Surety Insurance

Industry Snapshot

Surety insurance, sold in the form of a surety bond, is a tool used to guarantee the performance by one party of an obligation to another. It differs from other types of insurance in several ways, including the number of parties involved, the way companies determine premium rates, and in the way that the burden of risk is apportioned. The most common type of surety insurance is construction bonding, which insures that contractors will be able to complete a construction contract and pay their suppliers and subcontractors. Other common types of surety insurance include bonding of employees (fidelity insurance), license and permit bonds, and court bonds.

According to the Surety amp; Fidelity Association of America, in the late 2000s the surety industry generated approximately $3.5 billion in written premiums from surety bonds and another $930 million from fidelity bonds. After suffering losses during the first half of the 2000s, the surety industry began to stabilize by 2005 as underwriters became much more conservative and the economy rebounded from a recession. However, the U.S. economy fell into a major recession in 2008, and surety bond insurers, like the rest of the nation, felt the effects.

Organization and Structure

Surety insurance can cover almost any contractual agreement, whether the contract is written or implied. Although it is often classified as a line of property/casualty insurance, surety is similar to other types of insurance only in that it is a form of risk management. Because it is different in other ways, surety bonding is usually offered through a separate division or department within an insurance company and is governed under a different set of laws from other insurance lines.

Surety insurance involves three parties: the principal, the obligee, and the surety (insurer). The principal is the party who agrees to perform an obligation. For example, a builder may contract to construct a building. The obligee expects the principal to fulfill a contract. In the example above, the obligee would be the party with which the builder agreed to construct the house. The surety, then, is the party which guarantees that either the principal will perform adequately or the obligee will be compensated for the principal's failure. For instance, if the principal finished building only part of the house and then quit, the surety might compensate the obligee for any losses incurred in getting another builder to finish the home. In the example, and in most cases, the surety is not necessarily responsible for fulfilling the broken contract, but is responsible for the obligee's losses related to completion of the contract. For this reason, surety insurers do not necessarily cover risks associated with devastating losses, but only with varying degrees of default risk.

Another major difference from other types of insurance is that surety insurers look to the insured party for repayment of losses it incurs. In the example, the surety would be entitled to recover its losses from the principal, unless the principal was insolvent. For this reason, the risk associated with writing bonds has traditionally been very low. Theoretically the surety anticipates no losses if the underwriter has used the necessary information about the principal required to determine whether or not to write the bond.

Surety insurance also differs from other insurance lines in the methods insurers use to determine premium rates. Because the risk to the surety is usually very low, premium rates for surety bonds are primarily service fees and are less influenced by the risk of loss. Fidelity insurance, which covers a company against losses caused by dishonest performance by its employees, is a major branch of the surety industry. In the late 2000s, fidelity bonds constituted about 21 percent of all direct surety premiums written.

Company Structure
The surety market is divided into the standard market and the specialty market, each of which is served by different types of surety companies. The standard market represents the more traditional approach to surety bonding and is served primarily by large national agency companies. These companies tend only to underwrite clients who have a very sound financial history and represent little risk of insolvency or contract default.

The specialty market, on the other hand, is served primarily by regional agency companies. These companies are less strict in their underwriting requirements and will generally bond contractors that the standard market may have rejected. Regional companies are able to serve these clients because they require collateral of 20 to 30 percent of the bond obligation for each contract they insure. In addition, regional companies are more likely, as well as able, to vigorously pursue recovery from their clients in the event of default.

The biggest expense for surety underwriters involves qualifying applicants not providing loss compensation. Surety writers do not expect losses, and they focus their efforts on screening to reject risky applicants. Premium rates reflect the cost of providing a credit-based guarantee rather than loss compensation. Although during the mid-1990s, surety writers reported an improved operating ratio, indicating they were controlling costs such as commission and brokerage expenses and other underwriting expenses associated with screening applicants, during the 2000s, liberal underwriting practices led to significant losses within the industry and resulted in stricter criteria for issuing bonds.

