2019 Surety Mid-Year Update

From the ENR Magazine

Construction employment is high, as is the total dollar value of construction put in place, and just as importantly, profit margins are rising—this is mostly good news overall, according to a quick survey of industry professionals. “Early apprehension about an imminent economic cooling off has not been reflected in our industry,” says Ken Simonson, chief economist of the Associated General Contractors of America (AGC). “Overall, construction is still running flat out. As well, despite tariffs and workforce shortages, we’re not hearing about owners postponing, scaling back or cancelling projects, with a few exceptions, because of rising costs. Contractors tell us they have as much work as they can handle— and they’d be happy to take on more employees if they could find them.” Along with plentiful work for contractors, the surety market remains strong while contractor failures are low, though workforce shortages, volatile material prices and stalled federal infrastructure investment now threaten continued growth. Capacity, Credit and the Bottom Line Across the board, surety capacity is high, premiums are low, and underwriting terms and conditions are softening. Surety premiums have more than doubled over the past 20 years, and the industry has seen six years of steady growth. The Surety and Fidelity Association of America (SFAA) reports that 2018 direct premiums grew from $6.2 billion in 2017 to $6.6 billion in 2018. “Surety bonds help to build America,” says SFAA President Lee Covington. “Whether on a federal, state or local construction project, a P3 project or private construction, surety bonds play an important role in the success of construction projects. No other risk management product provides the same comprehensive protection as a surety bond—ensuring projects are completed and subcontractors are paid.” The megaproject sector (more than $250 million) is the only market segment with signs of problems. “We’re seeing some stress in this sector with limited capacity,” says Geoff Delisio, senior vice president and head of surety at Berkshire Hathaway Specialty Insurance (BHSI). “From a surety perspective, it’s stable, but with ever-tightening underwriting conditions.” Looking at other sectors+, capacity is plentiful for small (under $10 million), medium ($10–$100 million) and large ($100–$250 million) contractors. “If anything, there’s more surety capacity available today than there was is 2018,” says Kevin Waldron, Chubb’s senior vice president and surety director. Merchants Bonding Co. Vice President of Contract Underwriting Jason Dettbarn adds that he sees wide market availability for medium and large contractors, “though many of these organizations are pushing aggregate limits with the large amount of work available to bid.” Looking at the small contractor market, Dettbarn and others note that surety capacity is high, with sureties competing aggressively on program and underwriting standards. Additionally, there’s been a rise in credit-only 2   programs, with increasing limits making it easier for small and emerging contractors to secure bonds. Darrel Lamb, regional vice president for Old Republic Surety Co., says, “While credit-based bond programs seem like they could become a vehicle for default, that’s not happening. The credit-based bond programs are very successful with excellent loss ratios.” However, as Jeff Cose, associate vice president of the National Bond Center at Nationwide Surety, outlines later in this section, credit-based programs should ultimately be used as a stepping stone to more traditional bonding solutions. Signs of Stress? Along with strong surety capacity, contractor failure has been low. Just as importantly, profit margins seem to be on the rise thanks to increased opportunities and increasing backlogs. Michael Groman, vice president of CNA Surety, says he’s seeing some increase in contractor failure rates in the market, which are resulting in $10- to $50-million surety claims, though “not at a level that will stem the run of strong results for the industry as a whole.” He adds, “There has not been a meaningful combination of highfrequency and high-severity losses in the surety industry since 2000–2003, and we don’t see any signs of that changing in the near future.” Delisio has a slightly different perspective, adding that he’s seen a slight increase in failure in 2018. “I think that will continue to increase in 2019 and 2020. Profit margins are improving but are still not strong. In particular, large multiyear civil projects have had extremely poor performance in 2018 and the first part of 2019.” Chubb’s Waldron warns, “There appear to be some large contractor failures accruing that may affect the broader market once they become fully realized. There also appear to be some issues/concerns in the middle contractor market, but none that I expect will change surety underwriting behavior in the short term.” All those surveyed about the surety trends and challenges noted that while the contractor margins and amount of work are increasing, labor shortages, onerous contract provisions, scope changes, compressed schedules