1. CONTRACT SURETY BONDS: UNDERSTANDING TODAY’S MARKET
Contract surety bonds are the construction industry’s most trusted and valuable risk management tool. Understanding today’s surety market helps you manage risk in a changing economy.
Twice each year, the Surety Information Office (SIO) interviews top surety company executives and surety bond producers to find out what is happening in the surety market. Their views are reflected in this presentation as we look at surety and construction industry statistics; examine underwriting standards, bond premium, capacity, and claims; and offer advice to owners and contractors on making the most of the current market.
Updated 2/2013
2016

2. Surety Losses & Profitability
To understand the surety market, it is important to look at the history of losses and profitability. This slide shows a 57-year tracking of the construction-related surety direct loss ratios as incurred by surety companies. The straight line is the 57-year average, which is about a 42% direct loss ratio. The contract surety direct loss ratio for 2015 was 12.6%, which is down sharply from 29% in These loss ratios exclude loss adjustment expenses.
SOURCE: The Surety & Fidelity Association of America’s “Twelve-Year Experience Summaries ( ) Surety Countrywide (Preliminary)”
Rev. 8/2014

3. Surety Losses & Profitability
This slide shows a 54-year tracking of the contract surety combined ratio as incurred by surety companies. Recent combined ratios were approaching the long-term average of 104% (the straight line), but have been trending downward since 2011.
Combined ratio is the sum of the direct losses and the total loss adjustment, underwriting and administrative expenses as a percentage of earned premium.
The expense data (excluding commission) for years contains data net of reinsurance basis. Data from 1997 to the present is based on direct business due to a methodology change reflecting the significant use of non-proportional reinsurance, which is not coded specifically for surety on company insurance expense exhibits.
SOURCE: SFAA Insurance Expense Exhibit reports
Rev. 5/2016

4. Surety in the Early 1990s Strong economy
Excess capacity in surety market
Low premiums
Relaxed underwriting
Commercial surety expansion
As the previous chart illustrated, throughout the 1990s, as the economy boomed and interest rates dropped, surety was a profitable industry. The strong economy kept contractors busy and failures low. Excess capacity built up in the surety market as a number of new surety companies entered the market. As a result of competitive practices, bond premiums were artificially low. Many companies relaxed underwriting standards as they competed for market share. Commercial surety also expanded rapidly into new areas – creating many new surety products with unknown risks.

5. Surety in the Early 2000s Sagging economy
Significant commercial losses
Heavy contract surety losses
Increased failure rates
Beginning in 2000, after more than a dozen years of profitability, the surety industry began to experience losses as the economy began to falter. Commercial surety was especially hard hit in 2001 and 2002 from the effects of a series of high-profile corporate failures and by 2002, contract surety losses soared. The economy rallied in , and with it the construction and surety markets.

6. Surety in the 2000s Source: BizMiner
In 2002, many large general contractor defaults hit the industry, followed by the failure of many subcontractors. According to BizMiner, of 853,372 building, heavy/highway and specialty trade contractors operating in 2002, only 610,357 were still in business by 2004 – a 28.5% failure rate. Of the 850,029 companies in business in 2004, 649,602 were still in business in January 2006, an improved 23.6% failure rate. And, of the 1,155,245 companies operating in 2006, 919,848 were still in business in 2008 – a 20.4% failure rate. Surety executives attributed the decline in failures to a robust construction economy, disciplined underwriting, better job selection by contractors and improved profit margins.
Executives, however, expect failure rates to increase, citing reduced construction starts, increased competition, tightening credit terms, inflation, new entrants into public construction, the weak U.S. dollar and a downward pressure on profit margins. While many of today’s contractors are better businesspeople – with more sophisticated systems for estimating, monitoring, and constructing projects – and sureties have implemented tools to better judge the credit and performance worthiness of their clients – the economy is still the primary driver of contractor success.
The latest figures from Bizminer confirm executives’ expectations. Of the 897,602 companies operating in 2009, only 702,618 were still in business in December 2011—a 21.7% failure rate. The failure rate for startups was even higher—35.0%.
Rev. 11/2016
Source: BizMiner

