Loss Ratios Increase for Surety Bonds—Will Bonds Be Available?
August 2002
Lynn Schubert examines recent changes in the
surety industry: increased losses, rates, and underwriting focus; return to
personal indemnity requirements; and reduced capacity. But the picture is not
all bleak.
by Lynn
M. Schubert and Robert J. Duke
The Surety Association
of America
The Surety Association of America (SAA) has released its 2001 statistics
for fidelity and surety bonds showing a dramatic increase in the loss ratios
for both lines. Further, both the contract surety and commercial surety lines
of business show increases in losses. This article will address surety only,
and address both contract and commercial surety bonds.
The Statistics
Until recently, loss ratios for the total surety line have remained steady,
with moderate increases and decreases since 1989. In 2000, however, there was
a large increase in the loss ratio for the total surety line from a 24.7 percent
loss ratio in 1999, to a 41.9 percent loss ratio. According to the report entitled
"Top 100 Writers of Surety Bonds," released by SAA on May 21, 2002, the industry
reported the following results for the year ended December 31, 2001:
| Direct Written Premiums: |
$3,473,100,578 |
| Direct Earned Premiums: |
$3,330,170,608 |
| Direct Losses Incurred: |
$2,748,411,932 |
| Direct Loss Ratio: |
82.5% |
As you can see, these results reflect significantly increased losses compared
to prior years. How did this happen, and what is the likely result to risk managers?
How Did This Happen?
Each company has specific reasons for its own loss ratios. However, there
are some general dynamics that clearly affect the industry as a whole and which
helped lead to the 2001 results. The 2001 results are a continuation of a trend
that first was manifested in 2000 and are a result of market activity over the
past decade. There is no one event that instantly triggered the 2001 results.
For over a decade, the surety industry had experienced considerable profitability.
The positive results attracted new players to the surety market and caused existing
players to battle for greater market share. Two mechanisms to attract greater
market share are to reduce pricing and to relax underwriting standards. The
combination of reduced pricing and relaxed underwriting, however, can create
a dangerous condition.
Like most businesses, the surety industry depends on the state of the general
economy. A significant factor in surety results is the financial strength of
bond principals. A surety bond is written with the expectation that the bond
principal will perform its obligations or hold the surety harmless if it defaults.
Surety theoretically is written to a 0 percent loss ratio. Therefore, the financial
health of bond principals is crucial. This financial health, of course, is affected
by the general health of the economy. According to the percentage change in
gross domestic product, the economy began to experience some softening in the
third quarter of 2000. The quarterly percentage change is as follows:
| Third Quarter 2000 |
1.3%
|
| Fourth Quarter 2000 |
1.9%
|
| First Quarter 2001 |
1.3%
|
| Second Quarter 2001 |
0.3%
|
| Third Quarter 2001 |
-1.3% |
| Fourth Quarter 2001 |
1.7% |
Simply said, as the economy began to falter, more principals on surety bonds
got into financial trouble, requiring the support of the surety either to keep
them in operation or to complete their obligations. This was true in both the
contract and commercial surety arenas. Commercial surety, however, had some
additional challenges.
Over recent years, as more sureties entered the commercial surety market,
sureties became more interested in writing bonds for newer principals and guaranteeing
new types of obligations. Businesses were more creative in looking to the surety
market to assist them in entering into contracts where their credit alone was
not sufficient to satisfy the other party. That is the essence of the surety
relationship: the surety enables a principal to enter into a contract with another
party by putting the credit of the surety behind the principal. The underwriting
process is the process by which the surety determines whether it believes the
principal is qualified to perform the obligation it is undertaking.
Unfortunately, this move into new products, coupled with the softened underwriting
and pricing discussed above, added to the losses of the industry. Adding a major
corporate bankruptcy to the mix created the results we see today.
Reinsurance companies suffered serious losses in this surety market downturn
as well. In response, reinsurance companies are requiring primary sureties to
retain more risk and have tightened the terms and conditions in reinsurance
treaties. For example, we are aware anecdotally that certain reinsurance treaties
exclude coverage for long-term obligations, such as self-insured workers compensation
bonds or reclamation bonds, unless specifically consented to by the reinsurer.
This, in turn, impacts the primary sureties' underwriting decisions.
Impact of September 11, 2001, Attacks
The September 11, 2001, terrorist attacks did not impact surety companies
directly. However, the impact was felt by the property and casualty insurance
companies that are the sureties' parent companies and affiliates. The terrorist
attacks caused an erosion in capital as property and casualty losses were paid.
Although some of this capital has returned to the market, insurance companies
have become especially careful in allocating how capital is used. This decision
regarding capital usage affects underwriting decisions as well.
