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Clear Skies Ahead For US Surety Bond Sector

After 2 successive years of growth, rally in overall premiums is expected to continue

Things are looking bright for the surety bond industry.

After two successive years of growth, the rally in overall premiums is expected to continue next year despite an expected rise in loss activity. Industry experts say the U.S. economy is showing signs of true recovery and most contractors are reporting a return of acceptable profit margins.

After all, the health of the surety sector is correlated with the construction industry.

From its peak of $5.5 billion in premium in 2008, the volume saw a sharp drop as the financial crisis spread across all sectors, particularly hurting the construction sector that saw public construction drop significantly.

However, surety premiums saw a steady rebound in recent years with the improvement in the U.S. economy and as the construction industry gathers its pace again. Surety premiums surpassed the $5.5 billion high mark in 2015.

Surety industry in slow but steady rise

As the U.S. economy and the financial markets improve, the surety industry also saw its share of modest gains. Over the past several years, the sector has recorded a slow but steady rise. This year, the industry is expected to close 2016 on a positive note.

Indeed, 2015 was the most profitable year in the history of the surety industry. Total industry direct-written premium reached $5.62 billion last year with an 18.3% loss ratio compared to the industry standard of 34% break-even loss ratio, according to U.S. Surety Industry data. The growth in the industry spilled over through the second quarter of this year with nearly $3 billion in total direct premiums written in just six months and an 18.4% loss ratio. The figures edged the 2015 numbers.

The expansion in the industry will likely grow as the market capacity rises. As a result, some new entrants have joined the industry and are offering new products that provide better alternatives to clients, including subcontractor default insurance (SDI) and letters of credit. The steady supply of new surety bond products is likely outpacing demand.

And while the number of carriers is on the rise, the top five surety companies – Travelers (NYSE:TRV), Liberty Mutual, Zurich (ZSA), CNA (NYSE:CNA) and Chubb (NYSE:CB) (recently acquired by ACE LTD Group [ACE]) – still control the lion’s share of the market. These top carriers control 50.3% of the written premiums. The other five carriers comprising the top 10 of the largest surety companies in the U.S. write 13.4% of the overall premiums. The 10 biggest surety companies in the country control 63.7% of the surety market.

Still, the U.S. surety sector is considered competitive, and there are signs of more relaxed underwriting terms and conditions for sureties with the aim of broadening the markets and maintaining clients.

Sure ‘arms race,’ new trends

Industry players have noted concern over emerging trends wherein “noncontract” surety companies have joined the contract underwriting field. This so-called “arms race” for premium could prove costly for the players, many of whom have set relaxed underwriting standards because they are used to issuing commercial (noncontract) bonds. This trend could result in a rise in loss frequency and force market corrections if not closures.

Another industry trend is the rise in mergers and acquisition activities. Chubb & Son Inc. Group was acquired by ACE LTD Group and HCC Surety Group (NYSE:HCC) merged with Tokio Marine Holdings (TSE:8766). Philadelphia Insurance Cos. (PHIN) launched its surety operation three years after being acquired by Tokio Marine Holdings.

New entrants bring fresh capital, new products

Even with the unexpected exit of XL Catlin in the first quarter that took away over $1 billion in capital capacity, it had no significant impact on the overall industry. But as expected, the sector saw an increase in the number of new entrants over the past few years, bringing with them fresh capital and property as well as new products with the idea of expanding profits.

“The future of the surety market remains bright indeed,” commented Greg Rynerson, president and CEO of Surety Bonds Authority, a full-service surety bond company and one of the new players in the sector.

“There are just too many opportunities in the surety sector, including energy, construction, transportation, etc.,” he said. “There are too many insurance firms that also want to get in.”

Rynerson explained that surety underwriters are also facing intense pressure to grow. Many of these sureties are publicly traded stock companies that are expected to report consistent growth to their shareholders.

Data released by the Surety & Fidelity Association of America, the sector’s loss ratio, is below 20% in seven of the past 10 years. In the first six months of this year, the loss ratio was a little above 18%.

Contract surety vs. commercial surety

The surety industry is divided into two main sectors: Contract surety used in the construction industry and commercial surety serves the rest of the bonding requirements. Both sectors face tough competition but more so in the commercial bond.

Susan Hecker, director of national contract surety and area executive vice president at Arthur J. Gallagher & Co. (NYSE:AJG), commented, “Where we see severe competition to the point where rates are significantly impacted, or underwriters are complaining about other companies doing things that are ‘hypercompetitive,’ it’s typically in the commercial surety space. That’s also where we see most of the new entrants as well.”

Because of the cutthroat competition in the commercial surety sector, some bonding companies are offering premiums that alarm and concern the industry. Ed Titus, senior vice president of surety for Philadelphia Insurance, complained that some sureties are undercutting existing companies by at least 20%.

The same grim prospect faces the contract surety side with some underwriters being lenient in conducting personal financial backgrounds, particularly on personal indemnity and relaxing some requirements. Some are skipping financial presentation that is normally required from contractors.

“A highly competitive contract surety market has definitely impacted underwriting,” says Carl G. Castellano, surety chief risk officer and vice president of contract security at Philadelphia Insurance. “We must remain disciplined while also being somewhat creative in our underwriting approach.”

Future of surety remains bright

Still, industry players agree that the surety market holds a bright future, particularly if public spending continues with the new administration funneling fresh funds to infrastructure, transportation, education and the military.

As a whole, there is still plenty of room for growth in the surety sector. The more organized companies are capable of managing their expenses and cash flow even in a highly competitive environment, said Rynerson. He added that even struggling sureties can find a niche in the industry if they know how to manage their balance sheets pretty well.

Premiums are seen to remain competitive as long as the current loss ratio is maintained. And even if the existing loss ratio jumps several points, the sector is still capable of producing attractive profits in 2017. Some are even predicting that the industry could breach the $6 billion premium mark in the coming year.

“It will take some severe losses or significant economic changes for the industry as a whole to see some tightening,” added Hewett.

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