7. Contract Surety Premiums & Losses
According to The Surety & Fidelity Association of America’s “Twelve-Year Experience Summaries ( ) Surety Countrywide (Preliminary)”, $384 million in contract surety claims were incurred in 2015 , with a 12.6% loss ratio. Contract losses incurred losses and loss ratios had been increasing since 2008, including a sharp increase from 2011 to 2012, but since 2013 losses have generally decreasing. Sureties have paid approximately $14 billion since 1994 on contractor defaults; nearly half of that was paid from
Recent loss ratios for contract surety:
2015: 12.6%
2014: 29.2%
2013: 22.5%
2012: 37.1%
2011: 23.1%
2010: 18.5%
2009: 14.3%
2008: 6.1%
2007: 13.4%
2006: 11.0%
2005: 43.8%
2004: 73.0%
2003: 64.8%
2002: 67.0%
2001: 49.8%
2000: 45.4%
1990: 30.4%
Source: The Surety & Fidelity Association of America, “Twelve-Year Experience Summaries ( ) Surety Countrywide (Preliminary)”
Rev. 10/2016
Source: The Surety & Fidelity Association of America “Twelve-Year Experience Summaries ( ) Surety Countrywide (Preliminary)”

8. Top 15 Writers of All U.S. Surety
Each year we now update this slide to show the changes in the marketplace. This slide shows the companies and the specific premiums.
There are about 200 insurance groups writing surety bonds. Thirteen of the Top 15 writers of all U.S. surety have merged or left the market since In 1990, the Top 10 wrote slightly less than half of total surety; by 2015 the Top 10 wrote 64% of all U.S. surety. In 2014, the Top 5 companies wrote about 50% of all U.S. surety. Both the Top 10 and Top 5 market share percentages in 2015 are near or at the same percentages they were in 2014.

9. Construction Activity
U.S. Census Gains August August 2016
All Construction
Public
Private
Total Construction
+4.9%
-1.3%
+7.0%
Nonresidential
+4.0%
+7.8%
Lodging
+25.6% -
+27.1%
Manufacturing
-2.9%
-3.0%
Public Safety
-7.7%
-5.8%
Power
+4.7%
-17.2%
+7.7%
Educational
+5.2%
+4.2%
+9.0%
Transportation
-4.0%
-3.2%
-6.0%
Amusement/Rec
+8.7%
-3.5%
+22.2%
Office
+21.9%
-6.1%
+26.9%
Highway/Street
0.0%
+0.1%
Health care
+1.0%
+1.7%
Commercial
+9.6%
+31.4%
+8.8%
For the current U.S. Census “Value of Construction Put in Place” data, go to
Updated 10/2016

10. Outlook for 2016 & Beyond Optimism about surety capacity & demand
Increase in contractor failures and losses as economy recovers
Continued disciplined underwriting, exposure management & project analysis
Surety available for best contractors
Marginal contractors have difficulty obtaining bonding
Public private partnerships (P3s)
What’s in store for 2016 and beyond?
History indicates that recovery periods can be fraught with hazards to contractors and sureties, as safety, productivity, and cost inflation of labor and materials can erode still recovering margins. However, surety executives are optimistic about future bond capacity and demand. The very best contractors, regardless of size, should have no trouble obtaining bonds, while the marginal contractors will have difficulty. The surety industry continues to focus on the basics of sound underwriting, exposure management, and project analysis and have positioned companies to ride out the recent economic downturn.
There will remain few options in the public construction arena for the foreseeable future, but an uptick in the private market should create some opportunities. Overall, surety capacity will remain strong because construction firms have become more sophisticated as a result of the economic downturn and are better able to manage risk.

