Understanding the Importance of Surety

Ray Batistoni, Hertz Global HoldingsStephen Haney, ACE Professional Risk

Robert McDonough, AON Risk Solutions

PresentersThe Broker:Robert McDonough, Surety Regional Managing DirectorAon Risk Solutions’ Construction Services Group

The Underwriter:Stephen Haney, Executive Vice PresidentACE Professional Risk - Surety

The Risk Manager:Ray Batistoni, Risk ManagerHertz Global Holdings

Underwriting

The Underwriter:Stephen Haney, Executive Vice PresidentACE Professional Risk - Surety

Any positions or opinions expressed are the presenter’s own and not necessarily Any positions or opinions expressed are the presenter’s own and not necessarily those of any ACE company. those of any ACE company.

Surety is NOT Insurance

1. Three Parties• Obligee• Principal• Surety

2. Indemnity3. No Losses4. Pricing

Characteristics of Surety

Surety Bond• Independent instrument• Conditioned on an underlying contract, ordinance or obligation

Risk of loss in bonding• Failure to perform assumed obligations

Surety bond is not a risk transfer mechanism for the principal

If Surety sustains loss due to default on part of principal, loss is recovered from principal and/or any Indemnitor(s)

Classes of Bonds

Construction Commercial

• Bid• Performance & Supply• Maintenance

• Court Bond• Customs• License & Permit• Public Official• Miscellaneous

Examples of Surety Obligations

Fiduciary Bonds: Be an honest employee (e.g., Tax Collectors)

Allow importation of goods without the immediate need to pay taxesCustoms Bonds:

Comply with contract’s terms and conditionsPerformance Bonds:

Pay those supplying goods and services in performance of a bonded contractPayment Bonds:

Meet all conditions of an ordinance or statute in the performance of licensed trade or businessLicense and Permit:

Alternatives To Surety BondsLetters of credit• Ties up borrowing facility• Can trip covenants• Not conditional

Cash• Reduces balance sheet liquidity• Cost of capital

Treasury securities• Cost of capital

Sometimes, there are no alternatives• Public funds typically require surety• Certain federal court obligations mandate surety

Underwriting Considerations: Non-Financial

Identification and Evaluation of Obligation

Pricing

Indemnity

• Cancelable• Demand vs. conditional forms

• Market driven• Credit sensitive• Obligation sensitive

• Ultimate parent vs. subsidiary• Captive arrangements

Underwriting Considerations:Financial Underwriting

Balance Sheet

Income Statement

Cash Flow Analysis

• Liquidity• Leverage• Debt maturity

• Free cash flow vs. no cash flow• Capital expenditure needs

• Earnings predictability• Interest coverage

Broker

The Broker:Robert McDonough, Surety Regional Managing

DirectorAon Risk Solutions’ Construction Services Group

U.S. Surety Industry: Strong Profitability, Default Concerns Continue

2010 YTD 9-30-11YTD 9-30-10

Earned PremiumsLoss Ratio

2009

$5.24B $5.27B19.5% 13.2%

Paid Losses $1.0B $694M

$3.96B $3.87B16.7% 12%

$654.5M $465M

Through 9/30/11 top 20 surety companies accounted for:• 82.6% industry-earned premiums • 85.9% losses

Industry results were profitable, but:• Largest surety provider results are inconsistent• Industry fears greater contract default experience

Source: The Fidelity & Surety Association of America

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Direct Written Premium Direct Losses Loss Ratio

Surety History Premium / Loss Results

Adapting to New Market RealitiesUnderwriters expected increased loss activity in 2011. Fortunately, companies made rapid changes to adapt.

Reduced overhead: Many contractors implemented financial model with lower backlog and smaller margins

Increased liquidity:– Slowing down capital expenditures – Negotiating new contracts with better payment terms– More modest M&A activity– Replacing letters of credit with surety bonds

Result: Stronger balance sheets collectively improved credit risk portfolios of the underwriting companies

Six Years Consecutive Commercial Surety Profitability Leads to New Capacity

2011 New Commercial Surety Capacity ($M)

Company Single Aggregate

Aspen Re $5 $50

Arch $25 $50

XL $200 $200

Hanover $10 $25

Argo $15 $35

Main Street America $25 $25

Philadelphia Insurance $10 $30

TOTAL $290 $415Aggregate expansions for established markets:

ACE $100M; Chubb $250M; Liberty $1B

2010 premium placements:• Approx. $1.5B: • 28.3% of $5.3B total industry

premium

New capacity developed through:• Hiring new commercial surety

leadership• Current writers expanding capacity• New capital entering the sector

Excess capacity and increased competition provided:

• Better credits/improved pricing• Lower credits access to previously unavailable credit

Source: The Fidelity & Surety Association of America

Market Discipline Challenged by Premium Growth Plans

Given finite universe of statutory risks, Sureties expanding writings through financial guarantee obligations (e.g., insurance program bonds)

2012: A record year for bankruptcies?

– On pace for 60: 5 U.S. and 6 global companies currently in default– S&P: 39 US defaults in 2011 vs. 58 in 2010

Companies that refinanced maturities instead of reducing debt and those faced with refinancing significant debt maturities in 2012 may risk default

Bankruptcy isn’t sole barometer for commercial surety losses – the confluence of soft market and potential increased defaults may reverse trends in the space in 2012

Expect continued “flight to quality” within the commercial surety segment

Construction Surety Sector Slow to Increase New Capacity – Despite Profitable Results

Contract Surety Earned Premium Placements

Underwriting Concerns

Underlying Sector Risk

• Approximately $3.8B in 2010• 21.7% of $5.3B total industry earned premium

• Continues to grow• Must navigate industry issues to avoid far-reaching impact of contractor default

• Weak construction spending & margins• Increased subcontractor payment claims • General contractors managing sub contractor default

issues

In extending credit, underwriters continue to consider:

• Health of existing backlog• Timing of payment from owners• Rising subcontractor failures/impact on profitability• Require more frequent financial updates• Onerous bond forms/contracts shifting risk to customer

Higher Loss Activity = More Questions for Project Approval

Greater financial reporting requirements

More stringent capital and liquidity retention requirements

Heightened discussions around surety indemnity language and credit facility documents

Rate increases for higher-risk clients and projects

Contractor default insurance may become a less viable option due to risk and cost

Varied Impact of Current Industry Trends

Clients consider alternate collateral structures to support unique transactions

Surety bonds can serve as viable alternatives to letters of credit

Holistic view of client internal cost of capital driving more opportunities to surety

Larger capacity available for investment grade type companies

Surety capacity a critically important credit tool for construction companies

A Risk Manager’s View of Surety

The Risk Manager:Ray Batistoni, Risk ManagerHertz Global Holdings

Keys to a Successful Surety Program

Price

Reputation of the backer

Working relationship

Administrative efficiency

– Ease of application

– Turn-around time

Questions?