Surety Outlook 2015: It’s Still About Cash Flow

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by James P. Schabarum II, CPCU, AFSB

 

The surety industry has experienced better than average loss experience in the last few years and remains optimistically braced for profitable results again in 2015.

During the recent post-recession recovery, many contractors have been able to put to rest their problems of the past and pursue more revenue volume opportunities.  However, securing and collecting on acceptable profit margin work is still a challenge for the majority of contractors.

The most successful firms will adhere to the disciplined principles that got them through the toughest economic period in recent history. Although there are several factors that contribute to a contractor’s success, one key element is consistent over all others: Cash flow.

Surety Results

Results for the midyear 12-month comparison for 2Q 2013 and 2Q 2014 from the Surety and Fidelity Association of America (SFAA) Top 100 U.S writers of surety bonds showed a slight improvement of premiums and losses.  As of 2Q 2014, the surety industry remained profitable, with more than $2.658 billion in total direct premium written with an improved 17.3% loss ratio (the surety industry breakeven loss ratio is plus or minus 34%). Compared to the prior year 2Q 2013, the total direct premium written was $2.541 billion and the loss ratio was 20.8%.

The modest improvement in total premiums and losses indicates we might be starting to see the long-anticipated growth out of the flat market results seen during the past few years.  The noticeable increase in construction spending has not only been realized in the public arena, which contributes to about 75%-85% of the contract surety industry bond premiums, but also in the private commercial, mixed-use and residential subdivision markets. Although cautiously optimistic, for the right opportunities, sureties are once again “softening” in underwriting practices.

The industry remains top heavy.  The top five largest surety companies (Travelers, Liberty Mutual, Zurich, CNA and Chubb), write 50% of all premiums and have a direct loss ratio of 8.6%. The top 10 surety companies control 64.6% of the overall surety market.  More alarming is that the top 15 sureties account for almost 3/4 (73%) of all premiums in the U.S. surety market, with a combined loss ratio of 13.2% — nearly five points worse than the top five sureties.  Regardless of the concentration, the U.S. surety marketplace remains very competitive for now, but concerns over future underwriting flexibility and claims handling conflicts remain.

Current Surety Market

Since the 1990s, consolidation has narrowed the surety market considerably. However, to offset any market availability concerns and support growing capacity, the surety reinsurance market is a “buyers” delight.  The record level of overall global reinsurance capital is peaking over $3.54 trillion and seeing no stop to the continued inflow of funds. Surety reinsurers will continue to provide significant opportunities for reinsurance buyers (front-line sureties) to lower their cost of capital and enable growth into areas previously restricted.  Share repurchases and other opportunities will improve sureties return on equity. Hopefully the ample availability of reinsurance and desire for premium growth will not erode the surety industry’s controlled approach to responsible underwriting and credit selection.

Loss frequency will continue to be up for 2015. With more losses from smaller specialty trade contractors and, recently, a few large ENR firms, sureties will likely continue to see sporadic severe losses from larger general building and engineering contractors. Several years of performing low-margin work with tough contract terms are wearing down many contractors. Having low to no “net” cash and significant interest-bearing debt while failing to cut overhead over the last few years will undoubtedly be the death of some contractors.

A competing interest to the surety industry continues to be Subcontractor Default Insurance (SDI). SDI has taken a noticeable amount of surety premium and some losses away from the surety industry. The reduction of premiums has hindered the industry’s efficiency and frequently created adverse selection. More of a concern, SDI has shifted losses from sureties onto contractors that are often ill equipped to handle or manage the large deductible losses.

Sureties are very hungry for the best contractors and will compete aggressively on capacity, indemnity and rates. However, sureties are very tight on struggling contractors in the recovering construction market. Surety underwriters are now more concerned about project financing, contract terms (including warranty and efficiency guaranties), collection of account receivables (and retainage), approved and “unapproved” under-billings, access and use of bank debt, and exposure to subcontractor default. As a result, sureties will now want to meet with contractors and evaluate financials more frequently, look harder at the details, and confirm acceptable contract, bond form, and financing terms. Sureties now have a high standard expectation of risk assessment and risk transfer, including subcontractor bond-back policies and overall standard of conduct and reporting.

Industry Trends

As the construction industry cycles into a growth mode, contractors should prepare for the pent-up demand that has been built up during the recession. While contractors must retrench during lean times, they also need to see the warning signs along the road and protect their core resources to be ready to capitalize on the real opportunities that will eventually return in the form of higher profit margins. Some of the key current industry trends to look out for and harness are:

  • Public budget reductions, private lending restrictions and project delays are resulting in past work availability and schedule performance uncertainties
  • Preference contracts for Disadvantage Business Enterprises (DBE) contractors are reducing work available to standard contractors
  • Competition for less work has compressed margins below acceptable levels
  • Fewer contractors are able to continue to produce multiple years of consecutive profitability
  • Balance sheets have deteriorated
  • Operating leverage has increased in total and interest-bearing debt to net worth
  • Working capital and liquidity have been adversely affected
  • Hung receivables, unapproved change orders and REA are teetering some contractors on bankruptcy
  • Onerous contract and bond form terms and conditions have shifted risk
  • Pressures are being felt from labor compliance and governmental regulations
  • Firms must keep up with innovative technology in the form of integrated project delivery, BIM, sustainable construction and expansion of pre-fabrication

Success in 2015 and Beyond:  Cash Flow

In order to survive and thrive, all contractors should accurately assess their own capabilities, balance sheet strength and ability to internally support cash flow. It is more important than ever to maintain a history of completing contracts profitably, and consistently producing net retained earnings. Create a flexible and realistic plan, examine all direct and indirect expenses and keep your hand on the throttle at all times. Complete, accurate, and timely job costing and financial reporting is an expected requirement, along with transparent and regular communication.

Today’s environment and challenges require a stronger capital base that will allow contractors to control their own destiny. Cash continues to be the lifeblood of every construction operation. Contractors don’t fail for lack of work or opportunities; they fail for lack of cash. The failure rate for contractors is two to three times greater during a recovery than during a downturn.

Cash management spans over all operations for the “best-in-class” contractors.  It starts by seeking work with acceptable risk-reward balance, setting aggressive payment and retainage scheduling and terms, maintaining proactive billing and collection policies, having assertive change order and REA negotiations, utilizing all known cash management techniques and scrutinizing all expenses. Good cash management activities are essential to being a successful contractor.

Conclusion

2015 will be a good year for most contractors that have done their homework and have a good plan going into the New Year.  A great business plan that will strategically maximize a contractor’s strengths must include the ability to cash flow operations and take advantage of every opportunity to build its cash position. While contractors will continue to be tested on every front in the upcoming business cycles, it’s indisputable that the world is still on the gold standard and “Cash is King.”