Future Assurances

Industry stands ready to support qualified contractors to build infrastructure. By Marc Ramsey, The Surety Information Office

“Surety executives say public construction will not rebound completely until single-family residential construction takes root again in severely depressed construction areas”
-Marc Ramsey, The Surety Information Office

The question "What is the current state of the surety market?" is often posed to the surety industry. The inquirer actually may be asking, "Is there enough surety capacity in the marketplace to meet the demands of the construction industry, particularly in my sector?"

The simple answer is, "Indeed, adequate surety capacity is readily available today to qualified contractors in all market sizes."

The complex answer is, "Yes, but ...."

The surety industry is cyclical. Some years are profitable, while other years experience severe losses. How the industry performs depends, in large part, on how the construction industry performs. For the rest of 2009 and into 2010, the surety industry is bracing for a down-cycle, which is coming as bank credit tightens, contractors' backlogs run out, and competition increases for less available work. Contractors may begin to bid work beyond their experience as the recession continues and they are unable to secure more familiar work. This means more contractor defaults. Contractor defaults on bonded projects may result in surety industry losses.

Surety industry executives do not anticipate catastrophic losses, but they do expect an increase in losses beginning later this year. Recent years of profitability and solid underwriting are expected to compensate for the coming losses, and 2009 should still be profitable. Surety executives predict a difficult 2010 and beyond, but insist the industry is ready to meet the challenge. After all, unlike banks, property and casualty insurers have proved financially fundamentally sound. Keeping in mind that surety is a long-term, highly volatile product, surety companies have remained conservatively reserved and maintained disciplined underwriting to mitigate the impact of the current downturn.

Surety executives also foresee an increase in the severity and frequency of losses. Underwriters will continue to look not only to limit these losses through solid underwriting, but also to protect obligees by supporting what they believe to be qualified contractors on their projects. Underwriting requirements are not changing, but contractors' balance sheets are. Surety capacity is available, but sureties are responding to the changing composition of their clients' balance sheets and adjusting program commitments as necessary.

So, how did we get here? Will the federal stimulus plan make a difference? And how long will the down-cycle last?

Most contractors rely on bank lines of credit to fill gaps between when they incur expenses and when they receive payments for work. The tightened credit market is causing cash flow problems for many contractors, whose banks have reduced or eliminated their lines of credit.

Contractors need to monitor their bank renewals far in advance and be prepared to discuss their financial institution with their surety, as many sureties are no longer satisfied only that a contractor has a line of credit, but require that it is with an acceptable financial institution committed to supporting their client.

Surety executives encourage contractors to maintain a strong banking relationship to ensure that working capital lines are available to sustain cash flow, but advise contractors to have a backup plan in case their existing bank does not meet their company's needs.

The decreased public investment in construction is driven more from declining tax revenues and large budget deficits than by any linkage to the troubled credit market. Municipalities and states are working to identify sources of revenue including their designated shares of stimulus money and align the anticipated revenue streams with high priority construction projects.

They also are cutting expenses, looking at all line items from education to capital projects. Many municipalities are canceling projects for which bond issues already had been approved, and in some cases, even after they had raised the capital, so they can use the money for other areas of their budget.

If the credit crisis has had any effect on municipalities and states, it has been on their ability to access credit at terms they find acceptable. This has contributed to delays or cancellations of some construction projects in 2009.

The US Census reported the seasonally adjusted annual rate of total nonresidential construction put in place declined 0.7 percent in June 2009 over June 2008. Total nonresidential public construction grew 5.1 percent over the same period.

The recession is affecting the entire nation, but the impact varies regionally. The regions suffering the worst may be those where residential markets have slowed most, forcing contractors to look to replace their private backlogs, which have deteriorated due to the tight credit market, with projects from the public sector.

The federal stimulus package is $787 billion. The amount allotted to construction is $130 billion. Presuming it will take two years to spend, or $65 billion per year, that is less than 7 percent of the current $965.7 billion in annual construction spending, according to the June Census figures. Some surety executives say 7 percent is less than ideal, considering the stimulus plan was supposed to be a jobs producer and construction affects everything.

Many say the stimulus program will not have a major impact on the broad construction marketplace. While it is better than nothing, they say, the competitive landscape of the national construction market continues to represent too many contractors competing for too few projects.

The public marketplace should experience an uptake in activity following the infusion of stimulus funding, as infrastructure, roads and bridges, and defense work stand to gain the most. These projects, however, will receive long bid lists, resulting in reduced margins for successful contractors. Executives add that the devil will be in the details as to how the work is let, how it is administered, and whether it will benefit communities down to the local level.

Surety executives say public construction will not rebound completely until single-family residential construction takes root again in severely depressed construction areas. Contractors then will realign to their most profitable sector, where they are best suited, and the market for all things tied to residential construction such as schools, retail, and commercial will resume to normal activity levels.

In today's challenging construction environment, contractors are faced with increased competition by new entrants in the public sector, while municipalities and states struggle with declining tax revenue and budget deficits, resulting in less available work. As contractors' backlogs run out, they will be pressured to reduce profit margins to compete more aggressively. The result may be better pricing for public owners, but the reality is that some contractors may not survive.

The stimulus package should have a positive effect on the sectors that stand to gain the most from the federal money, but executives say it is not enough to significantly affect the broader construction marketplace.

The surety industry plays an important role in construction. Despite financial scandals and the credit crisis, the surety industry has weathered storms in the past and continues to stand strong, ready to meet today's challenges by supporting qualified contractors to build infrastructure and other projects that help the US economy prosper.

Marc Ramsey is Communications Manager at The Surety Information Office.

For more information please visit www.sio.org.