11. Underwriting The 3 “C”s: Capital Capacity Character 4 and 5:
Continuity
Contracts
Today’s underwriting standards continue to emphasize the 3Cs – capital, capacity, and character. Sureties have been using the 3”C”s for more than 100 years to develop a thorough understanding of a contractor’s business. Some underwriters now look at two additional “C”s – continuity and contracts. Accordingly, the surety may request more information and examine it more closely than had been done in the ’90s. Sureties spend the majority of their time and money underwriting contractors to prequalify them. That involves an analysis of the particular contract to be bonded, including contract provisions such as liquidated damages, warranty requirement,s and the owner’s performance history. The underwriter evaluates the contractor’s financial strength, capacity, and the contractor’s ability to perform the work. Sureties look at equipment, project managers, the accounting system, and labor force, among other items. Probably the most important “C” is character – the “C” sureties cannot do without. It does not matter how good the balance sheet or how many jobs the contractor has performed, if the surety hears reputation problems, whether it is trustworthiness or quality issues, that “C” can negate the other two “C”s.

12. Underwriting Capital Financial statements Indemnity Working capital
Work-in-progress
Sureties usually require:
Independently audited financial statements within days that follow Generally Accepted Accounting Principals (GAAP).
Timely interim financial statements.
Aging of accounts receivable and payable.
Analysis of overhead costs.
Balance sheet, which shows assets, liabilities, and net worth of the company. This helps the surety assess the working capital and overall financial condition of the construction company.
Income statement, which measures how well the business performed. The surety will assess gross profit on contracts, operating profit, and net profit before and after tax provisions.
Statement of cash flow, which discloses the cash flow movements from operating, investing, and financial activities as well as cost control mechanisms.
Personal and corporate indemnity. While personal indemnity is nothing new, sureties are looking at personal guarantees on a more consistent basis.
Working Capital, including liquidity, receivables, over-billings, and under-billings.
Up-to-date work-in-progress reports.

13. Underwriting Capacity Resumes Contingency plan Business plan Equipment
In terms of a contractor’s capacity, the surety will review:
Resumes of key employees and management. Sureties may look for more management depth.
Contingency plan. Sureties want to see that plans are in place to deal with loss of key personnel.
Comprehensive business plan, forecast, or strategy (both short-term and long-term) and how well the contractor adheres to that plan. The surety also may look more closely at business operations such as risk management plans and insurance coverages.
Whether the contractor has or can obtain the equipment necessary to perform the work.

14. Underwriting Character Reputation Relationships References
In terms of character, the surety wants contractors with good reputations. The surety expects the contractor to have established, positive, and ethical relationships with subcontractors and suppliers, owners, and lenders.
In addition, the surety underwriter may look closely at the project’s contract terms and the contractor’s contract review process. The underwriter also may review the contractor’s subcontractor and supplier selection criteria. Successful contractors leave nothing to chance. They have a clearly defined business plan, know their costs, have financial controls in place, and can compile accurate forward-looking financial projections.
Sureties check references with bankers, CPAs, owners, architects, suppliers, and subcontractors.

15. Bond Premiums Geographic Area Contractor Size Type of Construction
Although surety rates are actuarially based and contemplate the potential for loss, they also act as a fee for the surety’s extensive underwriting and prequalification service. The cost of surety bond premiums depends on a number of factors including the size and bonding capacity of the contractor, geographic area, type of construction, and the specific project. Generally, surety bonds range in price from 0.5% to 2% of the contract price. The premium on a bond is generally charged when a final bond is written. Payment and performance bonds are generally priced together, so there is one premium for both. Typically, owners require a 100% performance bond and 100% payment bond.
Surety bonds remain an extremely cost-effective risk management tool for the obligee.
Still a Bargain
Pennies on the dollar