Impact of Enron Bankruptcy
The bankruptcy of Enron certainly magnified the 2001 losses. However, even
if the losses attributable to bonds written for Enron are not considered, we
suspect that the loss ratio would be equal to the 2000 loss ratio or higher.
A more tenuous effect of this bankruptcy is the claim by J.P. Morgan Chase that
surety bonds have no value. Specifically, J.P. Morgan Chase complains that the
sureties that issued bonds in favor of an affiliate of J.P. Morgan Chase did
not pay immediately when demand was made, but instead investigated the claim.
It is important to note three things in this regard. First, sureties already
have paid over $250 million on similar surety bonds written for Enron. In those
instances, there was no suspicion of misrepresentation or fraud by the obligee
on the bond.
Second, in the J.P. Morgan Chase case, there is a legitimate dispute as to
the conduct of the obligees on the bonds. In fact, the U.S. District Court has
found sufficient evidence of fraud in the procurement of these bonds that it
denied the bank's motion for summary judgment and stated, "The Court could not
possibly grant judgment to plaintiff."
Third, another bank, Westdeutsche Landesbank Girozentrale, is refusing to
pay the same Chase affiliate on a letter of credit given in a similar transaction
between Enron and the Chase affiliate. The point of these disputes is not whether
letters of credit or surety bonds are better security. It is how the bonds and
letters of credit were obtained and, specifically, whether the underlying transaction
was misrepresented. Sureties that wrote bonds for legitimate Enron contracts
have paid and will pay claims. Risk managers should not be concerned about one
instance of litigation arising among questionable circumstances, no matter how
highly publicized.
What Is the Likely Effect on Risk Managers?
To reverse the recent increased loss trend, sureties have reversed the factors
that played a role in the downturn, softened underwriting and pricing. We have
seen, and likely will continue to see, a firming of pricing and tightened underwriting
requirements in the coming months and years. For example, surety companies have
become especially hesitant to underwrite obligations that extend 5, 10, or 15
years into the future.
When a surety company writes a bond, it is making an assessment about the
bonded entity's financial and operational health during the term of the bond.
As the obligation extends further into the future, that assessment becomes more
uncertain, which creates greater risk. Sureties seek to control risk in part
by writing obligations that have a reasonable duration. Sureties also are addressing
the concerns of reinsurers and the diminished capacity through some creative
solutions. One solution has been an increase in the use of co-surety; that is,
more than one surety on a particular bond for a particular contract. We also
are seeing a return to the requirement of personal indemnity.
As the economy strengthens, and the principals on these surety bonds become
financially stronger, losses will again decrease, and pricing can be expected
to shift yet again. Tightened underwriting guidelines and creative solutions
to diminished capacity should be with us well into the future.
Surety Market Remains Viable
Despite the recent dramatic losses, the surety market remains well capitalized
and stands ready to meet its obligations. In January of this year, the SAA and
the National Association of Surety Bond Producers issued a joint press release
regarding the state of the surety industry, which can be found under News and
Information at www.surety.org.
This release provides an overview of the situation at that time.
Over time companies come and go in the surety business, based on a number
of individual business decisions. While one company may decide to sell its surety
business to another surety company, another may be adding surety to the lines
of insurance it provides. Additionally, there have been a number of mergers
in the surety industry in the last 10 years. The capacity to write surety bonds
for contractors and other businesses remains, but sometimes with different companies
than were used a decade ago.
Conclusion
There certainly are changes happening in the industry, beginning with increased
losses and the resultant increased rates. Sureties are looking closely at how
to curtail their losses. They are paying close attention to underwriting. They
are moving back to requiring personal indemnity. And they are looking at just
how much capacity they are willing to commit to any one type of surety bond
or any one principal, causing an increase in the use of co-surety.
Along with these changes, however, we will continue to see a commitment to
the business of suretyship. Surety bonds will continue to be a vital part of
the American economy as they have been for the past 100 years, and risk managers
will and should continue to rely on surety bonds both as principals and as obligees.
Robert
J. Duke joined the Surety Association of America in 1999 as director
of underwriting. Prior to that, he was a bond underwriter for Reliance Surety
Company and a bond department manager for Early, Cassidy & Schilling, Inc.,
an insurance and bonding agency in Rockville, Maryland. Mr. Duke is past president
of the Mid-Atlantic Surety Association and a former member of the Commercial
Surety Committee of the National Association of Surety Bond Producers. He graduated
summa cum laude from Loyola College of Maryland in 1988 with a bachelor's degree
in business administration, and he earned an M.B.A from Loyola College in 1992.
Mr. Duke has an AFSB designation.
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