1
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Surety Firms Weigh in on Construction Markets and Contractors:
FMI Surety Providers Survey
by Timothy R. Sznewajs and Curt M. Young
Introduction
As providers of essential credit instruments to construction firms, sureties are a critical
partner in the success of the contracting community. The unprecedented construction
environment of 2010 brings an increasing percentage of public work requiring performance
bonds and skeptical private owners seeking additional financial assurances that their
contractor will be able to finish the project. These factors prove that the surety community
plays an even more critical role in the assurance of adequately funded and qualified
construction capacity.
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Surety providers serve as key advisors for contractors, not just as someone selling
insurance policies or floating a loan. Any contractor with an outstanding bond has
regular dialogue with its surety provider and its surety agent. This dialogue, while
multifaceted, typically includes feedback and guidance from underwriters about
market posture, risk management and other business practices of the contractor. The best
contractor/surety relationships help to mitigate construction risk and help the contractor
avoid many of the common causes of failure to which contractors are prone. These
include being overleveraged, taking on more work than they have the capacity to
perform, not having sufficient management depth, working in markets where they are
not well-qualified, and carrying too much overhead. (See “Why Contractors Fail: A
Causal Analysis of Large Contractor Bankruptcies.” FMI Quarterly, Issue 2, 2007.)
The services provided by the surety industry are not just for the benefit of owners and
contractors; sureties are working to assure that projects are completed according to the
contract. Sureties lose money when contractors fail or fail to complete their end of the
bargain. Few industry participants share the unique perspective of the surety providers
as it relates to the health of the industry and the outlook of whether there will be
continued success or a growing number of failures. This is why FMI developed a brief
survey to ask a select number of surety industry representatives their opinions on several
key issues facing the industry in the next few years.
The brief survey was conducted by FMI’s Investment Banking Group to examine the surety
industry’s views regarding current market conditions, risk management practices of
construction firms and issues surrounding the transfer of ownership for construction firms.
2
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Since the relationship
of contractors and
sureties is so
interdependent, it is
Surety Industry Overview
Since the relationship of contractors and sureties is so interdependent, it is important to
look at the overall state of the surety industry to give some idea of the point of view of
those responding to our survey. The U.S. surety industry as a whole remains a dynamic
marketplace with several noticeable trends. These include the following:
important to look at
the overall state of
the surety industry
to give some idea
of the point of view
of those responding
to our survey.
1) The surety market continues to consolidate.
2) The industry has enjoyed an extended period of above average profitability and
remains relatively strong even in today’s market.
3) The surety industry has expanded through collaboration in order to support megaconstruction projects (>$100M in value), which have become more commonplace in
the construction market.
The surety market continues to consolidate.
Based on data from the Surety & Fidelity Association of America (S&FAA), the top 10
surety underwriters continue to increase their percentage of the overall premium written
in the construction industry. (See Exhibit 1.) From an average of approximately 50 percent
of all underwritten premium in the mid-1990s—a level that had been maintained since at
least the 1960s—today the top 10 firms account for nearly seven of every 10 underwriting
dollars. This trend is expected to continue through a combination of strategic acquisitions, business expansion and exits from the industry.
While the industry will continue to consolidate, it remains competitive due to the
number of potential insurance providers in the market. Consolidation also allows the
surety industry to be more efficient, since the merging companies often provide similar
products and services as the companies they merge with, thereby saving money due to
economies of scale. One of the concerns about
Exhibit 1
industry consolidation is whether the sureties will
have the capacity to generate bonds for the next
growth cycle of construction, especially considering
the trend toward mega-construction projects.
Top 10 as % of Total
Year
Underwriting Dollars
____________________________
1997
52.7%
____________________________
The industry has enjoyed an extended period
of above average profitability and remains
relatively strong even today.
2000
60.5%
____________________________
65.3%
2001
____________________________
The improved earnings in the surety industry in
the past five years are, in large part, attributable to
a return to basics after huge losses were sustained
between 1999 and 2004, a period when sureties
expanded too rapidly, underwriting standards
declined and several high-profile losses occurred.
