Is oversupply of surety credit cause for concern?

By JOHN CLAEYS
Reliance Surety Co.

Most of us are familiar with the theory in economics of "supply and demand." Today's surety market is a classic example of the theory in practice. As most contractors and bond professionals are becoming aware, the supply of surety credit now may exceed demand. The result has been increased competition for new business, resulting in relaxed credit standards, increased leverage, a greater awareness of customer service and decreasing prices.

Not all of this is bad. Certainly, our industry, like many other "mature" industries, needs to be challenged from time to time, to question how it does business.

The reasons for our current market condition are rather obvious. The economy continues to boom. In fact, many feel the current period of expansion may be unprecedented. The expanding economy has resulted in growth, and construction has been generally profitable. Again, the supply/demand theory in action.

When construction is profitable, and work abundant, surety losses tend to be less severe and less common. As a result, the surety industry has enjoyed several years of generally favorable results. At the same time, the insurance industry as a whole continues to suffer from excess capacity, resulting in eight years of declining premiums. Supply again exceeds demand. With standard insurance product rates sliding, many insurance companies are looking at the surety market as a niche to deploy excess capital. In short, long time players have seen favorable returns of late, and newcomers hope to gain some market share. Competition in a relatively fixed market has done the rest.

The surety market in the United States is dominated by construction bonds. The risk associated with this industry has not gone away. Statistics continue to show construction as second only to the restaurant industry in number of failed enterprises on an annual basis. As an industry, losses continue. Monies paid for direct losses by just the top 25 surety writers amounted to $702 million dollars in 1996, the most profitable year in surety history. What will losses total should the economy take a turn?

Despite the fact that surety companies are generally part of insurance companies, and regulated as such, surety is, in fact, a credit industry more akin to commercial banking. As such, the same guiding principles tend to govern the extension of credit. The old theory of "the three C's" of credit: character, capital and capacity still rule the day.

While everyone in the industry can cite cases of contractors getting bonds for jobs perceived to be beyond their ability, most of this talk is sour grapes on the part of both contractors tired of long bid lists, and surety underwriters threatened by new perspectives. The assumptions, and parameters used in granting surety credit have evolved through time, but most were set in the last 20 years. Those guidelines served the industry well, and brought us out of some rather dark days in the 1980s, when it is said the industry lost more money in five years than it made in the previous 100. In the last several years, competition and the desire by new players to enter the market has seen many folks bending and breaking the rules with respect to "capital" and "capacity," as well as price.

What then does the future hold? Many will prognosticate on the cyclical nature of the industry and, convinced the competition is reckless, claim the sky is sure to fall. While competition has driven some to take on more risk than might be prudent, and while it may be true there are contractors getting bonds today for which they may not have qualified in another market, one should look a little deeper.

Business in general, and construction specifically is far more sophisticated than it was just a few years ago. Continued emphasis on education and training, and widespread use of computers and software tailored to the industry have made contractors well informed, and given them time to react to problems that previously might have surprised a firm.

Additionally, the professionals that support the industry bring a level of sophistication never before seen. CPAs, attorney, bond agents and bond companies, as well as bankers and other professionals, have begun to specialize, and now provide true value in helping contractors mitigate risk. So while all industries may be cyclical, it may not be wise to assume things will ever go back to the way they were.

Efficiencies will be found resulting in cost savings in our delivery system, and the risk factors which determine our price and the parameters within which we grant credit will likely change, as competition forces us to re-evaluate our assumptions in granting credit.

Contractors in today's market have the deck stacked in their favor. Competition in the surety market means companies are paying more attention to customer service, revisiting their rate structures and raising the bar for their underwriters. It is no longer enough to stick to the ratios. Today's surety professionals need to understand construction and finance, and have the strength to question past assumptions, while providing valuable feedback to contractors from lessons learned in the broader market.

That said, contractors should act wisely in availing themselves of today's market. While the market may never "be as it was," it remains a cyclical market. When losses increase, the field of insurance companies dedicated to the surety business will shrink.

Most contractors view their surety as a partner with whom they share intimate details of the business. Rates should not be the driving force in making a decision on a surety. In looking for a partner, a contractor should look for a surety company that has demonstrated a commitment to the industry both in terms of time, and resources.

Copyright © 1998 Seattle Daily Journal of Commerce.