The Basics of Surety Credit
Why has the NY surety marketplace changed and have become so tight ? With significantly higher loss ratios for the surety industry in the last several years and prospects for still worse results ahead growing in large part out of the Banking Crisis, there is a move by both reinsurers and primary surety writers to return to more consistent and fundamental underwriting standards. Surety premiums are a very minor share of the revenue base for most insurers. The business, however, holds significant exposure for large losses as defaults like Enron and others have underscored.
The insurance companies who are the “parents” of most surety operations were already suffering from effects of a prolonged soft market and the affects of the banking crisis. Therefore, if you are an insurance executive managing risk, you may view the surety business as a low revenue business with a potential for big losses. Your choices appear quite clear: exit the line entirely; restrict your writings of this line; and/or implement sound underwriting standards. That is what is happening and it very likely will affect your current bonding arrangements.
The days of easy underwriting are gone:
Even without the financial melt down, their was an apathy as it related to the underwriting of the surety industry. In years past it’s almost as if anyone could obtain a bond regardless of experience, character, or financial acumen. Such an environment may have generated additional surety premiums for cash starved insurers, but it was also a disservice to the many surety principals who earned their surety credit,
resulting in a dilution of the bond issuance itself. It was also a dilution to owners, general contractors, and other obligees that relied on the surety’s much touted “prequalification” process. Therefore, bonding and surety programs that far surpassed the contractor’s financial base or experience, the unwarranted elimination of personal indemnity, or continually lower bond rates has come to an end.
How do we navigate this new surety environment when their has been such a tectonic shift? In our estimation we believe the first thing should be to perform a self-assessment litmus test. Has your bonding credit grown at a much faster rate than your financial base? Has the surety released the personal indemnity of the owners and or owner’s spouses? Has your bond rates decreased several times in the last few years?
If the answer to one or more of these areas is “Yes,” then you may expect some change(s). To the extent that you earned each of these benefits, you should work with your NY Bonding Agent and be prepared to support your position. Surety insurers want to continue their business relationships based on solid fundamentals, and the burden will fall on you and your agent to demonstrate that you meet those new standards.
The perennial challenge is how to make your account more attractive to a surety underwriter. To better help or clarify that challenge, it’s essential that you as the obligee understand what it is the bond underwriter does.
The surety becomes your partner and is guaranteeing your contractual performance on a particular project, or many projects. The surety is effectively becoming a silent business partner. When it approves your bond, it says to the world that it believes you have the capacity in every respect to complete the bonded contract as stipulated. Like any partnership the foundation must be built on a mutual respect and transparency . If you view the bonding relationship as a partnership, then the responsibility to each of the parties becomes quite clear.
What a surety looks for in their ideal client partner is full transparency as it relates to your past and present operations, including any affiliated business activities that may impact the operations and/or financial status of the obligee, (you). You have a pretty good idea of what events will impact the financial result of a given project, and you know in the context of your overall backlog how this may impact your company’s financial results.
The surety does not want or need a day-to-day accounting on each job, but if a major subcontractor defaults or there is a payment problem, it is probably a material event that should be shared with your agent and the bond underwriter. Bonding companies can deal with bad news, but what can really impair the relationship are surprises.
The surety’s approval of a particular contractor’s project and/or overall work program is made based on certain financial and operational parameters. If those conditions change for any reason, the rules of transparency and the surety partnership require full and timely disclosure.
Recall that what really caused the downfall of many contractors, and financial institutions was the failure to provide full and timely disclosure of its activities and financial position. That resulted in a failure of confidence in a business that relied heavily on trust. Your surety relationship is also based on trust, and if either party breaches that by failure to fully and timely disclose relevant information, it destroys that relationship. Bottom line: don’t hide or manipulate the data. Neither party should ever surprise the other. Strong , timely, transparent communication is essential.
With a tightening of the surety markets, what are the critical actionables you could do to improve both the your bonding line and your business? Begin by retaining a professional NY Surety Bonding Agent who will take the time to understand your business and help you to communicate your story with an appropriate surety market. You should retain a CPA who is active in the construction accounting arena.
You also should preferably secure an annual certified audit with adequate supporting schedules and footnotes that fully disclose and communicate your operations and financial picture. Review level financial statements may still be acceptable for smaller accounts, but my expectation is that sureties will increasingly demand fully audited financial reports. Compilations or in-house statements are of little or no value except perhaps for interim statements and then only if they reasonably “mirror” the format of the CPA prepared statements.
The issue of personal indemnity may become a discussion point. Depending on the financial structure of your company relative to work program, how much money the owners regularly take out in the form of salary and bonuses, the amount of net worth outside the company, and/or the length and quality of your past surety relationship all will bear on whether personal indemnity is appropriate.
Some NY sureties will consider a homestead rider that would exclude the indemnitor’s primary residence. Some may be willing to exclude specific assets, such as monies inherited by the spouse. Some may consider a personal indemnity cap limiting the financial exposure of a personal indemnitor. In the case of Sub-S entities, the surety may consider a Net worth/Working Capital Maintenance agreement to maintain a specific level of NW/WC in the corporation or personal indemnity triggers.
Spousal indemnities are nearly an absolute requirement if the owners are married and have mingled assets. It’s important that this is communicated with your spouse. Many sureties won’t issue a bonding line without this.
It’s critically important to have a bank line of credit that supports your business plan. . While revolving bank lines create no working capital per se, they do provide a facility to obtain cash to meet anticipated or unforeseen shortfalls in cash flow. On a relative basis, contractors have always been considered more hazardous than most other borrowers. Bank of America announced awhile back that they were exiting all contractor bank lines of credit nationwide.
The number of banks willing to provide unsecured revolving line of credit is also growing more limited. Nonetheless, the surety views an unsecured revolving bank line as fundamentally critical in risk management. Without a bank line, the surety may be one step closer to becoming your bank of last resort in the event of a cash flow problem. Having a bank line is important for your fiscal management and to enhance your relationship with the surety.
Cash Is King
Acknowledging the economy has become more difficult, the ability to acquire new profitable work has become more difficult, and the financial condition of NY owners and NY subcontractors more precarious, you would do well to manage your business to enhance your firm’s working capital position. A contractor with a strong net cash position may be able to fund problems without turning to third parties, e.g., the surety , banks, or others.
The adage “Cash is king” becomes more true during difficult times. Therefore, you may expect that with a tightening surety market, your working capital level and balance sheet composition will receive more scrutiny.
In summary the more salient points of this article I would say that the three most important fundamentals to a solid business partnership with your surety are:
* Understand, appreciate, and support the surety partnership . Understand it truly is a partnership.
* Encourage transparent, timely, and accurate communication with the surety.
* Effectively identify, allocate , and mitigate your business risks.
If you understand, and appreciate these points , you are well on your way to establishing a solid bond line, or even better increasing an existing one. To obtain a bond line, or make an inquiry on how you may get started on the process contact a Risk Advisor at Metropolitan Risk Advisory.