Again, utilizing data provided by the S&FAA, in
Exhibit 2 we present a summary of the industry’s
1998
53.8%
____________________________
1999
56.5%
____________________________
67.5%
2002
____________________________
65.8%
2003
____________________________
64.1%
2004
____________________________
64.1%
2005
____________________________
66.0%
2006
____________________________
66.9%
2007
____________________________
68.3%
2008
____________________________
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A 30 percent loss ratio
is generally considered
the break-even point
aggregate direct loss ratio from 1962 – 2008. While the data for 2009 has not yet
been aggregated and reported, preliminary indications are that in 2009 surety firms
experienced direct losses nearly double that of 2008; however, losses experienced in
2009 were still within the historical, long-term average.
for sureties. The
60%
50%
40%
30%
20%
2008
2006
2004
2002
2000
1998
1996
1994
1992
1990
1988
0
1986
10%
1984
obtain bonding.
70%
1982
qualifications to
Recessionary periods
80%
1980
requirements and
90%
1978
higher restrictions on
Exhibit 2: Surety Industry Direct-Loss-Ratio History
1976
bonding capacity and
1974
difficulties with
1972
can expect greater
1970
much, contractors
1968
sureties are losing too
1966
contractors is that, if
1964
surety loss ratio for
A 30 percent loss ratio is generally considered the break-even point for sureties. The
importance of the surety loss ratio for contractors is that, if sureties are losing too
much, contractors can expect greater difficulties with bonding capacity and higher
restrictions on requirements and qualifications to obtain bonding. Too many restrictions
can keep some contractors out of the markets requiring bonded work. While not all
contractors may look favorably on such tight markets, sureties can help to normalize
markets that become over-exuberant at times when contractors may be taking on too
much work or riskier projects.
1962
importance of the
___________________________________________________________________________________________________________________________________________________________________________________________
Source: Surety & Fidelity Association of America (S&FAA) Top surety writers and annual results, 1962-2008, published by S&FAA, Washington, DC.
Considering that surety
providers are additionally
supported by reinsurance
providers, the performance
of reinsurers is equally
relevant for our consideration of the state of the
industry. As shown in
the data in Exhibit 3,
reinsurers have also
enjoyed historic levels
of profitability.
Exhibit 3: Reinsurance Loss-Ratio History
250%
220%
Recessionary periods
150%
100%
50%
0
–50%
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
________________________________________________________________________________________________________________________________
Source: FMI analysis and estimates based upon data published by the Surety & Fidelity Association
of America (S&FAA) “Top Surety Writers and Annual Results,” 1995-2008, Washington, DC.
4
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Total put-in-place
construction is expected
to be down 4 percent in
2010, following a
13 percent decline in
2009. According to
FMI’s Nonresidential
Construction Index
The surety industry has the ability to continue to support mega-construction projects
(>100M in value).
While the recession may have temporarily slowed the number of large mega-project
announcements, the need to rebuild America’s infrastructure and industrial facilities will
continue to generate complex mega-projects. Through co-surety arrangements, increased
underwriting vigilance and other developments, the surety industry is currently
well-positioned to support the underwriting of increasingly prevalent mega-projects. As
the construction market gradually reemerges from the present downturn, this support is
expected to remain in place.
The benefit to owners of building large projects is that they do not have to be as concerned
(NRCI) for the
about dividing the mega-project into smaller projects, a task that can overwhelm an
First Quarter 2010,
owner’s internal staff as owners become more dependent on outside construction and
program managers. On the other hand, mega-projects usually have fewer bidders since
they tend to shut out smaller contractors due to lack of bonding capacity, another point
of concern that sureties must address.
contractors are
reporting backlogs
(down from
Construction Outlook
11 months in 1Q08).
13 percent decline in 2009. According to FMI’s Nonresidential Construction Index
of eight months
Total put-in-place construction is expected to be down 4 percent in 2010, following a
(NRCI) for the First Quarter 2010, contractors are reporting backlogs of eight months
(down from 11 months in 1Q08). Project delays and cancellations, largely precipitated
by weakened economic and credit conditions, continue to be approximately four to
five times the normal rate. While overall conditions in the construction market are
currently bleak, pockets of strength do exist, and overall growth is expected to resume
within the next year.
