J.P. Morgan also had to sue for recovery of millions in LOC obligations –hundreds of millions of dollars were paid by surety companies on legitimate paid-forward bonded contracts

K-Mart K-Marts “Perfect Storm” –a nation in recession –intense retail competition –poor holiday sales 2001Q4 –liquidity problems –bad press from securities analysts –Enron collapse –lenders, insurers, and suppliers thought K-Mart sounded a lot like Enron (everyone wanted cash that K-Mart simply did not have)

Bonds guaranteed workers compensation and liability self-insurance plans As financial condition deteriorated, bond prices rose plus... Collateral (cash) was required and this exacerbated the situation of cash strapped K-Mart K-Mart

Economic Trends Source: U.S. Department of Labor; Federal Reserve Board Release; Bureau of Economic Analysis, AM Best

Public Construction Spending v. Surety Industry C/R Source: AM Best’s Aggregates & Averages; U.S. Census Bureau.