Scared by surety

Hear the word from those on the front
line in the construction industry

BY LOU COLAGROSSI

The construction industry is notorious for its handshake agreements and the “good ol’ boy” method of doing business. In today’s economy, this methodology is no longer acceptable. Sureties are now dissecting contracts to determine if the risk transfer clauses contained in them are acceptable.
Verification of project financing, while always important to your surety, has become even more critical. Even if your agreement was made on a handshake, it’s still business, and only the strong will survive. Proper verification and contracts must be in place before you incur any expense mobilizing to the job site.
Let’s take a closer look at what is influencing the surety industry, and what it means to you. Dating back to the first quarter of 2006, the surety industry has seen profits increase as it achieved acceptable loss ratios of <20%. The current recession has begun to impact the providers of surety credit as principals are struggling to maintain meaningful backlogs, margins and sufficient cash flow. The past reliability of leaning on your bank line of credit and/or equipment financing companies to assist you is evaporating as they too have become more conservative and less willing to assist small businesses while they recover from their own financial misjudgments of the early 2000s. The end result is that the surety industry is bracing itself for increased losses, which will impact you at some level.
In 2009, the average reduction in surety premiums was around 15%. Having their top lines dwindle magnifies the losses they are beginning to experience, which ultimately could impact your existing relationship.
Downturns in the surety industry’s profitability were preceded by times of prosperity. We only need to look back to the ‘90s, when the economy was robust and surety underwriting was loose, which was the case up until 2000. The next five years produced record losses for the industry, with loss ratios of those years being 78%, 68%, 48%, 58% and 38% respectively. The most recent construction peak was 2007, which led us to the recession we are currently experiencing. History would tell us that a meaningful increase in construction opportunities will not surface until the surety industry has completed its loss cycle…which has just begun!
Consolidation within the industry has seen the top five writers of surety credit increase their national market share by 17% over the past 10 years. In 2008*, further consolidation in the industry resulted in the top five sureties controlling 55% of the marketplace. If sureties continue to consolidate, large contractors could experience capacity issues resulting in more co-surety arrangements, or a necessity to form joint ventures.
The financial market turmoil has far and away had the biggest impact on the industry. We see this in the banking community’s unwillingness to fund private residential/commercial development and its dramatic shift in underwriting benchmarks, right down to freezing (or worse yet, calling) working capital lines of credit. The flood of residential contractors now trying to compete in the public arena has driven profit margins down to a level most contractors cannot achieve and still maintain profitability.

What it means to you
What does all this mean to you? And what can you expect from your surety in 2010/2011? This is not the time to be highly leveraged or have your equity tied up in equipment and real estate. Sureties will be scrutinizing your debt levels and the cash flow required to service it.
It is imperative that you maintain a meaningful working capital line of credit with your bank. The best position to be in is to not have to access your line. If you are fortunate enough not to have to use your line, I would recommend exercising it from time to time. Banks have begun to reduce lines if they are not being utilized, as their lending capacity has been reduced, and they do not want their capacity sitting idle.
Sureties, for the first time, are not only interested in the amount of your line of credit, but which bank is providing it. Sureties underwrite financial institutions and monitor their credit ratings. The list of pre-approved banks has shrunk by almost 50% in the past 18 months. A careful review of the covenants is also becoming customary as banks are not as willing to waive common violations of these covenants as they have in the past. Establishing a back-up facility or maintaining lines of credit with two separate banks are two ways to protect yourself from having your access to capital shut off should your bank call their line and demand payment.
Profitability may be the exception, with losses from reduced volume and shrinking margins being the norm. The flexibility you have in your overhead must be acted upon, if you haven’t done so already. You need to be able to ride this storm out and cut overhead wherever possible. You can expect reduced volume for this year and next year, even with the ARRA dollars that have been pumped into your region.
If you are losing money, this is no time to hide that from your surety. The reduced volume of new construction coming out, in both the private and public sectors, increases your competition, reduces margins and expedites the need for strict overhead management practices. If you feel the need to travel outside your normal territory for work, it is important to explore that market thoroughly and devise a plan to penetrate the new territory, before you go to your surety and ask them for their support. Bottom line: you should create a business plan that identifies the issues and a strategy to address them.
No one is insulated enough not to feel the financial impact of this recession. The current economic realities present numerous challenges to managing your business….all of which impact your bottom line. A “best practices” approach to managing your business should enable you to maintain access to bonded projects. BXM

Lou Colagrossi is a bond manager the Dawson Companies. Contact him at 1340 Depot St. #300, Cleveland, OH 44116, 440-333-9000 ext 387, or www.dawsoncompanies.com.