Contractors have a reputation for being optimistic, a good quality when working in an
industry fraught with risk in almost every aspect of the construction process. FMI’s NRCI
captures the opinions of construction executives across the country and represents a
cross section of nonresidential construction companies of all sizes in a wide range of
markets. While NRCI panelists as a group feel the general economy is picking up, their
own businesses remain slow to recover. The only privately funded construction market
showing relative strength is health care; certain segments of the federal market have also
shown resilience (e.g. military-related construction). To date, federal stimulus funds
(ARRA) have been less stimulating than originally hoped, and many owners are looking
for prices below cost. At this point in time, contractors could use some optimism. The
Q1 2010 NRCI score was 48.4 and has remained in recessionary territory since Q1 2008.
If contractors are optimistic, surety providers generally serve as advisors who bring in
some realism. However, the surety executives we surveyed and interviewed for this
paper are only slightly less optimistic than our NRCI panelists, as both groups do not
5
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surety providers are
expect a return to growth for nonresidential construction markets until the latter part of
2010 or first half of 2011. (See Exhibit 4.) What might be of greater concern to surety
providers are the increased competitive pressures that can tempt contractors to bid and
get work at unprofitable levels. NRCI panelists see this too, as the following selected
the increased
comments to the first quarter 2010 NRCI survey illustrate:
unprofitable levels.
“Eventually, there will be significant increases
in costs to clients, because many contractors,
subcontractors and suppliers will close their
businesses, and there will also be less skilled
labor available due to lack of young people
entering the crafts and forcing immigrant
laborers out of the country.”
“[There will be] fewer competitors when
markets finally revive. We expect BIM
requirements on most projects.”
45.0
44.8
47.7
48.4
and get work at
Exhibit 4: Nonresidential
Construction
Index (NRCI)
34.1
35.6
contractors to bid
“Competition levels will remain high and
margins lower until the number of contractors
reaches equilibrium with the amount of
available work.”
52.6
that can tempt
46.1
46.5
44.7
competitive pressures
“Fewer competitors and those that don't
embrace change and advanced management
techniques will not exist.”
These comments from panelists were in response
to a question about what they expect to see when
markets recover. There is a sense in these comments
and the responses to questions below from surety
providers that the recovery may be even more
risky than the long recession as the contractors
that have been struggling to survive on low profit
margins or losing projects risk losing their bonding
capacities. In any event, it is clear that contractors
are struggling to “rightsize” their organizations
without jeopardizing their capabilities to serve
their customers and run profitable operations.
Although sureties provide bonding coverage on
individual projects, they are clearly concerned
with the health and longevity of their clients, as
the survey responses below testify.
2007
2008
2008
2008
2008
2009
2009
2009
2009
2010
greater concern to
Q4,
Q1,
Q2,
Q3,
Q4,
Q1,
Q2,
Q3,
Q4,
Q1,
What might be of
CURRENT NRCI
READING Q1-2010
48.4
PREVIOUS READING: 47.7
________________________
Scores Since Inception of NRCI:
Q4, 2007 to Q1, 2010
___________________________
(Scores above 50 indicate expansion,
below 50 indicate contraction)
6
TM
that the bottom would
be reached prior to
2012. That means
that the construction
industry will have
experienced three to
four years of market
contraction before
returning to a period
of significant growth.
Survey Overview
The survey respondents represent on average more than 3,000 contractors per firm and
account for roughly 60 percent of the bonds written in the total surety market in 2009.
Each of the respondents provides services across a number of different geographic regions,
and they are exposed to almost every subsegment of the construction industry. The surety
producers and brokers were asked numerous questions relating to three primary topics:
1) current market conditions for contractors; 2) probabilities of success for contractors in the
current environment; and 3) continuity planning and execution for their contractor clients.
