by Michael J. Mitchell, CPA, CPCU, Vice Chairman
I just returned from the National Association of Surety Bond Producers’ annual three-day national conference in Orlando with over 600 surety executives from around the country. The top people from every major surety company were in attendance, and their prevailing message was: “Let’s hope the economy moves forward while ensuring that inherent risks are prudently managed.” However, any construction financial officer knows that is far easier said than done in today’s still-sluggish construction market.
It seems the worst of the recession may be behind us, but we must stay grounded in reality: construction spending for commercial buildings is still down about 40 percent from its 2008 peak; infrastructure spending saw an uptick last year, but today federal, state and local governments have budget restrictions; and residential development remains stagnated. Backlogs are only improving for the largest construction organizations and in some niche markets like multifamily housing (e.g., apartment buildings and senior living) and healthcare. And even that growth must be evaluated with cautious optimism.
I don’t like to cast doubt in our industry’s bright spots, but in this still-sluggish construction landscape, competition for work is more intense than ever, and margins are razor thin. Furthermore, the sureties are now seeing claims hit, and although they aren’t significant losses, your credibility and a sound strategy will be increasingly important to your future surety credit. The good news is that you’ve weathered the worst of the recession by adapting your business to the market. But by understanding the reality of the surety market and by adopting best practices to further reduce your risk, construction financial officers can shift into neutral for the short term in order to preserve their balance sheet for the long term. If you focus on preserving your balance sheets rather than taking big risks to increase revenue, you can put your business in prime position for growth when the economic recovery finally hits the construction market.
Premiums are down, claim count up
Like many construction businesses, surety company revenues are also down. However, sureties have still remained profitable. But this year they are seeing an uptick in claim activity, which translates into surety company losses. They’ve long been expecting more claims activity since the economy started its decline several years ago, but they did not start seeing its impact until recently. Fortunately, none of the major sureties have been hit with significant losses; rather it’s primarily an increase of small performance and payment bond claims.
Shrinking backlogs, smaller failures
Sureties suffer significant losses when a contractor fails because they have too much work. That’s not an issue in today’s construction market, where contractors fail because they don’t have enough work. As a result, the sureties expect to have claims this year, but generally the major sureties don’t expect monstrous claims.
Lesson Learned: As long as backlogs stay low, major sureties will continue to be more flexible in giving their bonding support to contractors who otherwise might not be creditworthy. But as the construction market’s recovery stalls contractors that opt to chase projects with greater risks and lower margins, it could put sureties at risk for significant claims later – ultimately leaving less surety credit available to the contractor population.
Despite the above push and pull between the sureties and contractors, the market has not yet hardened, and there is still plenty of capacity in the industry. This is the result of very responsible underwriting on the part of most sureties, which is a smart move for the market’s long-term success.
The outlook for smaller, regional sureties may not be as positive. Unlike the major sureties, regionals do not have as much capacity to handle a few medium claims in the $25-50 million range.
Lesson Learned: If you are with a smaller, regional surety, be aware of its results and also take initiative to meet with its local underwriters and home office management.
Pushing back on subcontractors
A surety will be tougher on subcontractors than general contractors. By nature, subcontractors are typically under-capitalized and at the mercy of the GC for payment. If you have heavy debt and are highly leveraged, you will also represent a challenge to your surety. Additionally, if you are being asked to sign project contracts with unfavorable conditions, expect even more push-back from your surety. This push-back will also apply to bond forms that include onerous terms.
Lesson Learned: There is little you can do about your payment structure with the GC and even less you can do about your current debt load (unless you consider renting your equipment). You can, however, reduce the risks of the project contracts on the table. Start by speaking the language; get familiar with the terms and conditions that will be red flags to your surety:
Translation of onerous bond language:
|1. Default language||The surety’s liability should be triggered upon a “default” and not merely a “breach” of contract. Default language should contain the phrase “in default and declared in default.”|
|2. Confession of judgment wording||Allows the obligee to confess judgment against you, and you are responsible to pay the amount claimed without having the ability to dispute the judgment.|
|3. Amount of time given for surety company to respond||A surety needs time to investigate a claim. Language limiting the time the surety has to respond (e.g., 10 days or 15 days) does not allow sufficient time for the surety to investigate an “alleged” default and choose the option that is in the best interest of all parties.|
|4. Liability in excess of bond penalty||Language that adds amounts covered such as court costs and attorney fees that are in addition to (“plus”) the penal sum of the bond.|
|5. “Obligee’s sole discretion” wording||Allows the obligee sole determination of an issue. For example, whether or not an item is covered under the maintenance period because it is the result of faulty workmanship or materials.|
|6. Time allowed for filing suit under the bond||Typically, state statute sets the minimum amount of time during which suit may be brought against the surety. Although language in the bond cannot reduce the amount of time, it can expand it.|
|7. Payable on Demand wording or Forfeiture Clause||Such wording limits the surety’s response option to paying now and litigating after the fact.|
|8. Limitations on surety’s options to respond to a claim||Sureties typically have several options available, such as taking over the contract and completing the project, funding the contractor in order to complete the work, tendering a new contractor to the owner, tendering payment to the owner for the determined amount of liability or denying liability. Any wording limiting these options should be avoided.|
Sureties will want you to readily provide more information and they will want to know and understand your game plan. If you don’t have a strategic plan to outlast the slow recovery, your surety will lose confidence in you and will not support you. On the other hand, if you lost money in 2011 but you have a sound strategy for 2012, your surety will stay with you because its business is built on long-term relationships.
Lesson Learned: Timely and accurate information will translate to credibility with your surety. Start with the following steps:
–Share year-end results: Do it timely and accurately. Deal with a quality CPA who can also help you manage your business and provide good, sound business advice.
–Make projections for the short & long term: Analyze your backlog and know how much is bonded (which represents the surety’s exposures) versus unbonded. Be prepared to explain how fast your backlog is running off and determine how much work you need to cover overhead. Use this backlog and run-off analysis to project your year-end results. This shows you are taking the information that you have today and proactively translating how it will impact current year-end results and long-term plans for future years.
Be Cautiously Optimistic
Be patient and view the current construction market as a time to maintain. You’ve survived the recession and the industry will improve; don’t make risky moves now without considering how you’ll maintain your business. And don’t ignore new opportunities (because they are out there!).
Sureties are talking a lot about GAP Financing and Public-Private Partnership projects, but these types of opportunities may only be good for the very large, well capitalized construction companies. The good news is sureties realize they need to be flexible in this environment and they need to find ways to support these new types of deals, but there are many surety challenges yet to be addressed, so proceed with caution.
Philadelphia, PA, 19102