Spring 2021 McGriff Market Update: Surety
According to the Surety & Fidelity Association of America (SFAA), the surety industry posted a direct loss ratio of 22.3% through the first nine months of 2020 (includes IBNR – Incurred but not Reported). For full year 2020, we expect it will be in the 20%-25% range. While the full-year results will be 5%-7% higher than the past 8-10 years, it’s too early to tell if this is a COVID-19 anomaly or a broader trend due to market softness over the past 8-10 years. With plenty of capacity in the surety marketplace, we expect the industry to remain fairly competitive.
The Surety market is aligned with construction spending cycles as well as the overall economy. The Architecture Billings Index (ABI), a leading indicator of future construction billings, reported a score of 53.3 in February of this year, eight points higher than the January score. The South saw the most growth, the West and Midwest experienced slight declines, and the Northeast had the weakest growth (Source: American Institute of Architects).
Large contractor surety markets have continued to show strong results throughout the pandemic, primarily due to the construction industry’s designated “essential” status. Underwriters have been hyper-focused on contract terms, the labor market, access to construction materials, and profit estimates throughout the acquisition phases of contract pursuits.
Both public and private owners continue to pass significant risks to general contractors (who then transfer to their subs, when applicable). These risks may include consequential damages, right of way/permitting acquisitions, delays out of the contractor’s control (such as those related to an unforeseen pandemic), unknown site conditions and payment risk associated with change orders. Contractors, owners and sureties often seek to work together in order to negotiate more favorable terms by engaging early in the procurement phase. This is especially true in light of rising contract values and longer project durations (specifically in the civil/infrastructure sectors).
The shrinking labor market continues to be a cause for concern both at the large general contractor and subcontractor levels, due to:
- An aging construction workforce
- Fewer immigrants
- Waning interest among young people to pursue construction as a career
- Pandemic concerns
The cost of materials, especially foreign materials, has risen during the pandemic due to a lack of factory production and shipping limitations. This has led to scheduling issues and budgetary constraints. Proper planning, owner expectations about completion times and escalation clauses within contracts will be underwritten more strictly until things normalize.
Small- to Middle-Market Contract
The small- to middle-market construction segment is subject to the same labor market and subcontractor availability concerns as the large contract segment. But this market space is more competitive since projects are generally smaller in nature and have more traditional (and somewhat more predictable) delivery methods.
The appetite for new business is robust and capacity is plentiful. New entrants are aggressively seeking market share, while incumbent markets are doing everything necessary to keep their current clients. This is not to say the surety market isn’t carefully monitoring industry trends, such as adherence to schedules. We are beginning to see an increase in the default rates in this sector due to labor shortage and supply chain issues, leading to an inability on the part of prime/subs to keep schedules.
On the Commercial Surety front, we’re seeing carrier activity stabilize following a pullback in at the start of the pandemic. We are optimistic that the industries most impacted (e.g., hospitality, transportation, retail) will have a strong recovery as the economy fully reopens and picks up steam. However, these sectors took on significant new debt over the past 12-15 months, a situation that will be closely monitored over the next several reporting periods. From an underwriting perspective, liquidity and access to capital will be imperative. Underwriting scrutiny has intensified, but it has not had any dramatic impact on terms and conditions. Capacity seems readily available for right deal.
On a macro level, industries such as mining and oil and gas will face challenges in 2021 as the Biden administration enacts policies targeted at climate change. The oil and gas industry also could be affected by potential ramifications following the bankruptcy of an offshore operator. The bankruptcy could be a very large loss to the surety industry and surety reinsurers, and have broad implications for all offshore operators. We’ve seen at least six markets pull back from new oil and gas opportunities, and most of the other markets look to tighten terms and conditions.
The ongoing pandemic and resulting impact on the economy continue to be the biggest concerns in the surety industry. Geopolitical pressures are another potential threat (e.g., tariffs, trade wars and issues related to Iran, North Korea and China).
Following the significant disruption in the construction industry early in the pandemic, the Paycheck Protection Program (Cares Act) helped the industry recover relatively well. Many contractors received PPP1 and have already received forgiveness letters from the Small Business Administration. Due to tighter restrictions, fewer contractors have applied for PPP2.
It is too early to tell, if passed, what impact the Biden administration’s $2.3 trillion infrastructure plan will have on the construction market.
Threats to the construction industry, and thus the surety industry, include:
- Labor/shortage (safety/quality/schedule issues)
- Supply chain disruptions caused by tariffs and other issues
- Polyethylene and petrochemical plant shutdowns caused by the February deep freeze in Texas
- Lumber pricing
While the above issues must be addressed, we remain bullish on the construction industry and feel certain the surety industry has the capacity to support bonding.
Much of the surety industry completed re-insurance in the later part of 2020 and into 2021 renewals. While there is still more than adequate capacity, we now have more restricted terms and higher pricing, which should result in a bit of tightening in the extension of surety credit for the rest of this year and into 2022.
While far from a hard surety market, we might see tightening in the terms and conditions of bonding support in the next 24 months.
*This is a result of new entrants into the market as the total surety placement has been essentially flat in the $5.5 billion to $6 billion range. Expect to see the market share of the top ten to continue to decline as new entrants take larger positions. Source: Surety & Fidelity Association of America.
Source of Regional Chart: https://www.aia.org/pages/6384963-abi-february-2021-architecture-firm-billin
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