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The year-end results for 2005 represent the first time since 2000 that the surety industry had positive results. According to the Surety Association of America's figures for the calendar year 2005, the surety industry produced a record $4.38 billion in earned premiums. It experienced direct losses of $1.7 billion, for a pure loss ratio of 39.7 percent.

As further testament to this recovery, the top-20 surety writers generated $3.4 billion in earned premiums--approximately 77.6 percent of all earned premiums--with direct losses of just under $1 billion--approximately 57.3 percent of all pure losses. This performance yielded a 29.3 percent pure loss ratio and exceeded overall industry expectations.

The Surety Association of America's results for the first quarter of 2006 indicate a continuation of this trend. Earned premiums (excluding AIG, which has not yet reported) totaled $1.14 billion, which exceeds the first quarter of 2005 by some 5.43 percent.

More importantly, the pure loss ratio was 20.7 percent. Recent interviews with several surety executives indicate that, among the major sureties, premium growth will continue to be strong in 2006.

How did the surety industry recover from its years of poor performance?

To understand the answer to that question, it's important to look at what led to the surety industry's poor performance in the first place. Profitable results for the industry in the 1990s, strong investment returns, and an abundance of attractively priced and structured reinsurance capacity led insurers to push premium production. This resulted in increased competition, reduced premiums, underwriting standards and utilization of surety credit for business--for which the sureties did not have the requisite underwriting sophistication--and, finally, commoditization of this line of business.

As a result, in 2001, the surety industry experienced a record pure loss ratio of 82.53 percent, followed by another three years of losses. This was then compounded by the tragedy of Sept. 11, 2001, and its impact on the insurance industry in general.

The results were surety consolidation, the exit from the market of sureties and surety reinsurers, and tightened terms and conditions from those that remained. Reduced capacity, increased premiums and a return to underwriting discipline all followed.

As for the success of 2005, it is clear that the 2005 results primarily stemmed from improved underwriting discipline, including much more sophisticated credit scoring.

Higher premiums based on new pricing models, a reduction in both loss severity and frequency, and a stronger economy also all had a hand--not to mention a stronger construction economy. Higher commodity prices provided a lift, as well, in premiums due to higher construction contract values.

ON TO 2006

The surety industry represents about 1 percent of overall U.S. insurance premium writing. It requires a specialized type of underwriting, akin to bank credit rather than insurance, and it demands a significant amount of capital. As has been seen early in this decade, this line can be volatile and presents an aggregation of liability issues. But continued profitable surety results can be expected through 2006. Sustained economic expansion supported by consumer spending, corporate investment and a very healthy construction market are all anticipated.

On Aug. 10, 2005, President George W. Bush signed the Transportation Equity Act, or SAFETEA-LU, to a five-year extension, committing $286.4 billion in federal surface transportation spending.

In California alone, there will be a $37 billion construction bond proposition on this November's ballot. This represents the most comprehensive public works infrastructure program in the history of the state of California.

While most contract surety bonds are written for public works contracts, surety executives have indicated an increased usage of contract surety bonds for private work. This is, in part, due to lenders requiring the protection of contract bonds on private projects they are financing.

Competition for middle-market contractors, meanwhile, is expected to remain strong as primary surety markets are seeing rate competition for this business from both regional and niche markets. Given the consolidation among the top-tier sureties, regional and niche surety markets are finding that the middle market is the one area where their capital structures allow them to compete.

Construction clients with significant backlogs and national developers, however, may continue to face challenges in securing ample surety capacity to support their business plans.

These and other large users of surety credit could also be adversely affected by one or more of the top-20 sureties exiting the business, such as XL Insurance's Surety business, the 15th largest surety, did in 2005. Catastrophic events impairing insurers' balance sheets may also lead to renewed volatility.

For traditional surety needs, commercial surety clients are expected to find stable rates and ample capacity based on their credit profiles. Strong investment-grade credits will appropriately find the most competitive pricing.

While the top-50 writers of surety in 2005 generated contract bond premiums totaling $2.9 billion at a 32.5 percent pure loss ratio, they produced $1.17 billion in commercial surety premiums at a 10.5 percent pure loss ratio.

If the 20.7 percent pure loss ratio of the first quarter of 2006 was broken out between contract and commercial lines, it would likely continue to validate the lower commercial surety pure loss ratios.

Once again, the commercial surety line, as it has done in the past, is achieving better results than the contract surety line.

THE PLAYERS

While Quanta Surety exited the marketplace in early 2006, their former key executives have now joined Chubb, and their experience and market expertise may increase capacity in this line.

As surety reinsurers have reaped the benefit of the primary surety results, improvements are being seen. While the marketplace has been stable with 10 to 12 surety reinsurers over the past few years, there has been some movement toward providing more capacity to select primary surety markets.

These primary markets have demonstrated success to their reinsurers by evidencing consistent pricing and underwriting discipline.

Additional capacity may also be available on a case-by-case basis for those surety lines previously restricted or excluded by reinsurers.

The future of the surety industry looks promising, but this optimism is tempered by the potential of additional capital exiting the line, as XL and Quanta did within the last year.

Further insurer consolidation involving the larger sureties, such as the speculation of a merger between St. Paul Travelers and Zurich (the No. 1 and No. 3 surety insurers, respectively), quickly denied earlier this year, would likely create volatility again, and these concerns extend into the surety reinsurer marketplace as well.

JOHN T. LETTIERI is a regional managing director of surety for Aon Construction Services Group. He oversees client service, strategy, broking, carrier relations and new business development for surety for Northern California, the Pacific Northwest and Hawaii.

October 1, 2006

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