Construction firms are being hit with the double-whammy of a hardening surety market along with the pain already being doled out by insurers. And the well-publicized bankruptcies of Enron and K-Mart are adding to the pain of sureties and their customers as bonding firms overhaul their book of business.
The problem on the contract side of the surety business started appearing in a big way in 2000 when "there was an overheating of the economy" and an uptick in failures by subcontractors that had taken on too much work, says Robert J. Lamendola, president and CEO of the Surety and Construction Group of the St. Paul Cos., St. Paul Minn., the nation's largest construction surety. This produced $600 million in losses for sureties, $400 million of which was shipped off to reinsurers, causing big problems for them.
But that was only the start. A recession started in the spring of 2001, dragging down construction volume and contractors, followed by a record 255 bankruptcies of public companies of all types, many of which were heavy users of commercial surety bonds. Then, the World Trade Center attack on Sept. 11 rocked reinsurers and insurers to the tune of $40 billion. When "Hurricane Enron" hit the financial world on Dec. 2., "reinsurers panicked," says Lamendola. Today, the commercial and contract surety markets are struggling with capacity limitations due to reinsurance, say industry sources.
The hard market definitely is here and is compounded most recently by the Enron and K-Mart bankruptcies, says David H. Skillings, president of Skillings-Shaw & Associates, South Freeport, Maine, and president of the National Association of Surety Bond Producers. Contractors "need to deal with a professional bond producer and are going to have to pay more attention to the needs of the surety to show that they are in good shape," he says. Skillings says sureties "all are rewriting their book of business" and consolidation and closures have sharply cut the number active in the market. Two recent departures are Fireman's Fund Insurance Co., which sold its 800 surety renewals to St. Paul, and AIG, which cut loose firms with less than $50 million of net worth. "In the last 18 months, five companies have left the surety business," says Lamendola. "Ten years ago the top 10 sureties had 20% of the business. Today, they have 40%."
The commercial side is worse off than the contract side of the surety business and "is almost gone on a larger scale," says Skillings. "Reinsurance is in desperate shape and primary firms won't take the whole risk," he adds. Enron and K-Mart "got the ball rolling," he says. Sureties offered financial guarantees for partnerships that Enron set up and K-Mart was self-insured for workers' compensation, which required financial guarantees in some states, say industry sources. Estimated losses to sureties range from $700 million to $2 billion for Enron and $200 million for K-Mart, in a business that produces premiums of about $3.5 billion annually.
Larger projects and contractors now often require participation of several sureties to spread the risk. This was the case in the $220-million Maumee River Bridge in Toledo, Ohio, which was just bid. Hugh Rice, managing director of management consulting firm FMI in Denver, says contractors often face an aggregate account limit of $250 million in the surety market. But Lamendola says St. Paul can and will write very large bonds by itself it it chooses to, since it has renewed its reinsurance treaties and has large surety revenue, about $426 million in 2000.
"What imploded the surety market is the absolute collapse of Enron," says Scott Trethewey, a vice president with Centex Construction Group, Dallas. He expects a tightening of surety underwriting and a reduction in capacity. He and others also believe that "the use of personal guarantees is going to become more prevalent." That means owners who took equity out of their construction firms may have to put it back.
Lynn M. Schubert, president of the Surety Association of America, is not as pessimistic. "We believe the sureties will be looking more closely at each contractor in their underwriting, [but] we have not seen a significant change in the overall capacity for construction bonds," she says.
But sureties may be expendable businesses. "Usually, a bond department makes up only a small amount of a carrier's overall book of business," says Chester Butler, president of The Butler Co. Inc., a Nashville, Tenn.-based broker. "So when that appendage starts to bleed, they simply cut it off."