Surety Industry Addresses Increases in Surety Losses
July 2001
This article examines the top 20 surety writers
in 1999 and 2000, showing premiums and losses, as compiled from Surety Association
of America statistics.
by Lynn
M. Schubert
The Surety Association
of America
On the whole, the surety industry is very well capitalized and financially
sound. Periodically sureties incur greater or lesser losses based on a number
of factors. To understand just how and why losses increase or decrease, you
must understand that the concept behind surety bonds is to prevent losses, both
for the obligees and the sureties themselves. As you will see by the statistics
cited in this article, the success of sureties in this effort varies from year
to year. However, the theory remains valid and one that anyone using surety
bonds should understand.
Surety underwriters pride themselves on their underwriting abilities, that
is, to write bonds only for contractors who pass their prequalification regarding
the contractor's ability to perform the project. This prequalification process
involves an extensive review of a contractor's business, both financially and
substantively. Does the contractor have experienced people on board who can
perform the work? Is the contractor financially capable of continuing work if
pay requests are delayed on the project? Has the contractor ever performed this
type of work before in this general geographic area?
While the surety evaluates many different issues to determine whether or
not the contractor, in the surety's judgment, is likely to perform, a surety
cannot predict with 100 percent accuracy. That is why sureties, as an industry,
always have losses.
The Premise Behind Surety Bonds
As mentioned above, it is important when talking about losses in the surety
industry to understand the premise behind surety bonds. Most insurance policies
anticipate losses. An insurer expects losses from fortuitous events and charges
a sufficient premium to pay for them and still make a reasonable profit. The
insurer uses premiums to pay losses rather than to prevent defaults.
A surety, on the other hand, tries to avoid losses by prequalifying the contractor
and, if cost effective, when problems do occur, financing it to complete the
work. Over 100 years of experience has taught sureties that the benefit from
money spent to avoid loss is greater than from money used to pay losses after
they happen. The delay and disruption from a contractor's default often will
cost more than completion of the work. It always is better and less expensive
to do something right the first time than to have to pay to do it over. That
is why any move away from traditional surety underwriting ultimately has such
a dramatic effect on results.
Why Construction Booms Lead to Greater Losses
Often, the precurser to increased losses actually is a boom in the economy.
A booming construction market frequently leads to greater bonding lines and
more capacity. During a boom, contractors' financials look good, more and more
work is available, and it is easy to carry unprofitable jobs with payments from
new projects. Sureties often are as susceptible to the belief that a boom will
continue indefinitely and provide bonding credit beyond what their normal underwriting
standards might suggest is prudent.
Certainly this occurred in the mid- to late-1990s. Although not all sureties
fell prey to this philosophy, even the failures of a few extremely large contractors
can affect the results of the surety industry as a whole.
When a boom is followed by a slow down, surety losses ultimately increase.
Fundamental is the principle that the principal on the bond is primarily liable
and the surety is secondarily liable. If contractors begin to have financial
difficulty and lose the ability to complete all of their bonded projects, sureties
begin to step in the shoes of these contractors, paying subcontractors and suppliers
who have performed on the project, and arranging and paying for completion of
the project. Often, if a contractor gets to this point, it also is unable to
repay the surety for moneys spent on its account. That is when surety losses
begin to mount.
1999 Loss Results on Contract Surety Bonds
The results of the surety industry for 1999 begin to reflect losses caused
by a combination of aggressive underwriting and the rumors of an impending economic
downturn, among other factors. Moving toward the present, it should come as
no surprise to anyone that contractors have felt the pain of the recent shift
in the U.S. economy. This pain is reflected in the estimated surety results
for the year 2000.
This article will address only the results in the contract surety line, in
other words, bonds to guarantee construction projects. There are a host of other
types of surety bonds called commercial bonds, such as license and permit bonds,
tax bonds, customs bonds, etc. There also are bonds that insure against loss
from employee dishonesty, called fidelity bonds.
The Surety Association of America (SAA) has statistics on premium volume
and losses on all of these types of bonds. If you are interested in these areas,
please feel free to e-mail me for information or log onto
www.surety.org.
This article, however, discusses only the statistics on contract surety bonds.
