Surety—U.S.

JEFFREY CAREY, MBA, CPCU, AFSB, CRIS

Assistant Vice PresidentConstruction Specialist

816.960.9360jcarey@lockton.com

CHUCK TETER, MBA, AFSBVice President Unit Manager816.960.9795

cteter@lockton.com

L O C K T O N C O M P A N I E S

Market Update May 2012

SURETY MARKET PERFORMING WELL,

BUT TROUBLES STILL LOOM AHEAD The preliminary 2011 surety industry results once again shattered many of the “crystal ball” predictions, as significant surety losses failed to materialize. On the surface, the recent meetings between Lockton’s National Surety Team and top industry executives left the Lockton team with a case of déjà vu.

Excellent financial results paired with predictions for a monsoon of losses on the horizon was a familiar theme. While one could overlook the predictions because of continued positive financial results, it would be wishful thinking at best. Digging deeper into the preliminary results and reviewing historical information will bring new points of concern to the surface.

Overall, industry results were fabulous: $5,139,092,292 in written premiums, $671,681,201 in direct losses, and a 13 percent direct loss ratio in 2011. Several sureties generated record profits, capacity has never been more abundant, and sureties are hungry to write well-qualified credit/contractors.

While all these points are true, they don’t provide the whole picture.

Market Update, Surety—U.S. Lockton

As the table below illustrates, the Top 10 sureties command more than 67 percent of the industries’ $5.14 billion in gross written premium, or $3.46 billion. Because of this, the results of the entire industry can be skewed both positively and negatively. As noted in Table 1, when you exclude the Top 10 sureties and look at “All Others,” the direct loss ratio jumps to 28.4 percent. This represents approximately a 7 percent increase for this group over the previous year.

Table 1

Direct Written Premium Market Share Direct Earned Premium Direct Losses Direct Loss Ratio

1 through 5 $2,735,472,373 53.2% $2,771,253,081 $86,924,495 3.1%

5 through 10 $727,372,395 14.2% $722,165,682 $103,651,321 14.4%

Top 10 $3,462,844,768 67.4% $3,493,418,763 $190,575,816 5.5%

All Others $1,676,648,449 32.6% $1,660,819,130 $ 471,935,823 28.4%

Total Industry $5,139,092,292 100.0% $5,154,257,812 $671,618,201 13.0%

The debate can be had as to why significant losses have been slow to materialize, but the 2011 loss ratio of the “All Others” group is a clear sign that the losses have started.

Historical evidence supports this as well.

The construction industry typically lags 18 months behind the general economy, and surety results tend to lag an additional 12 to 18 months. While the economy was stalling significantly in 2008, the construction industry was coming off a boom, and most contractors enjoyed full, profitable backlogs.

This acted to postpone contractor defaults, but the sheer length of the deflated construction market has taken a toll on most contractors. As illustrated in Chart 1, history reveals that construction surety losses typically occur during the recovery period subsequent to a recession. Contractors that are already strapped for cash secure work quickly at margins which are often inadequate to support overhead and cover payments to subs and suppliers.

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Est. Breakeven Total Industry Top 10 S&P Defaults

SFAA Loss Data v. S&P Global Corporate DefaultsCHART 1—SFAA LOSS DATA VS. S&P GLOBAL CORPORATE DEFAULTS

Market Update, Surety—U.S. Lockton

If losses do continue to build, it is the sureties in the “All Others” group who are the primary focus of concern. Two sureties have already fallen into insolvency during the past 12 months: Western Insurance Company of Utah and First Sealord Surety of Villanova, Pennsylvania. While the failure of smaller sureties has little effect on overall capacity and results, they can leave the industry with a black-eye.

2012

Surety capacity for well-capitalized contractors will continue to be abundant. New entrants into the marketplace and existing large sureties will continue to compete to extend large branches of credit to contractors with robust balance sheets. Strong middle market contractors will enjoy ample capacity and competitive terms as an abundance of sureties seek market share in this space. A few national sureties continue to pursue international opportunities, expanding their ability to provide a surety product that competes with banks for demand guarantees.

New insurance products are being presented to the market as an alternative to traditional performance and payment bonds. CapAssure, an XL Capital product, offers protection to owners of private projects from GC default, as well as protection from subcontractor default. The product covers both direct and indirect costs required to complete the general construction scope of work. Limits up to $25 million are available to GCs with sales of $200 million and greater. Other sureties/insurance carriers are evaluating alternative products.

Both XL Capital and Zurich Surety have formally announced PPPs (public-private partnerships) bond forms. These forms serve as a hybrid between a traditional performance bond and letter of credit, primarily driven by project lenders. They contain a specified amount of liquidity, which is available upon contractor default, with the balance of the bond amount responding in a traditional fashion.

Recommendation to Contractors/Clients

Surety companies should be evaluated as long-term business partners. We encourage our clients to continue to create well-thought-out business plans, including financial projections and adjustments for economic downturns. Contractors and commercial clients who anticipate market changes and adhere to their projections will find their surety partners more receptive to extending credit. We also recommend sincere and open communication, which includes both good and bad news.

The fundamentals of surety remain the same: contractors with a proven track record and strong financial performance will continue to receive ample surety credit. During a surety market cycle like we are currently experiencing, there will be a tendency for surety underwriters to make underwriting decisions, instead of business decisions, if they are presented with only underwriting factors. Companies with distressed financial statements can expect to pay a

Market Update, Surety—U.S. Lockton

© 2012 Lockton, Inc. All rights reserved.Images © 2012 Thinkstock. All rights reserved.

significant premium for surety credit; this will be reflected by higher bond rates, collateral, and possibly stronger indemnities.

The ability to effectively tell your story will enable the surety to make a comprehensive business decision, versus a template underwriting decision. Lockton’s resources are designed to impact our clients’ ability to effectively present their story:

� Proprietary software that analyzes historical job performance and translates the results into a more meaningful report.

� Profit forecasting model enables forward-looking analysis.

� Credit-modeling tool provides deeper financial analysis and communication platform.

� Software to help mitigate subcontractor risk.

� Investment in talented surety professionals who have experience in all market cycles.

� Credibility throughout the surety community based on relationships and results.

The combination of analytical tools, risk management software, expertise, and relationships provides a platform for deeper understanding that builds the foundation for a solid partnership between our construction clients and their surety partners.