Surety Industry Overview: State of the Industry by Cissie Scoggin

Proprietary and Confidential

Surety Industry Overview

State of the IndustryPresented by

Cissie ScogginCore Contract Manager


What is Suretyship? Suretyship is a very specialized line of insurance that

is created whenever one party guarantees performance of an obligation by another party. There are three parties to the agreement: – The principal is the party that undertakes the obligation.– The surety guarantees the obligation will be performed.– The obligee is the party who receives the benefit of the

bond.

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What is a Surety Bond? A surety bond is a written agreement that usually

provides for monetary compensation in case the principal fails to perform the acts as promised. There are many different types of surety bonds, but the two general categories are contract and commercial surety bonds.

I am going to focus on Contract bonds.

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Types of Surety Bonds There are three primary types of contract surety

bonds. – The bid bond assures that the bid has been submitted in

good faith, that the contractor intends to enter the contract at the price bid and provide the required performance and payment bonds.

– The performance bond protects the owner from financial loss in the event that the contractor fails to perform the contract in accordance with its terms and conditions.

– The payment bond assures that the contractor will pay certain workers, subcontractors, and materials suppliers.

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Proprietary and ConfidentialWhat characteristics of suretyship are like more common forms of insurance?

They are both risk transfer mechanisms. State insurance commissioners regulate them both. They both provide for financial loss.

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Proprietary and ConfidentialHow is suretyship different from more common lines of insurance? Most surety companies are subsidiaries or divisions of

insurance companies, and both surety bonds and insurance policies are risk transfer mechanisms regulated by state insurance departments.

In traditional insurance, the risk is transferred to the insurance company. In suretyship, the risk remains with the principal. The protection of the bond is for the obligee.

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Continued… In traditional insurance, the insurance company takes

into consideration that a certain amount of the premium for the policy will be paid out in losses. In true suretyship, the premiums paid are "service fees" charged for the use of the surety company's financial backing and guarantee.

In underwriting traditional insurance products the goal is "spread of risk." In suretyship, surety professionals view their underwriting as a form of credit so the emphasis is on prequalification and selection. The bond is underwritten with little expectation of loss.

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Why do we have surety bonds? In 1984 Congress passed the Heard Act to protect

federal projects from contractor default and protect subcontractors from nonpayment by contractors. The Heard Act was supplanted by the Miller Act in 1935, which basically requires performance and payment bonds in excess of $100,000 and payment protection for contracts between $30,000 and $100,000. A corporate surety company issuing these bonds must be listed as a qualified surety on the Treasury List. Also, almost all 50 states, the District of Columbia, Puerto Rico, and most local jurisdictions have enacted similar legislation requiring surety bonds on public works. These generally are referred to as “Little Miller Acts.” Owners of private construction also manage risk by requiring surety bonds.

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Continued… Construction is a risky business. Of 1,424,124

contractors in business in 2007 only 969,937 were still in business in 2009 – a 31.9% failure rate. I don’t have more current figures but strongly suspect that in this economy and with the losses the industry has susteind that that number is more in the 40% range. Surety bonds offer assurance that the contractor is capable of completing the contract on time, within budget, and according to specifications. Specifying bonds not only reduces the likelihood of default, but with a surety bond, the owner has the peace of mind that a sound risk transfer mechanism is in place. The burden of construction risk is shifted from the owner to the surety company.

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How does a surety underwrite? Each surety company has its own guidelines and

underwriting criteria. However, the following basic factors will be taken into consideration in some format. They are commonly referred to as the Three C’s - – Cash. Does the financial condition of the applicant justify

approval of the particular risk? – Character. Does the applicant's record show him to be of

good character and likely to perform the obligation he or she assumes?

– Capacity. Does the applicant have the skill and ability to perform the obligation?

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Continued… The surety company’s rigorous prequalification of the

contractor protects the project owner and offers assurance to the lender, architect, and everyone else involved with the project that the contractor is able to translate the project’s plans into a finished project. Surety companies and surety bond producers have been evaluating contractor and subcontractor performance for more than a century. Their expertise, experience, and objectivity in prequalifying contractors is one of a bond’s most valuable attributes. Before issuing a bond, the surety company must be fully satisfied that the contractor has, among other criteria:

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Continued…

– good references and reputation;– the ability to meet current and future obligations;– experience matching the contract requirements;– the necessary equipment to do the work or the

ability to obtain it;– the financial strength to support the desired work

program;– an excellent credit history; and– an established bank relationship and line of credit.

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What is Personal Indemnity? It is common for a surety to request the indemnity of

the owners of a closely held corporation. Typically, the spouse's indemnity also is required because personal assets are jointly owned. The two main reasons for this requirement are that the surety requires all personal assets to be available to back the guarantee and that there is less chance a principal will avoid its responsibilities if its personal assets are at stake.

