CAPACITY ANDCONTINGENCIES

Are PerformanceBonds a Sure Thing?

Hurricanes, terror attacks, and flu pandemics have the entire insuranceindustry on edge. The nervousness extends to every type of insurer.Even life insurers fret about massive payouts because of aggregateddeath claims. A pandemic could demand $133 billion more from life insurersthan they could have otherwise expected to pay, according to the InsuranceInformation Institute.

All the wariness in the insurance industry is bad news for contractors. Shared risk — including shared risk across insurance divisions — is giving insurers second thoughts about surety.

Consider it part of the law of unintended consequences. Someone has to pay for the consequences, even though the outcomes may relate to the payer in only an oblique way. The entire insurance industry operates on the premise that contingencies can be identified, evaluated, and even quantified with some probability. When risk measurements are wildly off the mark — as with a Katrina or 9/11 — the company sustains a huge loss. And someone pays.

Places to Cut

Performance and payment bonds to contractors constitute a small portion of the insurance industry. In most big companies, the surety division accounts for no more than 3 percent of the gross revenue. But even a specialized niche such as surety comes under scrutiny when the industry is looking for ways to cut costs. If the surety division shows negative results, the questions really get tough.

Perhaps at no juncture since the 1930s, when the entire economy faltered, has capital been harder to come by in the surety industry than it is today. At the same time, the surety industry can only meet its obligations by making the correct call about most contractors on the front side.

Contractors that have blemishes on their records, such as a small safety violation, begin to look like greater risks than they might if capital were abundant. After all, the surety industry insures the client against loss, damage, or default.

The last thing a surety agent wants one of its bond holders to do is to sustain or cause a loss or damage or to default. Try to see things from the perspective of the surety underwriters, and it all makes sense.

Making Money

Profit drives the insurance industry. As the economic climate changes, the industry adjusts. The double-digit interest rates in the 1980s are well-known even to those too young to have had to deal with them. It sounds terrible.

And in some ways it was terrible. But 18 to 21 percent interest was actually a good thing for some sectors.

Premiums collected by insurance writers could easily be put to work earning great returns. The period of easy returns on investment is fondly recalled by some in the insurance industry as one of cash-flow underwriting.

Compound interest when the interest rate is 20 percent adds up quickly. Because the construction industry in the late 1980s and into the 1990s was relatively strong, surety underwriters could underwrite without much worry that they could not make good on bonds without going into negative territory. There were many premiums paid, and they could be invested well.

Flush with cash, underwriters served more and more customers with less and less assessment made of the business worthiness of the customer. Many contractors obtained bonds when they should have been rejected.

In short, the surety industry became overextended, and by the early 1990s, it took huge losses. That was bad, but then it got worse. No lesson learned, the insurance industry followed the promises of the dot.com boom and began market-share underwriting. In other words, it was part of the bubble.

Market-share underwriting put the insurance industry in peril. Enron and other calamities were in every sense disasters waiting to happen. If insurers had looked closely at what they were underwriting, they could have saved a lot of money. That brings us back to the law of unintended consequences.

Conservative Practices

Today, there are questions aplenty. Contractors that need performance and payment bonds in order to bid on jobs must be ready to answer all queries from insurers with accuracy.

Every aspect of a construction business now interests a surety agent. It’s not just the safety record or the on-time record. It’s also the financial information that the agent wants to see. Those financials must be up to date. They also must be credible and verifiable.

But there is good news for contractors. Since bonds are more difficult than ever for contractors to obtain, they speak loudly about the capabilities of the contractor.

It takes a lot of effort and demonstrated reliability for a construction company to get a performance bond in 2006. The rigorous review by surety underwriters often even encompasses personal financial information.

The performance bond means something. It genuinely says: This contractor is a good risk.