Survey Results
As displayed in the graph below, the perspectives of the survey respondents generally mirrored
FMI’s forecasts, with the vast majority of respondents foreseeing a bottoming of the nonresidential construction markets in late 2010 or early 2011. A relatively small percentage of
respondents felt that a bottom would not be reached in nonresidential construction until
the latter half of 2011. All respondents felt that the
bottom would be reached prior to 2012. That means
Exhibit 5: Based upon conditions
that the construction industry will have experienced
you are currently observing in the
marketplace, when do you expect to
three to four years of market contraction before
see growth in the U.S. nonresidential
returning to a period of significant growth. Such
construction markets?
an extended downturn suggests that even robust
backlogs built before the recession will not be
sufficient enough to carry contractors through
2nd Half
2nd Half
of 2011
the downturn.
13%
Given their clients’ current strategies and mix of
business, only 25 percent of respondents believe
their clients are “well-positioned to succeed in the
marketplace over the next three to five years.”
(See Exhibit 6.) Respondents generally felt that
contractors did not recognize the magnitude of the
downturn quickly enough to adjust their organizations
to effectively deal with the perils of the current
environment. Many of the respondents’ concerns
related to three common items: 1) clients failed to
bring down overhead in conjunction with declining
revenue and backlog; 2) clients have strayed too
far from their areas of competency; and 3) clients
have taken on unacceptable levels of risk in
bidding new work.
Surety providers are attempting to assist their clients
to improve their efficiencies and mitigate certain
operational risks. Common resources provided by
the respondents relate to financial benchmarking,
business planning, and contractual risk counsel
and support.
of 2010
25%
1st Half of 2011
62%
Exhibit 6: What percentage of your
clients would you characterize as
"well-positioned to succeed in the
marketplace" (i.e. likely to earn at or
above long-term industry average
returns) for the next three to five years?
% of All Responses
All respondents felt
40%
35%
30%
25%
20%
15%
10%
5%
0
0–25%
26–50%
51–75% 76–100%
7
TM
Sixty-seven percent
of respondents
expect their clients
to have a more
difficult time
Sixty-seven percent of respondents expect their clients to have a more difficult time
obtaining bonding one year from now, while the remaining 33 percent indicate that no
significant change in their clients’ ability to obtain bonding was expected. (See Exhibit 7.)
No respondents indicated that bonding would be easier to obtain one year from now.
Respondents also felt that obtaining bonding would still be more difficult two years
from now than it is today. However, a small percentage of respondents, 11 percent, felt
that it would be easier to obtain a bond two years into the future. (See Exhibit 8.)
obtaining bonding
one year from now.
Surety provider concerns over their clients’ ability to obtain bonding in the future stem
from a number of factors other than natural risk aversion. There is an expectation that
contractors will be less profitable, more highly leveraged, and will have more difficulty
collecting receivables in a timely manner. Contractors that are more concerned with
just surviving the downturn may be neglecting or putting off important management
responsibilities, such as management succession and leadership development.
Exhibit 7: Compared to today, in one year,
do you expect your clients will have an easier
or a more difficult time obtaining bonding?
Easier 0%
No change
33%
More difficult
67%
Exhibit 8: Compared to today, in two years
do you expect your clients will have an easier
or a more difficult time obtaining bonding?
No change
22%
Easier
More difficult
67%
11%
8
TM
To help assure that
contractors do not
start down a path
toward failure, having
good long-term
relationships with
their surety advisors
will be even more
important than
normal as contractors
struggle to return to
acceptable levels of
profitability.
The most important criteria for providing surety credit, according to surety executives
surveyed, is the expertise of the client’s management team, (33%), followed closely by
balance sheet strength (30%). Respondents also considered successful project history,
(18%) and consistent profitability (11%) as important criteria when considering
requests for surety credit. (See Exhibit 9.)
For contractors scrambling to keep up the strength of their business in the current
recession, it is important to realize that sureties consider the strength of their management
team and the strength of their balance sheet as the top two areas of concern when
assessing their bonding capacities. The reasons for these concerns are illustrated in the
top three causes responsible for contractor financial difficulties as recognized by the
surety executives responding to our survey; these are insufficient capital/excessive
debt (89%), mismanagement (78%) and imprudent risk taking (67%). (See Exhibit 10.)
