By GREGORY DL MORRIS, who has covered chemical and financial industry issues for the past 20 years
Bonds. Surety bonds. Not exactly a secret service, but certainly a risk management tool that has not received much attention until recently. Surety is roughly a $5 billion business, but long has been relegated to backing construction projects as required by contract or regulation.
But risk managers, underwriters and brokers say that, since the economic recovery began in other sectors of the economy, surety bonds are booming in mining, refining, chemicals and environmental services. Surety bonds are also becoming a major factor in the advancement of alternative energy projects.
Insureds say there are three reasons for this. Bank letters of credit (LCs) were almost always easier to obtain and less expensive than surety bonds, but that was before the meltdown on Wall Street. Today, LCs are much more expensive, when they can be got at all. Also, they typically tap the same credit-worthiness and total credit pool of the insured, limiting liquidity for other purposes.
Second, the construction industry historically represented two-thirds to three-quarters of the surety bond market. With all segments of construction still becalmed, underwriters are actively seeking other sectors to augment the bond business. To be sure, the initiatives are low-key and most often directed toward existing clients, to expand an existing surety relationship, or to expand a traditional insurance program to include surety.
The third driver comes from the insureds themselves.
"Many companies have obligations that can be met by funding a trust, a letter of credit or a surety bond," said one director of risk management. "Typically, people put into place a mechanism for meeting those obligations, usually an LC, and then they just leave it there. You have to question what you are doing and review your financial obligations. We have significantly expanded our surety bond portfolio. That has improved our capital and our liquidity positions."
Insureds report capital requirements for their obligations being reduced from as high as 100 percent collateralization for some LCs to 35 percent or less for some surety bonds, coupled with lower rates and reduced associated costs. That contrasts with increased costs of LCs ranging from 20 percent to as high as 100 percent.
"The supply of credit tied to LCs is very dear," said Ted Sevier, leader of the national commercial surety team at insurance brokerage Marsh, based in St. Louis. "Because of the credit crunch, many banks have stopped or cut back significantly on writing and renewing LCs. They are not just less available, they cost more when they are available. The P/C companies that are the leading surety writers are not having the same troubles as the banks."
Owners report that as with any underwriting, pricing has multiple variables. At the low end, a well-known repeat customer with a large program with the carrier might get a surety bond for 40 basis points and a signature. At the other end, lesser known clients could pay as much as 200 basis points, and be required to put up significant capital or get an LC for some portion of the project.
Often, as a project reaches major milestones of completion or operation, the incumbent bond is retired and replaced with one with less collateral and lower expenses. That option reflects the increased likelihood that the project will be completed, on time, on budget and out of court, and thus a lower risk for the underwriter.
That said, not just any owner can wander in off the street and secure such savings. The bonding protocol is very much like traditional underwriting, in contrast to the credit review at a bank. For new clients, the process often takes at least six to eight weeks, but can take from three to four months. Notably, existing clients with whom an underwriter has a large bond portfolio and a history of having previous bonds retired report getting new bonds issued, even in large amounts, in days or even hours.
"Bank LCs are an extension of the total amount of credit a borrower can call upon," said Sevier. "In contract for commercial surety bonds, the underwriters look more at the performance of the owner. Credit is certainly one of the factors, but the underwriters are most interested in how the project is designed and how likely it is to be completed."
Other brokers concur that a well-financed owner with a strong credit rating but poor project design and oversight would have to pay more for a bond and put up more collateral, as compared with an owner with less wherewithal and a lower credit rating but a clear and detailed project plan and strong management.
The bond underwriting process, as with other forms of insurance, involve multiple meetings with multiple members of the insured's executive team, as well as a detailed analysis of the project. A site visit is also common.
Marleen Judge, another broker with Marsh who has integrated surety bonds into her practice, noted that often an insured will still have to get a letter of credit for a project, but that the bonds can significantly alter the capital requirements. For instance, say an owner has an environmental cleanup that costs $1 million. It could post the $1 million in a trust or a letter of credit, or seek a surety bond. In that case, the surety company may write a bond for the whole project, or may ask the owner to post an LC for just $250,000 and bond the rest.
"In any case, the owner has freed liquidity and lowered costs," she said.
A GROWTH BUSINESS
Sevier at Marsh noted that he has worked with clients on bonds from $17 million to a recent placement of a $500 million bond.
"This business grows in discrete packages, but it just keeps growing," he said.
He described a situation where, after a few single bond underwritings and retirements, the client brought its entire project portfolio to the carrier.
"The surety was able to cherry-pick the projects within their area of comfort," Sevier said.
The underwriter gained significant new business, while the owner saw its obligation costs markedly reduced.
Judge stressed that that level of disclosure and cooperation was only possible because the client and underwriter were already well known to each other.
"The LC replacement issue is the only real organic growth opportunity in the last few years," said Brian Steele, senior vice president of national commercial surety for HCC Surety Group, part of underwriter HCC Insurance Holdings. HCC was the 7th largest surety underwriter by premium in 2009, ranked by the Surety & Fidelity Association of America. Rankings for 2010 will be released in May.
According to Steele, HCC has a very broad client base in its commercial surety. There has been a significant increase in capacity in the market, he said, with both existing players increasing their commitments as well a new entrants. HCC increased its capacity in the surety market in late 2008, making the underwriter one of the earliest to anticipate an expansion of demand outside the construction sector.
One of the oldest players in the arena, Zurich, is also one of the largest at No. 3 on the association ranking.
"Commercial surety has been an excellent business and a great complement to our global portfolio," said Theodore Martinez, head of commercial surety for North America. "We have seen huge growth, especially for customers doing business with Zurich in other areas."
With all the disruptions in global financial markets, Martinez noted, there has been a flight to quality in all risk management tools, which favors surety. Within that niche market, there's been a flight to quality that favors the older and larger carriers.
"Our S&P rating has been bumped up to AA- stable recently, and that has certainly helped," Martinez said.
Martinez mentioned one further driver in the growth of surety: "We have long had a litigious society, but in rough economic times, litigation becomes and even greater factor."
As with other situations, the surety bond is often a mutually agreeable solution either in reducing the initial capital burden of a court-ordered action, to provide security that a remedy will be enacted or sometimes as part of a negotiated settlement to prevent a long and expensive trial.
As noted, the growth in all aspects of surety has attracted new entrants and new capacity from existing players. No one was willing to project how long the current situation will last. Bank-sector analysts suggest that, with capital reserves rising at some institutions, they may begin to feel more comfortable returning to the LC market later this year or next.
Even so, surety bonds are unlikely to lose their new place in the risk manager's quiver. A few market watchers suggested some of the expanded capacity, especially by the new entrants, may be hot money. But the well-established underwriters insist they are committed to surety and its long-term growth.
June 1, 2011
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