Major Products
Surety products can be separated into two categories: those that are easy to obtain, and those that are more difficult. Bonds that are relatively easy to obtain typically involve small amounts of money or present a low level of risk to the surety. Bonds in this category include license and permit bonds, which protect city or state governments against claims that arise because of a license that the government body issued to a party. Court fiduciary bonds, which bond a person to handle money for an estate, and judicial bonds, which ensure that a plaintiff will pay damages to a wrongly charged defendant, also fall into this category. Public official bonds, which bond officials against losses resulting from their failure to conduct their duties within the confines of the law, are also easy to obtain. Bonds that are difficult to obtain include construction-related bonds such as performance, payment, and bid bonds.

Legislation
Surety companies benefit from state and federal legislation that requires bonding of various types of contracts. For instance, these laws require employers who self-insure employee benefits to be bonded. Similarly, many states require automobile owners who have been in an accident to post a bond of financial responsibility before they allow them to operate their vehicles again. One of the most prominent pieces of legislation in this regard is the 1935 Federal Miller Act, which requires prime contractors in the United States to provide a performance bond for any construction contract that exceeds a certain amount. Bonds were required for projects with a value in excess of $100,000.

Background and Development

Although the concept of surety dates back more than 2,000 years to ancient Babylon, the commercial surety industry in the United States did not begin until 1884 with the incorporation of the American Surety Corporation of New York. Since that time, the industry has grown steadily and, until recently, has had comparatively high profitability. The industry realized its greatest growth and profitability during the rapid national expansion that occurred between the end of World War II and the early 1970s. During this time, the construction industry was not very competitive, a booming economy created demand for all lines of bonds, and profit margins were high. During the past 20 years, however, increased competition, as well as an overall decrease in demand for construction, has reduced profit margins for insurers and increased the risk of default and insolvency for those insured or bonded. Surety and fidelity underwriters showed profitable underwriting results in the late 1980s and 1990s, with surety lines being profitable from 1989 through 1995 and fidelity lines being profitable from 1986 through 1995. Surety premiums written increased steadily from 1987 through 1994. Premiums written for fidelity bonds, after double-digit increases from 1985 through 1987, declined from 1988 through 1992, then began increasing slightly from 1992 through 1995.

Direct premiums written for surety and fidelity bonds in 1995 amounted to $2.8 billion, with $2.71 billion for surety bonds and $927.5 million for fidelity lines. That represented the third straight 9 percent or better annual increase for surety lines, while fidelity lines posted a 2.1 percent increase in net premiums written. Surety and fidelity underwriters reported profitable results in the late 1980s and 1990s. In 1995, surety underwriting profits nearly doubled to $276.9 million, while fidelity underwriting profits were flat with only a 1.9 percent to $232.9 million. By comparison, most other lines in the property and casualty insurance industry experienced underwriting losses from 1979 through 1995. In 1995, the overall property/casualty industry posted underwriting losses of $18.1 billion.

In 1995, national agency companies wrote nearly 60 percent of all surety premiums, with about 30 percent written by regional companies and 11 percent by direct writers. Of these premiums, the 20 leading surety writers accounted for $1.87 billion in premiums, which was 69.1 percent of the $2.71 billion surety market. National agency companies wrote 68 percent of all fidelity premiums in 1995, with 10 percent written by regional companies and 22 percent by direct writers. The top 20 fidelity writers accounted for $843.6 million in premiums written, or 91 percent of the $927.5 million fidelity market.

In the mid-1990s market share in the surety industry was split between national agency, multi-line companies, which serve the standard surety market, and regional agency companies, which serve the specialty market. In 1995, national agency companies wrote nearly 60 percent of all surety premiums and 68 percent of all fidelity premiums. Regional companies wrote about 30 percent of surety premiums and 10 percent of fidelity premiums, and direct writers wrote 11 percent of surety premiums and 22 percent of fidelity premiums. Of the surety premiums, the 20 leading surety writers accounted for 69.1 percent of the surety market. The top 20 fidelity writers accounted for 91 percent of the fidelity market.

The surety industry is considered to be part of the overall property and casualty insurance industry despite distinct differences. In 1995, surety and fidelity insurance accounted for about $2.8 billion in premiums written, which is a small amount compared to the $250.7 billion in net premiums written by property and casualty insurers in 1994. Surety and fidelity underwriters posted profitable results in the late 1980s and 1990s. In 1995, surety underwriting profits nearly doubled to $276.9 million, while fidelity underwriting results were flat, up only 1.9 percent to $232.9 million. In terms of premiums written, surety bonds recorded a 9 percent annual increase from 1993-95. Premiums written for fidelity bonds decreased steadily from 1988 to 1992, then began showing small percentage gains through 1995.