All of these concerns should be addressed in any business plan, but they are also
among the leading reasons that contractors fail, as mentioned above. To help assure that
contractors do not start down a path toward failure, having good long-term relationships
with their surety advisors will be even more important than normal as contractors
struggle to return to acceptable levels of profitability.
Exhibit 9: Which criteria do you view as important in providing surety credit?
Expertise of company
management team
Balance sheet
strength
History of
successful projects
Consistent
profitability
Experience in
project type
Amount
of debt
0%
5%
10%
15%
20%
25%
% of All Responses
30%
35%
Exhibit 10: Which criteria do you view as the major causes of financial difficulties
for contractors? (Select the top three.)
Insufficient capital/excessive debt
Mismanagement
Imprudent risk-taking
High overhead
Weak project execution
Inadequate controls
Character of management
Low profit margins
Slow collections
0%
10%
20%
30%
40%
50%
60%
% of All Responses
70%
80%
90%
100%
9
TM
The majority of
respondents rated
the quality of their
clients’ succession
plans as low or
average.
Management Succession Planning
Respondents were asked several questions relating to their perspectives on succession
planning. In FMI’s experience, succession planning is often either neglected or mismanaged
in the construction industry. Given the facts that construction firms are highly dependent
on the effectiveness of their top leaders and owners and that the average age of firm
owners is 55, this is not an area to be overlooked. Management continuity is particularly
important during a severe downturn, as disruption can precipitate and magnify
organizational and operational stresses. Some key observations by surety executives
concerning succession planning are listed below:
Sixty-four percent of respondents’ clients have a formal management/ownership
continuity plan in place.
Approximately 90 percent of respondents do not provide discounts or other incentives
to contractors that have implemented an ownership transition or management
continuity plan.
On a scale of 1 to 5, where 1= High Impact and 5=Low Impact, respondents gave
an average score of 3.1 regarding the impact a succession plan has in assessing
underwriting risk.
Respondents generally felt that most of the clients recognize the need for a
succession plan, with the vast majority viewing succession planning as a mediumor high-priority concern.
The majority of respondents rated the quality of their clients’ succession plans as
low or average.
For respondents’ clients that have an ownership/management continuity plan in
place or who are currently completing a plan, respondents estimate that only
17 percent are deemed "unacceptable" by their firms.
Respondents estimated that, of those clients that have an ownership/management
continuity plan in place or who are currently completing a plan, only 17 percent
"didn't work" (defined as an unsuccessful transition within the stated time frame).
As suggested by the responses below, continuity plans calling for significant
reductions in net worth may be deemed unacceptable by sureties.
Exhibit 11: For those plans deemed unacceptable, please describe the reasons.
(1=Least Important, 5=Most Important)
Plan called for unacceptable reductions in company net worth
Incompetent successor management
Uncertain terms/structure
Based on unrealistic assumptions
No fixed commitment for buy-out
Plan functions only at death
No death plan
0.0 .5
1.0
1.5
2.0
2.5
3.0
3.5
4.0
4.5
5.0
10
TM
According to our
survey respondents,
47 percent of the
third-party
transactions will
be initiated by
a private
Exhibit 12: For those plans which were (or are) unsuccessful, please describe why the plans
failed or are failing. (1=Least Important, 5=Most Important)
No competent successor management
Children not capable of running business
Price owner(s) want is too high
Key management leaves because of no ownership transfer plan
Failure of the business
Competent management leaves because of nepotism
Unaware of possible ownership transfer alternatives
Shift in competitive environment
0.0 .5
equity buyer.
1.0
1.5
2.0
2.5
3.0
3.5
4.0
4.5
5.0
% of All Responses
One potential exit option for owners of construction firms is selling the stock to a private
equity firm. FMI felt that this was an important topic to explore, given that a record
$400 billion of capital is currently
Exhibit 13: Recognizing that private equity
available for U.S.-focused private
transactions involving debt pose challenges for
equity funds. While transaction
contractors with a significant amount of bonded
activity among private equity firms
work, what is your firm's position on continuing
is generally down from the record
to underwrite these firms posttransaction?
highs of 2008, such a large amount
100%
of capital suggests the potential for
90%
88%
80%
a return of interest in private equity
70%
60%
acquisition activity in the construction
50%
industry as an option for ownership
40%
30%
transfer in coming years.