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Proprietary and ConfidentialHow much premium is in the surety market? What have been the results? Surety bond rates vary from one surety to another, but

can range from 0.5% to 2% of the contract amount, depending on the size, type, and duration of the project and the contractor. Typically, there is no charge for a bid bond if performance and payment bonds are required on the project. In many cases, the cost of a payment bond and a 12-month maintenance bond is included with the purchase of a performance bond.

2013 Total $5.2 billion. Of that the top 100 account for 99%. Losses were $841 million

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Continued… 2004 – 2013 the top 100 surety companies had DWP

of $50.1 billion with losses of $10.4 billion a loss ratio of 20.7%, an expense ratio of 44.7% which equates to a combined of 65.4%. Keep in mind this is reported by the surety companies and reserving practices vary by company so the combined is most likely higher than this.

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Source: SFAA

Top 10 Competitors – Premium


Top 10 Competitors - Market Share

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TravelersLiberty Mutual

Zurich

C N A

ChubbHartford

2013 Year End

Source: SFAA


Contractor Defaults and Balance Sheet Challenges Contractor default is an unfortunate, and sometimes

unavoidable, circumstance. In the event of contractor failure, the owner must formally declare the contractor in default. The surety conducts an impartial investigation prior to settling any claim. This protects the contractor’s legal recourse in the event that the owner improperly declares the contractor in default. When there is a proper default, the surety’s options often are spelled out in the bond. These options may include the right to re-bid the job for completion, bring in a replacement contractor, provide financial and/or technical assistance to the existing contractor, or pay the penal sum of the bond.

So how has the subcontract trade been impacted by this recession and are we seeing improvements?

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Electrical Contractors - 2011 vs. 2009

In the sample group: Revenue increased slightly. Operating Margin decreased

more than half, from 6.31% to 2.59%.

Net Margin deteriorated by more than two thirds, from 1.04% to 0.33%.

Operating Cash Flow decreased $257 million, or 62%.

Bank Debt Increased over $100 million, or 35%

Indications are that profit and liquidity trends will continue to be negative for 2012.

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Financial Aggregation of a sample of 85 Bondable Electrical Contractors


Mechanical Contractors - 2011 vs. 2009

In the sample group: Revenue increased by $3.5

billion. Operating Margin decreased

nearly by half, from 5.04% to 2.65%.

Net Margin decreased nearly by half, from 1.1% to 0.61%.

Operating Cash Flow decreased by $213 million, or 45%.

Bank Debt increased by $305 million, or 147%.

Cash decreased $114 million, or 18%.

Indications are that profit and liquidity trends will continue to be negative for 2012.

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Financial Aggregation of a sample of 119 Bondable Mechanical Contractors

2011 2010 2009

Revenue 10,589,270,124 6,549,008,192 7,037,176,277

Operating Profit 281,135,227 229,571,733 354,758,346

Operating Margin 2.65% 3.51% 5.04%

Net Profit 64,738,957 38,092,154 77,224,477

Net Margin 0.61% 0.58% 1.10%

Operating Cash Flow 257,286,173 135,131,849 470,580,176

Cash & Mkt Sec 533,468,747 554,326,556 647,650,939

Net Cash 597,759,183 492,083,798 471,207,160

Bank Debt 512,388,557 224,221,474 207,094,232

Working Capital 816,816,729 749,152,554 699,289,849

Net Worth 1,225,102,890 961,794,453 903,387,076


Subcontractors (Excl. MEP) - 2011 vs. 2009

In the sample group: Revenue decreased by $2 billion,

or 24%. Operating Margin decreased from

4.56% to 0.30%. The group continued to be

unprofitable. Cash decreased by $263 million

(32%), while Bank Debt increased $122 million (12%).

Net Cash decreased from $18 million to ($357) million.

Indications are that trends will continue to be negative for 2012.

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Financial Aggregation of a sample of 122 Bondable Subcontractors (Other than Mechanical, Electrical or Plumbing)

2011 2010 2009

Revenue 6,517,442,176 8,018,412,997 8,542,110,602

Operating Profit 19,743,998 190,401,687 389,238,610

Operating Margin 0.30% 2.37% 4.56%

Net Profit (137,644,972) (57,227,989) (163,647,523)

Net Margin -2.11% -0.71% -1.92%

Operating Cash Flow 90,698,289 183,669,690 656,123,273

Cash & Mkt Sec 549,091,814 761,986,550 812,714,361

Net Cash (357,405,702) (268,138,153) 18,694,755

Bank Debt 1,116,722,596 1,299,227,114 994,755,589

Working Capital 750,922,202 748,481,678 1,015,298,021

Net Worth 754,862,512 859,416,971 984,798,265


Electrical Contractors - 2012 vs. 2009

In the sample group: Revenue increased slightly. Operating Margins decreased by

24%, but are up 33% from the 2011 low.

Net Margin is more than double the 2011 low, but less than half of the 2010 peak.