Due in large part to the strong economy, 1998 saw a decrease in loss ratios
for contract surety. In 1999, however, loss ratios returned to the more normal
numbers seen in 1997, and started their creep upward. The days of normal surety
loss ratios, however, appear to be gone for the near future. Estimates of loss
ratios for the year 2000 see the results spiraling upward significantly.
So, what are the recent results and what are the predictions?
The average annual amount of direct losses incurred for the contract surety
industry for the five-year period 1995–1999 was $411 million per year, resulting
in a 29.2 percent loss ratio to earned premium. The losses incurred and loss
ratios for the latest available three years are:
| 1997 |
$403 million |
28.2% |
| 1998 |
$280 million |
18.4% |
| 1999 |
$422 million |
26.3% |
These figures reflect the consolidated results of all companies that report
surety data to SAA for the United States, which includes the 50 states, the
District of Columbia, and Puerto Rico.
SAA data generally is available in late-third quarter for the prior calendar
year. At this time we currently are processing data for the year 2000. However,
our projection of incurred losses for the year 2000 based on a survey of companies
is approximately $865 million with a projected loss ratio of 52.5 percent.
This increase in loss ratios already is affecting the surety industry. A
few reinsurers (insurance companies which insure losses of other insurance companies)
have determined that they no longer are interested in writing reinsurance for
the surety line of business. The majority remaining have increased the pricing
and limited the terms of reinsurance for many of their customers, the primary
sureties.
These primary sureties also are beginning to make some changes. Existing
accounts are receiving stricter scrutiny of their proposals for increased bonding
capacity or expansions to new geographic areas or types of construction. New
account proposals are receiving stricter scrutiny during all phases of the prequalification
process. Some of the fundamental requirements for receiving surety bonds in
the historical past, such as personal indemnity agreements signed by the principals
of the construction company, are being reinstituted by many sureties who moved
away from the fundamentals during the boom.
Surety credit still is readily available, and competition still is fierce
for qualified contractors. The surety industry has more than enough capacity
to provide surety bonds to protect taxpayers on public works projects as well
as private owners and developers.
The Top 20 Surety Writers
The following is a chart of the top 20 surety writers in the year 2000 showing
premiums and losses, followed by a similar list for the year 1999. These charts
are for all surety products combined, not just contract surety, and are compiled
from the SAA List of Top 100 Writers and the SAA List of Top 50 Writers.
Chart
You will notice significant changes between these lists. Expect more in 2001.
The chart for 2001 no longer will show either Amwest or Frontier. Amwest (excluding
its bail bond company Far West) has been put into liquidation by the Nebraska
Department of Insurance. Frontier no longer is writing new surety bonds. The
Reliance surety operation was purchased in 2000 by Travelers and no longer appears
individually on the list of Top 100 Surety Writers. The parent company, Reliance
Insurance Companies, currently is in receivership.
On the other hand, insurance companies continue to enter the surety field.
There always will be changes in the makeup of any list of top writers of any
line of insurance. Companies, of course, make decisions based on the current
profitability of a line, but also make decisions based on other overall company
strategies.
Conclusion
The surety industry as a whole remains financially strong and viable, and
committed to providing protection to construction owners and developers. The
changes in underwriting that are beginning to occur should help the surety industry
overall return to more normal loss ratios in the future. Most sureties are well-capitalized,
well-run corporations on which you can rely to secure your projects.
If you have any questions about a surety bond provided to you by a contractor,
check the Bond Authenticity Program—Obligees' Guide in the surety section of
www.surety.org.
Be sure that all bonds provided by your contractors are authentic, and that
all sureties provided by your contractors are financially sound and will be
available if a claim needs to be made on the bond.
The SAA has more detailed statistical data available for both the surety
and fidelity lines for purchase. If you would like to review what is available,
log onto www.surety.org,
or e-mail Sean Foley at sfoley@surety.org.
Opinions expressed in Expert Commentary articles are those of the author and are
not necessarily held by the author’s employer or IRMI. This article does not purport
to provide legal, accounting, or other professional advice or opinion. If such advice
is needed, consult with your attorney, accountant, or other qualified adviser.