It’s Either Here or Looming: How a Recession Could Impact Your Surety Program

COVID-19 brought uncertainty to the construction and surety industries.

Surprisingly and fortunately, both industries have proven resilient in the face of unknowns brought about by the pandemic. Now it’s time to plan for what’s coming next—even if we don’t know precisely when it will arrive.

With a few notable exceptions within the ranks of individual surety companies, the 2021 results indicate overall profitability for the industry. The surety market has been consistently profitable since the end of the Great Recession, leading to several new entrants, excess capital, and a softened market with relatively easier terms and conditions.

To this point, not even COVID-19 has been able to derail the industry’s run of good fortune. By almost any measure, 2020 and 2021 were two of the most successful the industry has seen. In 2022, we continue to see the same themes of abundant competition, capital, and capacity in the marketplace. However, all of this can easily change due to current events and broader macroeconomic factors.

As we approach the halfway point of 2022, it’s hard to deny a sense that we are in unfamiliar territory. After all, at one point the S&P 500 was down 20% for the year, mortgage rates are back above 5.0% for the first time since 2011, and inflation in April reached 8.5%—a 40-year high. As usual, there is a wide variety of opinions on what all the data means and how it should be interpreted as a macroeconomic crystal ball.

Fortunately, you don’t need to accurately forecast when a recession will occur in order to position your company for predictable and sustainable surety credit. Regardless of where we are in the economic cycle, there are tried-and-true steps you can take to give you confidence that your company will consistently have the surety capacity you need to execute your business plan.

Anticipating a Tightening Surety Market

As noted, the surety industry has remained profitable throughout the last 15 years, which has kept capacity flowing with relatively soft market terms and conditions. At some point, and likely in the aftermath of a recession, the current phase of the surety market cycle will end, and underwriting will become more disciplined. Capacity will be harder to come by, terms and conditions will be less favorable, and prices may even increase.

The sustained success of the surety industry also means there are well-tenured industry veterans who have never had to navigate a hardening surety market. So, how can you recognize a changing market? And what can you do to best insulate your company from this external inevitability?

Consider Surety Underwriting Factors Now

The good news is that financially sound, well-managed contractors can always use their “bondability” to differentiate themselves from less-qualified competitors. This becomes even more critical and advantageous against the backdrop of a slow-growth or contracting economy where surety credit may be less available.

As such, now is the time to develop a better understanding of surety underwriting qualifications and how to factor these into your business planning process.

Credit Analysis

As underwriting discipline ratchets up, there will be an increased emphasis on underwriting fundamentals, which will take the form of:

• Understanding how companies are managing liquidity, cash flow, and leverage
• Understanding that working capital is an important quantitative measure of liquidity; sureties will focus on the quality of the current assets, specifically accounts receivable and underbillings
• Work-in-process (WIP) schedules coming under closer scrutiny, with greater attention paid to indicators such as profit fade and under/overbillings
• Sureties assessing break-even points from WIP and overhead analysis and looking to see if contractors have planned for overhead reductions to help absorb potential reductions in revenues and profits
• Seeking adequate indemnity packages to include affiliated companies, LLCs, and individual owners.

Management Planning and Forecasting

Sureties will expect to see management plans and forecasting models that reflect the uncertainties and options for various future market conditions. Expect your surety to request revenue, profit, and backlog forecasts.

Succession and continuity planning will continue to be an important underwriting consideration, especially for those entering into long-term contracts.

Subcontractor and Supplier Risk Management

Sureties will want a deeper understanding of your subcontractor and supplier qualification processes, both before awarding work and on an ongoing basis. There are many factors they will want companies to consider, which are like their own underwriting considerations:

• Strong relationships built from a history of past performance
• In-depth knowledge of organizational capabilities and other client commitments, especially with respect to specific project personnel
• Credit analysis based on credible financial information (e.g., CPA-prepared financial statements, solid references, access to liquidity)
• Bonding of select subcontractors, particularly those that are on the critical path.

Managing Your Surety Relationship

As economic and market conditions continue to change, you need to take an active approach to your surety relationship. We recommend that you extend your planning process to this critical credit provider in the following ways:

Establish a rapport with the surety. Communicate with your broker and allow the surety to make an informed decision. In the absence of information, sureties will err on the conservative side.

Character matters. Be transparent and open with your advisors. Now is when your creditors will test and assess your leadership and integrity.

Have a professional bond producer act as your partner. Not all sureties will react to a downturn or hardening market in the same way. Make sure that your business plan is aligned with your surety’s underwriting philosophy and approach to market conditions.

Develop a business plan for the current economic environment. A plan that outlines your strategic goals supported by resources in finance and all key operational areas of the company will help guide the surety discussion. Your surety program should not dictate your business plan—it should support your business plan.

Evaluate your banking relationship. Available liquidity is always necessary. Should an economic downturn affect your cash flow, make sure you have a relationship with an individual construction-oriented banker, not just a bank.

Communicate financial progress throughout the year in a timely manner. Your ability to produce credible interim financial information is paramount. Disseminating accurate WIP information is critical, but you also need to determine how to best utilize it as an internal management tool.

Monitor the quantity and quality of your liquidity and practice prudent debt management. Construction companies go out of business when they run out of cash. Manage cash flow, reduce secondary assets, and examine leverage and debt service ratios. Increasing revenue will not solve a liquidity issue, and sureties will be reluctant to increase their support if it is not supported by their basic financial metrics.

Looking Forward and Upward

The robust market of recent years has offered construction firms the ability to be more selective in their projects while also enjoying unprecedented access to surety credit. Firms have been able to focus on the types of jobs they do best, while also building strong balance sheets, relationships, and internal processes during this time of economic expansion.

The discipline, financial resources, and tools developed during the good times will serve the successful construction organization well in the next downturn. The ability of a contractor and their broker to effectively communicate this to a surety is critical to laying the foundation for a sustainable surety program.

None of us can know exactly what the future holds. However, brokers, sureties and other professional advisors can help contractors prepare for multiple scenarios, helping them emerge stronger from whatever comes to pass.