and poor owner financial metrics threaten the current market strength. Public Investment One of the disquieting issues for construction and surety remains the lack of a long-term federal infrastructure bill, which puts considerable stress on both state and local agencies to come up with funding sources themselves. Nationwide’s Cose adds, “Estimates range in the $4–$5 trillion of investment needed to get our nation’s infrastructure and transportation system modernized. If deterioration is not addressed, we will put ourselves in a dire situation in terms of public safety.” Merchants Bonding President Larry Taylor, who is also the current board chair for SFAA, says, “I’m not optimistic about an infrastructure bill passing in 2019 or 2020. On the positive side, more funds could be attached to the highway bill (though not near the amount that an infrastructure bill would require) that will probably just simply renew again this year. With the lack of progress, or very slow progress, at the federal level, many states are finding ways to fund infrastructure needs on their own. Several states are doing so by adding a new gas tax or increasing an existing gas tax. I expect to see more of this in the next few years.” With regard to federal-funded construction through the Transportation Infrastructure Financing and Innovation Act (TIFIA) and Water Infrastructure Financing and Innovation Act (WIFIA), there are significant efforts to assure that bonds for the full amount of the construction work are required. SFAA believes that to ensure the federal investment in such projects is protected, TIFIA and WIFIA should be modernized to include the same payment and performance bonding requirements that currently protect all other federal infrastructure funding— particularly in light of the growth of public-private partnerships (P3s) for transportation and other agencies. The P3 Potential At last count, 39 states, the District of Columbia and Puerto Rico have passed some form (broad to limited) of P3 legislation and enabling statutes. CNA’s Groman says, “Nearly all of the states that have enacted P3 legislation have addressed bonding provisions in a constructive and positive manner for both the construction and surety industries. We also feel that privatesector bonding has continued to grow, albeit it’s difficult to accurately estimate in terms of percentages versus public works.” Over the past year, SFAA has partnered with other industry organizations to advocate for bonding on P3 projects to state legislators. Through advocacy and education, the Indiana Finance Authority (IFA) and the Indiana Dept. of Transportation both agreed to 100% payment bonds and performance bonds of at least 50% for P3s for road and transportation projects. Also of note is that Colorado signed Senate Bill 19-38 into law in April 2019, clarifying that surety bonds are required on P3 construction projects. Recent North Dakota legislation amends all three of the state’s P3 laws to require a 100% payment bond and a 50% performance bond. Speaking on the more general topic of bonding and private construction, Ed Sipfle, Merchants Bonding’s regional vice president of contract underwriting, notes that the use of surety bonds in private construction has grown somewhat, with lenders requiring the bonds to mitigate their risk. He adds, “We’ve seen this shift especially on multifamily housing projects. Additionally, we’re now witnessing general contractors requiring more sub bonds on private construction—as opposed to subcontractor default insurance.” Sure-Footed Future All indications show that the rest of 2019 will be profitable for the surety sector and construction in general. There’s ample surety bonding capacity, and the construction forecast looks good through the end of the year. Waldron from Chubb anticipates the percentage growth for surety bond premiums in 2019 to be in the single digits. “While margins may not have improved as much as anticipated, backlogs are relatively healthy so the main concern is building backlog for 2020 and making sure overhead does not exceed what the market can sustain.” Merchants Bonding’s Senior Vice President of Contract Underwriting Josh Penwell warns, “While largely well balanced and sufficiently capitalized, the balance sheets of some contractors are beginning to show signs of distress due to inadequate planning when managing rapid growth.” Most of those surveyed for this midyear report believe that both the frequency and severity of losses will likely increase in the next few years, largely because subcontractor and labor markets are currently stretched tight. “There’s considerable work in the pipeline—so it’s difficult to see how all of the work will be completed without issue,” confirms BHSI’s Delisio. “Loss activity will have a constraining impact upon capacity, but not to the extent where strong credits are shut out of the market.” Old Republic’s Lamb concludes, “While we’re in a soft market and bonding is relatively easy to get, don’t neglect the importance of building a strong team with your partners—from accountants to bonding agents to surety underwriters—who have a vested interest in your success.”