CASUALTY LOSS RESERVE SEMINARSESSION 2SEPTEMBER 10, 2001

CONTRACT SURETY CASE RESERVES

STEPHEN J. TRECKER

SENIOR VICE PRESIDENT

XL SURETY

PHILADELPHIA, PA

CLAIMS PROCESS

• Investigation of the Financial Condition of the Principal Reasons to Investigate

• Claims Made Against the Bonds by the Beneficiaries of the Bonds

• Requests for Financial Assistance

• Requests from Underwriting

CLAIMS PROCESS

• Investigation of Surety’s Liabilities Under Bonds Performance Bonds

• ”Excess” Completion Cost

• Delay Damages (Actual & LD’s)

• Marginal Legal, Architectural and Engineering Fees Labor and Material Payment Bonds

• Replace Lien Rights on Public Projects

• Indemnify Subcontractors, Suppliers, Laborers

• Delay Damages

CLAIMS PROCESS

• Methods of Satisfying Performance Bond Obligations Financing - Infuse Capital to Avert a Default Takeover - Become the Contractor of Record Tender - Arrange for Others to Complete Owner Completion - Allow Owner to Complete Deny Liability - Litigate

CLAIMS PROCESS

• Labor and Material Payment Bond Claims Subcontractors, Suppliers, Laborers, Unions Delay Damages Claim for Extra Work Pay if Paid Ratification

CLAIMS PROCESS

• Investigation Summary Amount of Money Left in Contracts The Estimated Cost to Complete the Work The Amount of Unpaid Subcontractors and Suppliers Quality of Work Condition of Books and Records Salvage Possibilities

CLAIMS PROCESS

• Basic Case Reserve Calculation Contract 1 Contract 2

Original Contract Price $1,000,000 $2,000,000

Approved Change Orders $125,000 $100,000

Revised Contract Price $1,125,000 $2,100,000

Paid by Obligee to Principal $625,000 $500,000

Contract Balance $500,000 $1,600,000

Cost to Complete the Work $700,000 $1,300,000 ($200,000) $300,000

Labor and Material Payment

Bond Claims $175,000 $100,000

Surplus/Deficit ($375,000) $200,000

Contingency %

CONTRACT SURETY RESERVES ISSUES

• Accuracy - Adequate and Not Redundant

• Gross or Net - Contract Balances and Cash Collateral

• Date of Loss - Insolvency of Principal

ACCURACY OF RESERVES

• Completion Method Issues Financing

• Cost to Complete is Principal’s Optimistic Estimate

• Variable Home Office and Field Overhead

• Employee Morale

• Managerial/Technical Weaknesses

• Ability and Willingness of Obligee to Pay

• Timing Differences in Cash Flow

ACCURACY OF RESERVES

• Takeover Must Collect the CB’s Ability to Pay Bond Penalty

• Tender Clean, Pay Net Damages

• Owner Completion Clean, but Lose Control, Pay Net

• Deny Liability Litigation ALAE Owner Damages

ACCURACY OF RESERVES

• Contract Payment Methods Unit Price Contracts

• Quantities are Only Estimated Until Final Completion

• Excavation Contracts - Cubic Yards

• Sewer & Water Pipe - Linear Feet

• Over/Under Runs Not Known Until Final Completion and Measurement

Cost + Fixed Fee or %

• Final Cost is Not Known Until Final Completion

• Stairstepping as Costs Increase

ACCURACY OF RESERVES

• Cost + Fixed Fee with GMP GMP Moves with Remedial Work GMP Close to Fixed Price

• Fixed Price Remedial or Corrective Work is Cost + Successive Defaults

ACCURACY OF RESERVES

• Quality of Principal’s Work Construction Defects

• Patent

• Latent

– Not Included in Completion Price

– May Require other Work to be Torn Out and Re-Done

– Time Sensitive (Delay Damages)

ACCURACY OF RESERVES

• Integrity of the Principal Access to Book and Records Access to Key Project People Candor of Management and Technical People Admission of Errors and Problems Fraudulent Transfers

ACCURACY OF RESERVES

• Bankruptcy Time - Automatic Stay Trustee Fighting for CB’s Assumption/Rejection of Contracts Fraudulent Transfers

ACCURACY OF RESERVES

• Condition of Books & Records A/P Posting Accurate Updated Cost Records Legitimate Back Charges (A/P Reduced)? Held Checks (A/P and Cash Reduced)? Change Orders Only in System if Approved

ACCURACY OF RESERVES

• Size of Contractor Geographical Diversification of Contracts Complexity of Work Number of Contracts in Process Overhead

GROSS OR NET

• Contract Balances• Collateral• Completion Options• Cash Flow• Negative Reserves

RCP $1,000,000 Paid by Obligee to Principal $700,000 Contract Balance $300,000 Cost to Complete $500,000

$200,000

Labor and Material Payment Bond Claims $150,000 Net Reserve $350,000

DATE OF LOSS ISSUES

• Loss is Not Fortuitous

• Risk is Insolvency

• Claim File Opened Before Date of Loss

• Reserve Date

• When is Principal Solvent

• Systems Problems, Effective Date and Expiration Date of the Bond