Operating Cash Flow is improving, but is $136 million below 2009.

Bank Debt is improving. Overall, the group has rebounded

from the 2011 low, but still remains stressed.

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Financial Aggregation of a sample of 85 Bondable Electrical Contractors

2012 2011 2010 2009

Revenue 6,264,301,628 6,464,918,560 5,936,093,588 5,873,737,559 Operating Profit 223,913,184 167,758,979 262,723,082 370,601,574 Operating Margin 3.57% 2.59% 4.43% 6.31% Net Profit 44,984,818 21,281,597 88,068,864 61,049,017 Net Margin 0.72% 0.33% 1.48% 1.04%

Operating Cash Flow 279,412,669 158,559,740 170,367,521 415,046,983

Cash & Mkt Sec 386,112,396 495,978,359 558,572,457 553,964,228 Net Cash 316,315,025 370,455,307 368,490,384 318,943,288 Bank Debt 346,193,656 396,154,590 340,135,037 294,422,948 Working Capital 661,960,027 738,999,095 720,191,052 712,316,838 Net Worth 1,040,577,130 1,113,343,927 1,085,117,008 1,011,394,949


Mechanical Contractors - 2012 vs. 2009

In the sample group: Revenue increased by $4.2

billion. Operating Margin decreased

nearly by half from 2009, but is improving from the 2011 low.

Net Margin decreased by half, and continues to deteriorate.

Operating Cash Flow is $114 below 2009, but is improving.

Bank Debt is improving, but increased 100% from 2009.

Net Cash increased by $189 million, or 40%.

Overall, the group has rebounded from the 2011 low, but still remains stressed.

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Financial Aggregation of a sample of 119 Bondable Mechanical Contractors

2012 2011 2010 2009

Revenue 11,252,867,010 10,589,270,124 6,549,008,192 7,037,176,277 Operating Profit 324,283,492 281,135,227 229,571,733 354,758,346 Operating Margin 2.88% 2.65% 3.51% 5.04% Net Profit 63,685,926 64,738,957 38,092,154 77,224,477 Net Margin 0.57% 0.61% 0.58% 1.10%


Cash & Mkt Sec 565,963,896 533,468,747 554,326,556 647,650,939 Net Cash 660,277,246 597,759,183 492,083,798 471,207,160 Bank Debt 414,711,116 512,388,557 224,221,474 207,094,232

Working Capital 798,293,858 816,816,729 749,152,554 699,289,849 Net Worth 1,323,687,262 1,225,102,890 961,794,453 903,387,076


Subcontractors (Excl. MEP) - 2012 vs. 2009

In the sample group: Revenue decreased by $2 billion,

or 24%, and remains flat. Operating Margin has rebounded

760% from the 2011 low of 0.30%, but is half of 2009 margin.

The group continued to be unprofitable.

Cash decreased by $359 million (32%), but Bank Debt decreased $147 million.

Net Cash decreased from $18 million to ($89) million, but shows significant improvement from the Deficit $357 million in 2011.

Overall, the group has rebounded from the 2009 low, but still remains very stressed.

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Financial Aggregation of a sample of 122 Bondable Subcontractors (Other than Mechanical, Electrical or Plumbing)

2012 2011 2010 2009

Revenue 6,696,006,329 6,517,442,176 8,018,412,997 8,542,110,602 Operating Profit 152,549,897 19,743,998 190,401,687 389,238,610 Operating Margin 2.28% 0.30% 2.37% 4.56% Net Profit (11,897,337) (137,644,972) (57,227,989) (163,647,523) Net Margin -0.18% -2.11% -0.71% -1.92%


Cash & Mkt Sec 453,934,365 549,091,814 761,986,550 812,714,361 Net Cash (89,971,527) (357,405,702) (268,138,153) 18,694,755 Bank Debt 847,654,917 1,116,722,596 1,299,227,114 994,755,589 Working Capital 627,253,013 750,922,202 748,481,678 1,015,298,021 Net Worth 1,141,292,826 754,862,512 859,416,971 984,798,265


The benefit of surety bonds After analyzing the risks involved with a construction

project, consider how surety bonds protect against those risks. Owners, lenders, taxpayers, contractors, and subcontractors are protected because:

The contractor has undergone a rigorous prequalification process and is judged capable of fulfilling the obligations of the contract;

Contractors are more likely to complete bonded projects than non-bonded projects since the surety company may require personal or corporate indemnity from the contractor;

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Continued… Subcontractors have no need to file mechanics’ liens

on private projects when a payment bond is in place; Bonding capacity can help a contractor or

subcontractor grow by increasing project opportunities and providing the benefits of assistance and advice of the surety bond producer and underwriter;

Surety companies may prevent default by offering technical, financial, or management assistance to a contractor; and

The surety company fulfills the contract in the event of contractor default.

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Surety Industry Overview: State of the Industry by Cissie Scoggin