20%
0%
We will continue
to underwrite at
existing levels.
13%
We would consider
We do not
underwriting
underwrite
with additional
contractors with
security provided significant amounts
by the purchaser.
of debt created in
"private equity"
transactions.
Exhibit 14: If you answered,“we would continue
underwriting with additional security provided
by the purchaser,” what are the most important
factors in determining your acceptance?
% of All Responses
As indicated below, given the amount
of debt typically involved in a private
equity transaction, sureties either
will require more security or will not
provide bonding to highly leveraged
contractors owned by private equity
firms. Sureties would likely require
higher net worth limitations on the
amount of debt in the transaction
and indemnifications. The responses
shown in Exhibits 13 and 14
demonstrate vividly the difficulty
associated with private equity
acquisitions of contracting firms that
have significant amounts of bonded
work and the potential workarounds that may be available to firms
which seek to pursue this alternative.
10%
0
30%
25%
20%
15%
10%
5%
0
29%
29%
29%
Limitations on
the amount of
debt involved in
the transaction
guarantees by
management
Other
14%
Higher
minimum
net worth
requirements
Letters
of credit
11
TM
Conclusion
Timothy R. Sznewajs is a
principal with FMI Corporation's
Investment Banking practice,
focused on buyer and seller
representation and the
Sureties exist to help assure owners that projects will be completed according to the
contract and/or that subcontractors will be paid on time so as not to jeopardize the
project. The surety shares the owners aversion to risk but also helps the contractor to
secure the project and advise on critical areas of finance and management to assure
the ongoing business health of the contractor. Although there are many reasons given
as causes for the current recession, most agree that easy credit and complex securities
share a good deal of the blame. The surety industry has seen such times before and felt
the effects. Now, as we work our way out of the Great Recession, there seems to be a cry
of “back to basics,” that is, assuring that businesses use sound management principles and
have clear strategies and the management teams to implement them. Both contractors
and sureties are recognizing these conditions (although some later than others) and are
adjusting their business plans accordingly.
structuring of internal
ownership transfer plans.
He can be contacted at
[email protected] or
303.398.7214.
Curt M. Young is a senior
associate in FMI's Investment
Banking group and manages
FMI's business valuation
practice. He can be contacted
at [email protected] or
303.398.7273.
The surety industry is an important part of the construction industry, and because of its
risk aversion, has managed to maintain sufficient positions to be able to help see the
industry through the downturn and will be there as we turn the corner on better times.
Generally, we found no surprises in our brief survey of surety providers. Their expectations
for the turnaround in construction match that of many contractors that we regularly
survey. We expected them to continue to be conservative in their practices, which they
confirmed. What this inquiry and report should confirm for all in the industry is that
there are signs of health in the construction industry, but there are also signs that some
contractors may not be in business to enjoy the next upturn. Long recessions favor
better-funded and better-managed companies. Firms that do not meet these criteria may
be lucky to survive a prolonged downturn. The surety industry will continue to assist
in taking the luck out of this equation.
About FMI
FMI is the largest provider of Management Consulting and Investment Banking to the worldwide construction industry.
Founded in 1953 by Dr. Emol A. Fails, FMI delivers innovative, customized solutions to contractors; architects and engineers; construction
materials producers; manufacturers and suppliers of building materials and construction equipment; private owners, managers, and developers;
residential builders; utility companies; surety companies and industry trade associations.
FMI creates value through enhanced performance of companies, teams and individuals and by mitigating risk.
FMI’s management consulting practice provides a wide array of services, including strategy, training and talent development, leadership and
organizational development, marketing and related research, business development; compensation consulting and project delivery improvement.
FMI’s investment banking practice provides merger and acquisition advisory services, capital placement and financial advisory services.
© 2010 FMI Corporation. No part of this document may be reproduced or transmitted in any form, or by any means, without permission from the publisher, FMI.