...years was the result of a clause that the contractor should have negotiated differently and the clause pushed the contractor into bankruptcy, says Cheatham. “Now that we have a risk manager, we keep track of risk-shifting clauses. And we are building an underwriting knowledge center,” he says. “We would reject underwriting someone because a lender would want to be named as a co-obligee.”

One major surety, which requested anonymity, says it has been finetuning its approach to rights after a default. For example, it now seeks the right to use existing equipment on site to finish the project of a bankrupt contractor rather than bringing in new equipment because the contractor’s bank already had seized the failed contractor’s machines.

The shift to tough underwriting fundamentals also applies to smaller projects and leads to a philosophical question: Are contractors more profitable and selective because they are smarter and better managed or because sureties have forced them to improve? Sorting it out can be confusing.

Take the issue of price. Sureties are charging more for longer term projects and using credit models to establish pricing for individual contractors rather than taking a more generic approach.

Contractors work more closely with sureties than with their banks. “It’s relationship driven,” says John F. Welch, chief executive of CNA Surety Corp., Chicago. As a result, the construction industry will not see sureties slash prices by 20% as the bond business gets more competitive. Big national sureties generally charge from 0.45% to 2% of construction value and smaller regional sureties charge two to four times higher.  Contractors “would rather [their surety] is comfortable to give them another $50-million credit and the contractor makes $5 million. It’s much more money than if he shaved 10% off his cost,” says Welch.

Sureties generally will only extend credit to a contractor for work that is no more than 20 times its working capital, retained earnings or net worth. The sureties also generally want to be certain a contactor’s debt—its total liability, including accounts payable and bank borrowings—would never exceed three times the contractor’s net worth.

But the requirements vary according to the risk the sureties see “and do not reflect consideration of the many elements entailed” in a sophisticated credit model, Travelers Bond says in its statement. Many large-market accounts have ratios higher or lower and are considered creditworthy “depending on the circumstances” and numerous considerations, says Travelers Bond.

Sureties deserve a lot of the credit for contractors improving their profits, a phenomenon that has not yet shown up in industry surveys but soon will be apparent, analysts say. “Guys who want major capacity have to get their profits up,” says one prominent broker executive. “Let’s say there’s a contractor doing $700 million to $800 million worth of work a year and the profit is only 3%. Sureties are forcing them to at least double their profits and do a better job of quality control and on safety.”

But less well capitalized prime contractors are being left out in the cold. One troubling sign is an upswing in fraudulent bonds tied to individual sureties, exposing subcontractors to payment risk.

BEI&K/Leisa Cole/Omni Studios

"...I have heard that...subcontractors have submitted fraudulent bonds." — Ed Cassady, Vice President and General Counsel, BE&K Inc.

Subcontractors also are having trouble qualifying. “We find that it is increasingly difficult for subcontractors to find bonding,” says Ed Cassady, executive vice president and general counsel of BE&K, the Birmingham, Ala.-based engineering and construction firm. “We find that they are paying proportionately more for their bond and there are plenty of them who are no longer able to bet on bonding. In the past six months, I have heard of incidents where subcontractors have submitted fraudulent bonds.” This trend limits the pool of available subs and boosts profits for those who do get bonds, he says.

Kirvin Doak Communications Perini used insurance for subs on $7-billion Las Vegas project.

When Perini Corp., Framingham, Mass., won the prime contract to build City Center, a $7-billion development in Las Vegas and some other jobs, it was forced to face the surety capacity issues affecting subcontractors in that city and nearby Phoenix. Because the subcontracts on City Center exceeded some subs’ surety limits, Perini set up a subcontractor default insurance program, says Scott J. Thomas, Subguard program director for Perini Building Co., Phoenix. Subguard is an insurance product offered by Zurich. It “provided a means to use” quality subcontractors, including more minority contractors, “without significantly changing the risk profile of the project,” he says.

Changing Times.

Times have changed and so have the executives atop the big insurers. They are financial managers focused purely on profits and return on investments and equity. Surety units must justify the use of the capital they employ to do business—and certainly will not get it if they run off the cliff again. But historic trends indicate surety loss ratios will start heading up again in 2007 because of escalation in materials prices, according to a report by William J. McConnell Jr., president of Vertex Engineering Services Inc., Weymouth, Mass. Such inflation is a significant factor in surety loss ratios because it eats away contractor margins.

Mullis, NewBy Hurst, LP

"At some point, we will see a return to more competitive pricing..." — Sam Mullis, Partner Mullis, Newby, Hurst LP

In the boom and bust construction industry, a steadier, unwavering approach may be best for both bonding companies and contractors. “At some point, we will see a return to more competitive pricing for contractors, but that’s not likely to occur until 2008,” says Sam Mullis, partner in bond broker Mullis, Newby Hurst LP, Dallas.

Whether or not pricing improves, times are flush and that in itself is a concern given past cycles. “The thing that concerns me, and I think is concerning the industry, is that all the cylinders are clicking like crazy in the construction industry [and that is overextending] the subcontractor and contracting community,” says Tim Hess, director of preconstruction services for Hensel Phelps Construction Co.’s southwest district office in Austin, Texas. “People [are] doing too much work without enough resources. You start getting failures and contract defaults and things like that.”

The search is still on for the middle ground. Rod Williams, vice president for contract surety at Safeco Surety, Seattle, says the firm has been consistently profitable while overall the industry sustained losses. “We as much as anyone else want a rational surety market. It was very irrational in giving away the store and being too loose in the 1990s and [then going] too far in the other direction....Good clients suffered the impact because of the time and attention and resources that went to cleaning up.”