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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?