In some ways, the surety insurance industry works opposite the rest of the insurance industry, acting as a counterbalance for integrated companies. For example, the overall industry chalked up 1997 as a banner year, in part due to the mild weather attributed to the influence of El Nino, which resulted in low catastrophe losses for the insurance industry. By comparison, 1998 represented a worse year, with more catastrophic weather requiring more insurance-financed construction. The surety industry experienced 1997 and 1998 conversely: the mild weather of 1997 meant less catastrophe-based construction, hence less surety bonds, while the more catastrophic weather of 1998 created more construction work requiring more surety bonds, thus bolstering the surety industry.

Because a large part of surety and fidelity insurance is related to the construction industry, the former industry tends to follow the cycles of the overall economy. The industry has been helped by good economic conditions in the 1990s, including low interest rates, low inflation, and stable oil prices. Other factors influencing the industry's performance include federal initiatives to build infrastructure and natural disasters that increase demand for construction bonds.

Legislation passed by Congress in 1991 was expected to expand the role of surety insurers in the cleanup of environmental waste sites. The laws free sureties from liabilities for tort claims related to default by bonded contractors. This could be an important development for sureties during the next few decades and beyond because of the potential for increased environmental cleanup costs and the billions of government dollars already earmarked for the Superfund cleanup. On the other hand, legislation that could raise the minimum cost for federal construction contracts, which must be bonded from the current level of $25,000 to $100,000, could hurt the industry. This legislation would allow contractors to bid on and complete smaller construction jobs without having to buy a bond under the Federal Miller Act.

In reality, the Superfund did not produce the kinds of results expected because its funding got bogged down in Congressional debate. Only one-third of the sites covered by the Superfund were cleaned up as of 1998. However, that year, Congress tried to jump-start the Superfund by allocating $650 million of expedited funds.

During the first half of the 2000s the surety market was volatile as the industry reacted to the declining economy, which produced significant losses in the industry when combined with the liberal underwriting practices of the late 1990s. The industry sustained numerous high-dollar commercial losses, including Montgomery Ward, Kmart, and Enron. The terrorist attacks against the United States on September 11, 2001, also fundamentally changed the tenor of the industry as many projects took on an unpredictable risk of future terrorist attacks and became uncertain liabilities.

The result was consolidation within the industry due to mergers and acquisitions as well as some firms leaving the industry. The industry shrank to approximately 100 companies, and 2 of the top 12 sought bankruptcy protection during the downturn. In addition, underwriters became much more conservative, leading to tightening in availability and higher premiums.

During the 1990s, surety bonds were easily obtainable for a low price because of high demand and industry overcapacity, but by the mid-2000s, underwriting guidelines had increased significantly. In the 1980s and 1990s, contractors were able to acquire bonds without difficulty, because the surety market was strong, but by the mid-2000s, contractors had to meet strict critria to even merit consideration.

Although the industry posted annual losses through 2004, industry analysts were cautiously optimistic as fiscally solid underwriting practices re-entered the market and stabilized the industry. To issue a surety bond, underwriters generally required 5 percent working capital, a debt-to-net ratio of three-to-one or less, profitable operations, stable management, and a coherent business plan in place. Unlike the 1980s and 1990s, underwriters did not issuing bonds to as many new ventures, ventures that relied too heavily on bank debt, or projects outside the firm's region or business expertise.

In 2004, the industry experienced loss ratios of nearly 70 percent. By 2005, however, the surety industry saw a modest profit. In 2006, that profit increased substantially, bolstered in part by loss ratios of only 20 percent where 35 to 40 percent ratios are common.

Current Conditions

After suffering through some tough times in the early 2000s, the surety insurance industry was just getting back on its feet when the floor fell out from under the U.S. banking and insurance industry. In a widely publicized and hotly debated move, the U.S. government bailed out life insurance and financial service giant AIG, which received $170 billion in public funds under the government's Trouble Assets Relief Program. With the banking industry in shambles, due in part to subprime lending, the housing market, including resales and new builds, declined rapidly during 2008. Surety bonding became a high-risk endeavor as construction contractors were only behind restaurants on the list of most likely to fail during the late 2000s. By 2009, government at both the state and federal level were upgrading lending restrictions and requirements. One of those changes was to increase the required bond amounts. For example, Iowa upped the required bond amount from $50,000 to $100,000, and Connecticut increased bond requirements from $40,000 to $80,000. Other states were expected to follow with passage of similar legislation.

