COVID-19 has brought uncertainty to the entire construction industry.
Contracting firms and their brokers will need to be prepared for the potential reactions of bonding companies.
With a few notable exceptions within the ranks of individual surety companies, results indicate that the surety industry had a successful 2019. Since the end of the Great Recession, the surety market has experienced years of profitability leading to a number of new entrants, excess capital, and a softened market with relatively easier terms and conditions. 2020 started from a position of strength and optimism, but this can easily change due to current events.
While contract surety typically lags economic cycles, the economic downturn due to the various shelter-in-place orders has prompted an accelerated market response. We expect the market to tighten, leading to more stringent terms and conditions for surety credit.
This change reflects the uncertainty surrounding the overall economy, the continuation of projects in progress, potential future project delays, lack of public and private financing for new construction projects, and other consequences due to COVID-19. Sureties are bracing for fewer new construction awards, which could lead to greater pressure on profit margins from increased competition and eventually balance sheet stress.
A Tightening Surety Market
Although we are not far enough into the current economic crisis to see broad surety industry trends, we are noticing specific instances of a tightening market. Already, we are aware of reduced amounts of bonding capacity, increased indemnity requirements, greater financial scrutiny, and higher financial benchmark requirements.
An increase in surety pricing may not be far behind. Reinsurers for the surety companies are already tightening which, over time, will flow down to the primary sureties (the surety companies that directly deal with contractors and surety brokers).
Those sureties that were more aggressive prior to the pandemic and new entrants who have sought to quickly increase market share may be the first to retract. We also expect those sureties that focus on smaller trade contractors versus larger prime contractors will react more quickly. The smaller trade contractors with less financial resources, limited banking credit, and greater weekly payroll cash needs will appear to be a greater risk for deterioration of their financial condition.
Consider Surety Underwriting Factors Now
With these changes in the surety market, underwriting will become more disciplined. The good news is that the financially sound, well-managed contractors can use their “bondability” to differentiate themselves from less-qualified competitors.
Now is the time to develop a better understanding of surety underwriting qualifications and how to factor these into your business planning process.
Sureties will strive to establish bonding capacity limits to be more in line with any uncertainty in job profitability and cash flow (from lenders, project owners down to subcontractors, suppliers, and labor).
There will be an increased emphasis on underwriting fundamentals.
- Understanding how companies are managing liquidity, cash flow, and leverage is critical.
- Working Capital is an important quantitative measure of liquidity. Sureties will focus on the quality of the current assets, specifically aged accounts receivable, and underbillings.
- Work in process schedules will come under closer scrutiny, with greater attention paid to indicators such as profit fade, under/overbillings, and job borrow.
- Sureties will assess breakeven points from WIP and overhead analysis, and will look 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 to 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 not unlike their own underwriting considerations.
- Strong relationships built from a history of past performance.
- Credit analysis based on credible financial information (CPA prepared financial statements, solid references, access to liquidity).
- Bonding of select subcontractors, especially 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 the pandemic in the same way. Make sure that your business plans are 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 a surety to develop a surety program that is in line with your plan. Your surety program should not dictate your business plan, it should support your business plan.
Evaluate your banking relationship. Access to working capital is necessary at all times. Should the economic downturn affect your collection of receivables, you need a solid relationship with your bank. Make sure you have a relationship with an individual banker, not just a bank.
Communicate financial progress throughout the year in a timely manner.
Interim financial information will become more important, and your ability to produce credible information is key. Providing accurate WIP information will be critical. but you also need to establish how you use it as a 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. To avoid financial disaster, 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 and within a preferred geographic territory, while also building strong balance sheets, relationships, and internal processes during this time of economic expansion.
While no one could have anticipated the slowdown the pandemic has wrought, the discipline, financial resources, and tools developed during the good times will serve the successful construction organization well. Contractors and their broker’s ability to communicate this to your surety is critical.
Brokers, sureties, and other professional advisors can help contractors emerge stronger than ever before. The construction industry has rebounded from crises before, and it will do so again.
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