FW speaks with Chad Rosenberg at Rosenberg & Parker about current trends in commercial surety.
FW: Can you provide some general background on the use of surety bonds as a risk protection mechanism? How do they work in practice?
Rosenberg: It is important to understand that surety is very different than insurance from a risk mitigation standpoint. One of the primary differences between surety and insurance is that insurance provides a direct risk transfer to the purchaser of the policy, whereas surety bonds do not. In fact, the entity that purchases the bond, which is known as the principal, receives no direct benefit. A third party, called the obligee, receives the benefit from the bond. The obligee requires the bond because they are entering into some sort of agreement or contract with the principal and they want to be sure that the principal will be able to fulfil the obligation. If the principal cannot fulfil its obligation then it falls on the surety company to do so. A classic example of this is a construction contract. When a company is going to have a new facility constructed it wants assurance that the project will be completed for the contract price and that all of the subcontractors and suppliers will be paid. By requiring performance and payment bonds from the general contractor they are protected against a default by the general contractor. At an average cost of less than 1 percent of the contract amount, and given that construction has the second highest rate of failure of any industry, surety is an outstanding and inexpensive form of risk protection. Companies can also require bonds from suppliers and service providers for such things as IT, telephony, supply chain, security, and more.
FW: What benefits can surety bonds offer to companies?
Rosenberg: Besides the direct benefit of the bond in the event of a default by the principal, surety bonds also provide a prequalification mechanism. Surety companies analyse a principal very similarly to banks in that they underwrite for no losses. In other words, if the surety does not think that the principal that is requesting the bond will be able to fulfil the underlying obligation, then they either will not write the bond, or they will require heavy security to do so. As such, an obligee has the knowledge that the surety has analysed the financial, organisational, and managerial capabilities of the principal and feels confident in their ability to perform. This process does not happen once, or even just once a year, but is ongoing. Therefore, a company can be assured that the principal has been underwritten and prequalified by the surety for its particular contract or obligation. And of course, if the surety is incorrect in their underwriting, then they will back it up with their chequebook.
FW: What major market forces are currently affecting commercial surety?
Rosenberg: First let me distinguish between contract and commercial surety. Contract surety is the term used to refer primarily to bonds written for construction contractors, including general contractors, road and highway contractors, heavy construction, and trade contractors. Commercial surety is the term used for bonds required by most other types of companies but is most often associated with large publicly traded and privately held companies, such as manufacturers, pharmaceutical, real estate, automotive, oil and gas, and just about any other company that uses surety. Many commercial surety accounts need contract bonds, but still fall within the commercial surety underwriting departments for most bonding companies. In the United States 60 percent of surety premiums are for contract surety and the balance is for commercial. In other countries contract surety makes up an even larger percentage of the overall market as no other country requires commercial surety bonds to the extent of the US. Now, to answer your question, the major market force affecting commercial surety is contract surety. Construction is a lagging economic indicator and as a result, construction did not really begin to feel the effects of the Great Recession until late 2009. Since then the construction market has been very weak. This has resulted in little or no growth in contract surety bonds over the past year or so. As surety companies look to maintain or grow premium they must rely on commercial surety to do so. As a result we are seeing many surety companies with increased appetites for commercial surety as well as a number of new players that have entered the commercial surety space.
FW: How would you describe the appetite for surety bonds in today’s market?
Rosenberg: Beginning in 2001 and as a result of such notable commercial surety claims as Enron and Worldcom, the surety industry saw numerous surety and reinsurance companies exit the commercial surety business, leaving a tremendous shortage of capacity. In the last few years, as a result of the downturn in the contract surety market not only have we seen existing surety companies appetites increase but we have seen a number of contract surety companies that have not been in the commercial surety market establish commercial surety departments. We have also seen a number of new surety companies emerge both in contract and commercial surety.
FW: Are surety bonds particularly attractive to companies operating in certain sectors?
Rosenberg: Any company that is investing in its facilities should consider bonding their projects. This is especially true today as the surety industry expects to see an increase in construction failures over the next 18 to 24 months. In addition, it is a good idea to bond suppliers and service contractors that are critical to your business.
FW: What trends have you seen in the pricing of surety bonds over the last 12 months or so?
