Contractors Should Be Prepared for a Hard Surety Cycle
By JD Weisbrot, Construction Executive
In the early 2000s, contractors felt the pain of another surety cycle as bonding companies incurred historical losses and surety capacity was drastically diminished.
Between the years of 2000 – 2004, the surety industry was in the midst of a hard market and the industry as a whole lost a massive $4+ billion. As the surety market hardened contractors felt the pinch. Contractors who traditionally qualified for bonding were either declined for surety support or provided smaller limits, which reduced their bonded job opportunities. Bond premiums also increased dramatically and contractors had little choice other than to ride out the storm.
Surety cycles are typically 10-12 years, and this has been true for more than 100 years when analyzing surety losses and premiums written. The current market cycle has lasted more than 14 years, which means according to historical data the hardening of the market is past due. Many contractors are left unaware of the potential issues, as they rely on the surety expertise of their bond partners to mitigate their risk and keep them competitive. When it comes to most contractors, their expertise does not include knowing how to navigate surety cycles, nor should it be. The responsibility of properly assessing surety cycles and how to navigate them should fall on the surety partner. Surety partners need to thoroughly understand the cycles and ensure the contractors they are partnered with are provided a custom tailored plan to navigate them properly. On the other hand, contractors must plan with increased foresight alongside their bond partner to remain competitive throughout surety cycles.
The hardening of the surety market is not a question of if, but when. Like any market, no one can say with certainty when the cycle will harden, but the perfect storm is brewing for massive change. There are two primary factors that impact a surety cycle:
- actions and events that occur within the surety industry; and
- actions and events that occur to the industries bonded by the surety industry.
Surety executives anticipated an increase in frequency and severity of claims in 2010 from the economic slowdown, but it never occurred. A surety cycle did not begin after the housing bubble collapsed simply because government spending on construction in the public sector was flat, but did not decline. The private housing sector, which did not require much surety participation, was depressed sharply. Since then, new surety companies have entered the market, bringing billions of un-needed surety capacity, resulting in an ultra-competitive surety marketplace. Currently, contractors are realizing the benefits of the loosened underwriting, resulting in lowered rates and higher bond limits; this however, will likely lead to larger surety losses. The competitive surety marketplace is accelerating the time frame of the next market shift.
Competition between the sureties is reaching a peak, which translates to the current soft surety market. As a result, many sureties are bonding contractors at very low premiums and qualifying contractors with surety support that they would not have supported in a harder market. The upper management of surety companies expect premium growth year to year despite a soft market, translating to irresponsible underwriting decisions for the sake of premium growth and beating other surety competitors. As in the past, an inevitable increase in surety losses will cause the markets to shift, retracting surety support and resulting in more contractors unable to obtain bonding. Any contractors that can obtain bonding may have to pay substantially higher premiums and experience reduced capacities in a hardening surety cycle. The surety market has once again set the table for events within the industries they bond to create massive losses, resulting in a surety capacity vacuum.
All indicators point to increased contractor and subcontractor defaults with resulting surety claims.
MAJOR FACTORS THAT COULD TIP THE MARKET SIDEWAYS
Construction Labor Shortage
The skilled trades job deficit is likely to get worse before it gets better. A recent hiring outlook report noted 73 percent of construction firms plan to expand headcount. A 2016 report from the staffing agency Adecco shows that a disproportionate amount of skilled trades workers are baby boomers. Between now and 2020, more than 30 million baby boomers will have to be replaced just keep at current staffing levels.
If an infrastructure bill passes, the labor shortage will dramatically worsen. The trillion-dollar infrastructure plan is estimated to be around $100 billion spent for 10 years, requiring an additional 570,000 construction workers to fulfill the projects.
Contractors could see the impact of unforeseen material costs. The Random Lengths Framing Lumber Composite Index rose 6.83 percent between February 3 and 10, the biggest single week since 2003. It’s important to keep in mind that contractors include material cost estimates in their projects bids. If material costs increase, it can lead to thinner profit margins and even project default.
As with surety market cycles, the next recession is not a question of if, but when. The current economic expansion has lasted twice as long as the average since 1919. However, Glenn Rudebusch, an economist at the Federal Reserve Bank of San Francisco asserts that “a long recovery appears no more likely to end than a short one.” Ben Herzon, a senior economist at Macroeconomic Advisers advised, “It’s not the age, but the maturity that matters.” Inflation is spurred by drops in the unemployment rate, which has been dropping since its peak in 2009. With inflation, the probability of a recession increases. Raoul Pal, author of The Global Macro Investor feels the economy is mature enough to declare a 100 percent chance of recession for President Trump’s first term.
As reliance on technology becomes more deeply rooted into everyday business operations across countless industries, the threat of cyberattacks becomes increasingly devastating. There are many examples of high-profile businesses being targets of an attack. As a recent example, in June of 2017, FedEx Corp. experienced a significant cyberattack affecting their communications systems, which caused delays in deliveries around the world.
It’s not likely that one of these events will push the surety industry into the next hard cycle. More likely, it will be a butterfly effect: a combination of smaller events, like the ones above, that lead to larger scale events, tipping the surety industry back into a hard market cycle.
Regardless of whether one is bullish on the economy or not, it is wise for contractors to plan ahead. This can be accomplished by contractors ensuring they execute an ongoing conversation with their surety partner regarding surety cycles, and which methods and tools are best for their business to navigate them properly. With 80 percent of contract surety bond claims coming from payment defaults to subs and suppliers, the surety market is bound to be impacted in the coming years by foreseen or unforeseen events coming to fruition.