President Barack Obama's economy recovery plan, intended to pull the nation out of recession, included a massive stimulus package of $130 billion to jumpstart the economy. Although the surety industry was posed to benefit from an increase in construction spending, how and when the stimulus money would translate into build-ready projects was still relatively unclear in mid-2009. While the funding was expected to help the surety industry, industry insiders remained cautious about the level of the impact. JW Surety Bonds Consultants reported in February 2009, "As one might guess, there is no clear answer on how the surety industry will weather this recession. Even the experts cannot predict what is going to happen, as this is uncharted territory for our industry and the country as a whole." Primarily at issue was the amount of money that would be targeted to new public construction, which generates more premium revenues than private construction contracts.

Numerous ongoing issues remained on the agenda of the bond industry's advocacy organizations such as the National Association of Security Bond Producers. Included in 2009 on this trade organization list of concerns was the preservation and expansion of statutory bonding requirements, legislation, and regulatory reform at both the state and federal level that encourage small or newly established contractors to operate successfully in the public construction market, and increased attention and funding for the U.S. Small Business Administration's Surety Bond Guarantee Program, which helps small contractors qualify for bonding.

The late 2000s brought uncertainty and concern to the surety industry as some common surety clients struggled to obtain credit. On the other hand, surety business looked for increased business as creditors sought more assurance that its private borrowers would make good on their loans. The Surety & Fidelity Association of America president, Thomas Kunkel, told the Security Information Office, "As bankers have been faced with their own credit issues, they are wisely looking to surety bonds as a way to protect their investment in a project as much as possible."

Industry Leaders

According to JW Bond Consultants, in 2008 Traveler's held its top position in the surety bond market, with $991 million in premiums. Although it remained number one, Traveler's bond premiums fell off by nearly $26 million between 2007 and 2008. On the other hand, Liberty Mutual Insurance Group jumped three spots in 2008 to become the country's second largest surety company, posing a strong challenge to Traveler's top dog status. Liberty's premiums increased from $341 million in 2007 to $833 million in 2008--due primarily to the company's acquisition of Safeco Insurance in 2008 for $6.2 billion. Zurich Insurance Group and CNA Insurance Group both dropped one spot to number three and four, with $482 million and $434 million in premiums, respectively. Chubb & Son Group rounded the top five with $297 million in premiums.

Workforce

The entire property and casualty insurance industry employed more than 600,000 people in the 2000s. Many of the property/casualty companies offered multiple lines of insurance, including surety insurance. Job opportunities in the surety industry mimic those available in the larger property/casualty insurance industry. Positions in the surety industry, as in the property and casualty industry, are available in sales, underwriting and accounting, legal, and staff support. According to a 2009 Dun & Bradstreet marketing report, the surety sector of the insurance industry employed over 36,609 workers. Although overall, on average, surety firms employed 15 people, more than one-half of all workers were employed by large firms (more than 100 employees).

Job opportunities also exist at regional agency companies, most of which do not provide other lines of insurance. Because these regional companies emphasize collateralized contracts and tend to vigorously pursue losses from bonded clients that default, positions with these companies require fewer credit and underwriting skills and more legal knowledge related to subrogation. As baby boomers age out of the surety industry during the late 2000s, the industry was expected to be in need of newly trained personnel.

America and the World

Although it had a late start, the surety industry in the United States is the largest and most sophisticated in the world. However, its organization and structure closely parallels the surety industry of Great Britain, after which it was modeled. While the fire, marine, and casualty insurance industry in the United States experienced an influx of foreign investment and participation, the surety industry remained relatively local. This is due in part to the advantage that regional companies have when pursuing losses in court from clients that default on bonds.

Another factor responsible for a lack of intra-industry activity is the nature of surety insurance compared to other lines of insurance. Surety bonding more closely resembles a fee-based service than it does typical insurance underwriting. Therefore, the investment advantages gained through foreign ventures are diminished.