16. Capacity Small ( < $50 M) SBA Program Medium ($100 M) Competitive
Surety Market
Jumbo
( > $500 M)
Multiple sureties
Joint ventures
Partial bonds
Small contractors were hit hardest by the recession, and while the market remains competitive, there is adequate capacity for qualified contractors. A number of surety bond companies specialize in marketing bonds to small contractors. In addition, several major surety bond companies have initiated programs to bond more small contractors. Many surety bond companies have designed special strategies that encourage their producers and underwriters to seek small contractor business. Many surety companies offer fast track programs designed for small or emerging construction contractors with a simplified application process and less stringent requirements for obtaining a bond.
Furthermore, the U.S. Small Business Administration Surety Bond Guarantee Program is a popular option for those unable to obtain bonds by traditional means. New and emerging contractors will need to provide well thought-out business plans, CPA-prepared financial statements and provide higher quality information on their company in a more timely manner than in the past. The Surety & Fidelity Association of America (SFAA) has developed a Model Contractor Development Program® and partnered with the U.S. Department of Transportation in creating the Bonding Education Program to assist this market in becoming the large and successful contractors of tomorrow.

17. Capacity Small ( < $50 M) SBA Program Medium ($100 M) Competitive
Surety Market
Jumbo
( > $500 M)
Multiple sureties
Joint ventures
Partial bonds
While there is plenty of surety capacity for contractors operating in the middle market, the industry has experienced several new entrants over the last few years that could bring increased competition. Surety executives say that they are focused on making sure that these contractors have the ability to grow as the market improves, especially since some contractors are taking on more complex projects or expanding outside their geographical area of expertise.
Large contractors continue to experience terms and conditions consistent with a profitable industry that has strong reinsurance support. Surety companies are, however, seeing some problem projects and liquidity burn. Well-managed firms will not have a problem finding surety capacity to meet their needs.
In the mega market, credit quality remains high for contractors, and opportunities for work are increasing. There continues to be more than adequate surety capacity for the mega firms.
Contractors with a solid balance sheet, profitable work program and experience should continue to be able to obtain the required surety bonds.

18. Severity & Frequency of Claims
The severity and frequency of claims has lessened dramatically from its high in the early 2000s, starting in 2006, thanks in part to disciplined underwriting.  The loss ratio for contract surety has dropped from 73% in 2004 to 11% in 2006, with an uptick in 2007 to 13.4%, and back down to 6.1% in However, it is increasing again.  As of 2010, the loss ratio was at 18.5%.  The contract surety direct loss ratio was 37.1% in 2012 and 22.5% in 2013.
Surety executives have seen more contractor failures since late 2009 on account of the weakened economy.  In addition general contractors are experiencing troubled subcontractors more frequently.  However, these failures are not as severe as in previous loss cycles.  Part of the reason behind this is contractors simply closing their doors rather than choosing to take work at a loss.  Nevertheless, as the economy rebounds slowly and work opportunities increase, contractors may be tempted to obtain work cheaply to build up backlog.  Thus, there remains a wariness about surety losses in the years ahead. 

19. Advice for Today’s Contractors
Know rights & responsibilities
Stay within capabilities
Manage growth & overhead
Learn why contractors fail
Contractors do have rights and responsibilities to owners, creditors, and others. In addition, contractors need to understand the surety’s rights and responsibilities toward them and the owner.
Accurately assessing one’s capabilities speaks for itself. It is important to look at operating profitability and completing contract profitability. Construction accountants typically use percentage-of-completion accounting, which allows contractors to take accruing profit on work that has not been completed. When you take the completed contract profitability of a company over a four- or five-year period and subtract the overhead that has been incurred during that same period of time, it really shows the true growth the company is achieving, what type of real enhancements in their retained earnings are taking place, and whether they are making money at the business that they have chosen.
Learn causes and warning signs of contractor failure. The Surety Information Office’s brochure, “Why Do Contractors Fail?” is available at by selecting “Brochures & CDs.”

20. Advice for Today’s Contractors
Communicate
Prepare for economic recovery
Communicate good and bad news to your surety bond producer and company underwriter if and when problems begin. The most important thing a contractor can do is keep the surety informed when problems arise. Many surety companies will work with the contractor to help him or her through the problem if possible.
Construction is cyclical and contractors should prepare for the pent-up demand that will build during recession. As the economy improves, contractors often are tempted to expand outside their areas of expertise, but contractors need to know their strengths and not be tempted to expand outside their areas of expertise or geographic area just because the job market is beginning to turn. The surety is a critical partner through good times and bad and can help owners and contractors manage the changing economic climate.