Rosenberg: Pricing for surety bonds have generally remained level or decreased somewhat over the past year. Surety is not subject to the dramatic hard and soft markets seen in typical insurance lines. In fact, historically, surety rates change very little. I began my career as a broker in the late 1980s. During the many years that followed, rates remained level or decreased slightly. In 2002, during one of the most volatile periods in surety history, surety companies began increasing rates. I can still remember, in February of 2001, the first time I had to tell a client that his rates were being increased. I had been in the business for more than a decade and had never had to do that. During the next 12 months I became very used to it. During that time period it was not unusual to see a company have its rates increase by 200-300 percent. Just about every surety increased its rates and just about every bonded account was affected. Since then, rates have remained relatively flat. With the increased capacity that is presently entering the market, it would not be surprising to see rates come down a little, especially on the commercial side and for financially strong principals.
FW: Have any significant legal and regulatory developments impacted commercial surety in recent times?
Rosenberg: In short, no. Contract surety bonds are required on all Federal construction contracts by the Miller Act, which has been in place since the 1930s, and was enacted to protect taxpayers from contractor default, and to ensure that subcontractors and suppliers are paid by general contractors for work performed. Most other public authorities and agencies have similar laws which are referred to as ‘Little Miller Acts’. These laws have changed very little over time because the same risk of contractor default still exists, especially due to the low bid system used by most public owners in the US. Under this system, the lowest ‘responsible’ bidder is awarded a project. While this system ensures the lowest price for the taxpayer, it is inherently flawed in that sometimes it encourages a contractor to become too aggressive to obtain an award. If this were to happen too often to a contractor, they would likely eventually become insolvent. The requirement of a bond protects the taxpayer from such an event. With regard to commercial surety, laws are constantly being enacted that create new surety bonds, such as licence and permit bonds. At the same time, laws are changed to eliminate certain surety bonds. We saw this a couple of years ago when the Low Income Housing Bond requirement was repealed. None of these changes stand to materially impact the overall surety industry.
FW: Could you provide an overview of any notable trends you are seeing among top surety companies?
Rosenberg: We see a growing interest by a number of the top 10 US sureties in the foreign surety market, specifically as it pertains to US companies doing business abroad or foreign companies doing business in the US. The global recession has caused many large corporations to look outside their borders, triggering the need for international bonding capacity. It is incredibly important for large multinational corporations to work with a broker and a surety that has the capabilities to meet their present and future foreign surety needs.
FW: How would you characterise the growth of surety bonds in various regions around the world?
Rosenberg: The use of surety bonds continues to grow around the world especially as banks continue to struggle during the ongoing global recession. More and more foreign governments are willing to accept surety bonds in lieu of bank letters of credit. This is especially true in Europe as well as some of the emerging markets in Latin America. Brazil is a prime example of a country with a rapidly growing surety marketplace. Recent changes in surety regulations, coupled with a booming economy, tremendous natural resources, and the fact that Brazil will be hosting the World Cup and the Summer Olympics in the next decade, are all contributing to a strong need for surety capacity. Many global surety companies are expanding their capabilities in Brazil in order to assist their clients who are doing business there, as well as to take advantage of one of the few countries whose economy is expanding. Asia and Australia are also seeing some growth, albeit slowly.
FW: In your opinion, what is the outlook for surety through 2011 and beyond?
Rosenberg: The outlook for the overall surety market for 2011 and 2012 is tenuous. On the contract side, surety companies are expecting losses to increase as a result of the significant downturn in construction and the resulting deterioration of contractors’ backlogs. The losses are expected to be highest for trade subcontractors who are furthest from the money and are least well capitalised. Commercial surety should remain strong, especially as the economy continues to recover. This, of course, assumes that there are no major bankruptcies that result in large surety claims as was seen in 2001-03 when several large companies became insolvent, resulting in the worse losses in decades. Hopefully the construction market will begin to recover both in the US and globally towards the end of 2012 and into 2013. Assuming that the worldwide economy stabilises, the overall surety market should become even stronger with rates holding steady and capacity continuing to grow. Of course this assumes that we don’t have any major events that trigger more global economic volatility, such as a natural disaster hitting a major developed economic power, a nuclear meltdown, or a civil uprising in a significant oil producing country…
Chad Rosenberg is a principal of Rosenberg & Parker where he oversees client and surety relations as well as marketing and technology. Mr Rosenberg has over 20 years of experience as a surety underwriter and broker. He began his career with Reliance Surety Company and held underwriting positions in the home office in Philadelphia, and in offices in Seattle and Sacramento. Mr Rosenberg writes bonds for publicly traded and privately held corporations in the energy, manufacturing, construction, technology, environmental, and waste hauling industries, and many other companies with surety requirements. In 2006, he was named as a ‘Power Broker’ for the technology industry by Risk & Insurance Magazine. He can be contacted on +1 (610) 668 9100 ext. 103 or by email: firstname.lastname@example.org.
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