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Understanding the Importance of Surety

Understanding the Importance of Surety. Ray Batistoni, Hertz Global Holdings Stephen Haney, ACE Professional Risk Robert McDonough, AON Risk Solutions. Presenters. The Broker: Robert McDonough , Surety Regional Managing Director Aon Risk Solutions’ Construction Services Group

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Understanding the Importance of Surety

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  1. Understanding the Importance of Surety Ray Batistoni, Hertz Global Holdings Stephen Haney, ACE Professional Risk Robert McDonough, AON Risk Solutions

  2. Presenters The Broker: Robert McDonough, Surety Regional Managing Director Aon Risk Solutions’ Construction Services Group The Underwriter: Stephen Haney, Executive Vice President ACE Professional Risk - Surety The Risk Manager: Ray Batistoni, Risk Manager Hertz Global Holdings

  3. Underwriting The Underwriter: Stephen Haney, Executive Vice President ACE Professional Risk - Surety Any positions or opinions expressed are the presenter’s own and not necessarily those of any ACE company.

  4. Three Parties Obligee Principal Surety 2. Indemnity 3. No Losses 4. Pricing Surety is NOT Insurance OBLIGEE PRINCIPAL SURETY

  5. Characteristics of Surety • Surety Bond • Independent instrument • Conditioned on an underlying contract, ordinance or obligation • Risk of loss in bonding • Failure to perform assumed obligations • Surety bond is not a risk transfer mechanism for the principal • If Surety sustains loss due to default on part of principal, loss is recovered from principal and/or any Indemnitor(s)

  6. Classes of Bonds Construction Commercial • Bid • Performance & Supply • Maintenance • Court Bond • Customs • License & Permit • Public Official • Miscellaneous

  7. Examples of Surety Obligations Fiduciary Bonds: Be an honest employee (e.g., Tax Collectors) Allow importation of goods without the immediate need to pay taxes Customs Bonds: Performance Bonds: Comply with contract’s terms and conditions Pay those supplying goods and services in performance of a bonded contract Payment Bonds: Meet all conditions of an ordinance or statute in the performance of licensed trade or business License and Permit:

  8. Alternatives To Surety Bonds • Letters of credit • Ties up borrowing facility • Can trip covenants • Not conditional • Cash • Reduces balance sheet liquidity • Cost of capital • Treasury securities • Cost of capital • Sometimes, there are noalternatives • Public funds typically require surety • Certain federal court obligations mandate surety

  9. Underwriting Considerations: Non-Financial Identification and Evaluation of Obligation • Cancelable • Demand vs. conditional forms • Market driven • Credit sensitive • Obligation sensitive Pricing • Ultimate parent vs. subsidiary • Captive arrangements Indemnity

  10. Underwriting Considerations:Financial Underwriting • Liquidity • Leverage • Debt maturity Balance Sheet • Earnings predictability • Interest coverage Income Statement • Free cash flow vs. no cash flow • Capital expenditure needs Cash Flow Analysis

  11. Broker The Broker: Robert McDonough, Surety Regional Managing Director Aon Risk Solutions’ Construction Services Group

  12. 2009 YTD 9-30-10 YTD 9-30-11 2010 Earned Premiums $5.24B $5.27B $3.96B $3.87B Loss Ratio 19.5% 13.2% 16.7% 12% Paid Losses $1.0B $694M $654.5M $465M U.S. Surety Industry: Strong Profitability, Default Concerns Continue • Through 9/30/11 top 20 surety companies accounted for: • 82.6% industry-earned premiums • 85.9% losses • Industry results were profitable, but: • Largest surety provider results are inconsistent • Industry fears greater contract default experience • Source: The Fidelity & Surety Association of America

  13. Surety History Premium / Loss Results

  14. Adapting to New Market Realities Underwriters expected increased loss activity in 2011. Fortunately, companies made rapid changes to adapt. • Reduced overhead: Many contractors implemented financial model with lower backlog and smaller margins • Increased liquidity: • Slowing down capital expenditures • Negotiating new contracts with better payment terms • More modest M&A activity • Replacing letters of credit with surety bonds • Result: Stronger balance sheets collectively improved credit risk portfolios of the underwriting companies

  15. Six Years Consecutive Commercial Surety Profitability Leads to New Capacity • 2010 premium placements: • Approx. $1.5B: • 28.3% of $5.3B total industry premium • New capacity developed through: • Hiring new commercial surety leadership • Current writers expanding capacity • New capital entering the sector • Excess capacity and increased competition provided: • Better credits/improved pricing • Lower credits access to previously unavailable credit • Source: The Fidelity & Surety Association of America

  16. Market Discipline Challenged by Premium Growth Plans • Given finite universe of statutory risks, Sureties expanding writings through financial guarantee obligations (e.g., insurance program bonds) • 2012: A record year for bankruptcies? • On pace for 60: 5 U.S. and 6 global companies currently in default • S&P: 39 US defaults in 2011 vs. 58 in 2010 • Companies that refinanced maturities instead of reducing debt and those faced with refinancing significant debt maturities in 2012 may risk default • Bankruptcy isn’t sole barometer for commercial surety losses – the confluence of soft market and potential increased defaults may reverse trends in the space in 2012 • Expect continued “flight to quality” within the commercial surety segment

  17. Construction Surety Sector Slow to Increase New Capacity – Despite Profitable Results Contract Surety Earned Premium Placements • Approximately $3.8B in 2010 • 21.7% of $5.3B total industry earned premium • Weak construction spending & margins • Increased subcontractor payment claims • General contractors managing sub contractor default issues Underwriting Concerns • Continues to grow • Must navigate industry issues to avoid far-reaching impact of contractor default Underlying Sector Risk • Health of existing backlog • Timing of payment from owners • Rising subcontractor failures/impact on profitability • Require more frequent financial updates • Onerous bond forms/contracts shifting risk to customer In extending credit, underwriters continue to consider:

  18. Higher Loss Activity = More Questions for Project Approval • Greater financial reporting requirements • More stringent capital and liquidity retention requirements • Heightened discussions around surety indemnity language and credit facility documents • Rate increases for higher-risk clients and projects • Contractor default insurance may become a less viable option due to risk and cost

  19. Varied Impact of Current Industry Trends • Clients consider alternate collateral structures to support unique transactions • Surety bonds can serve as viable alternatives to letters of credit • Holistic view of client internal cost of capital driving more opportunities to surety • Larger capacity available for investment grade type companies • Surety capacity a critically important credit tool for construction companies

  20. A Risk Manager’s View of Surety The Risk Manager: Ray Batistoni, Risk Manager Hertz Global Holdings

  21. Keys to a Successful Surety Program • Price • Reputation of the backer • Working relationship • Administrative efficiency • Ease of application • Turn-around time

  22. Questions?

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