21. Advice for Today’s Contractors
Contract terms
Bond forms
Construction CPA
Adjust overhead
Bank line of credit
Conserve capital
Bond subcontractors
Qualify the surety
Understand the contract and look for effective and equitable contract language.
Read the bond forms and watch for onerous terms.
Use a construction-oriented CPA.
Do not “buy” a job to keep employees busy – adjust overhead and maintain profit margins. Bid the job, not the competition.
Have a bank line of credit available to support the company’s business plan. Have a backup bank lined up in the event your bank reduces – or does not renew – your credit line, or becomes financially unstable.
Conserve capital – stay liquid.
Do what you do best. Protect your top talent, who will manage projects well no matter what the market conditions are and who will be essential when the economy recovers.
Procure materials and lock in prices whenever possible.
Bond subcontractors – requiring bonds on subs is an effective way for contractors to manage risk on projects. Subcontractor bonding policies also should be established – especially in today’s economic climate. Bonding subs always is a good policy, but subs certainly should be bonded when:
They represent a key trade to the project or a significant portion of the work;
They are the sole source for anything; or
When the contractor is unfamiliar with the subcontractor.
Qualify the surety by contacting your state insurance department.

22. Advice for Today’s Contractors
Producer
Contractor
Underwriter
Contractors need the backing of a financially sound surety company that is willing to extend the necessary surety credit. The best way for contractors to maintain and increase their surety capacity is by developing a lasting surety relationship. In times of economic uncertainty or difficulty, a well-developed surety relationship is essential. The contractor, professional surety bond producer, and surety company underwriter are the key players on this invaluable team.
The first step is to find a good surety bond producer, then listen to the producer’s advice. A good surety bond producer typically will:
Be a member of the National Association of Surety Bond Producers (NASBP);
Be able to recommend construction-oriented accountants, attorneys, and bankers; and
Introduce the contractor to an appropriate and admitted surety company.
Examples of possible questions to ask and factors to consider when assessing whether a particular bond producer might be a good fit for your company’s needs are:
Is the producer licensed in your jurisdiction and that of the project?
What is the reputation of the bond producer? Does he or she have a reputation for integrity and respect in the industry?
What percentage of his or her overall business are construction clients?
Does he or she have an understanding of the construction industry and of the construction process, particularly the management and administration of construction contracts?
Does he or she possess knowledge of construction accounting procedures, especially an ability to analyze financial statements, work-in-progress, and cash flow?
With how many sureties does the producer work?
Is the producer specifically authorized to issue bonds on behalf of sureties?
Has the producer developed solid relationships with licensed surety underwriters?
Has the producer developed solid relationships with other professional service providers, such as attorneys, CPAs and lenders?
How aware and interested is the producer in local, regional and national construction markets?
How active is the producer in local or national construction associations?
Can the producer demonstrate a commitment to maintaining frequent client contact through newsletters, site visits, or visits to client offices?
What other services does the producer provide clients to help them with their business needs?
The right bond producer will be an invaluable part of the contractor’s group of business advisors.

23. Advice for Today’s Contractors
Producer
Underwriter
Contractor
There are three basic stages to a long-term surety relationship:
Meeting – At least once a year contractors should meet with the surety underwriter and surety bond producer. The company’s CPA and CFO or comptroller also should attend.
Maintaining the relationship through frequent open and honest communication. The job status report is an essential component of this communication.
Nurturing the relationship. This requires commitment, trust, communication, timely reporting, and teamwork.
Sureties want more than a contractor that can build a project. They want sound businesspeople who run successful construction companies – companies that will continue to grow and be profitable.

24. For More Information Surety Information Office (SIO)|
SIO is a joint initiative of The Surety & Fidelity Association of America (SFAA) and National Association of Surety Bond Producers (NASBP).
For more information about contract surety bonds, visit the Surety Information Office online at