SURETY ISSUES IN A RECOVERING ECONOMY. April Sponsored by:

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1 SURETY ISSUES IN A RECOVERING ECONOMY April 2015

2 Surety issues in a recovering economy Introduction Things are looking up for the construction industry. Dodge Data & Analytics forecasts a 9 percent increase in construction starts in A recent survey on nonresidential construction by Wells Fargo Equipment Finance reveals a high level of optimism among contractors and equipment distributors across the country. 2 Similarly, the ENR Construction Industry Confidence Index, based on surveys of executives of large construction companies, For the period between 2006 and 2011, construction spending declined by one third, from nearly $1.2 trillion in 2006 to $785 billion in moved to a record 78 on a scale off 100 in March, a strong indicator of a growth market. 3 The recovery comes on the back of one of the worst periods for construction in modern history. The construction industry was hit especially hard by the crash of the subprime mortgage market in 2007 and the ensuing credit crisis and recession. Many contractors failed. Others survived, but were weakened financially. The picture is now much brighter, but contractors are not yet out of the woods. Many have not fully recovered from the impact of the recession, and nearly all are confronted with higher costs and slim margins. The surety market is well-capitalized and competitive. Many construction companies, however, still have trouble getting bonded, and therefore will lose out on some of the better opportunities in the rapidly improving market. Understanding the issues from the perspective of a surety underwriter can help contractors position themselves to be better candidates for - Bob Staples Senior Vice President, Surety Division, Allied World bonding, or to be eligible for higher limits or favorable terms. The Issues Few industries were hit harder by the Great Recession than construction, according to Bob Staples, Senior Vice President, Surety Division, Allied World. For the period between 2006 and 2011, construction spending declined by one third, from nearly $1.2 trillion in 2006 to $785 billion in The residential building construction segment experienced the steepest decline, with spending plummeting from $620 billion in 2006 to $244 billion in April 2015 Advisen Ltd.

3 For some contractors, a recovering construction market can be worse than a recession. In fact, the failure rate for contractors typically is higher during the recovery period following a recession than during the recession itself. Despite an influx of stimulus dollars, most contractors saw backlogs fall to unprecedented levels. More than 1,500 construction and engineering companies filed for bankruptcy during the height of the recession, from 2007 through Others reorganized or were acquired by stronger firms. More than 3 million jobs were lost from 2006 to The picture began to materially improve in 2012, and continues to look brighter. Total construction spending increased 5.6 percent in 2014 to $961 billion, consistent with the 5.7 percent increase in Many contractors are hiring again: 290,000 jobs were added in 2014, a nine-year high, and 80 percent of construction firms plan to increase headcount this year, according to a survey by the Associated General Contractors (AGA) of America. 7 Financing has become more readily available. The recovery clearly is good news, but doing business in the recovering market poses its own challenges. Contractors often are struggling because growth requires cash and many remain financially strained. In the non-residential sector, demand for new construction is rising, but so are raw material and labor costs. During the slowdown, owners became more aggressive in expanding the contractor s financial risk in contracts, while pricing has been extremely aggressive as contractors compete for work wherever they can find it. Several years of lowmargin work with tough contract terms are taking a toll on many construction companies. For some contractors, a recovering construction market can be worse than a recession. In fact, the failure rate for contractors typically is higher during the recovery period following a recession than during the recession itself. 8 The cash flow of many contractors simply cannot support the growth they need to achieve, leading to failure even while showing profits on paper. 9 In addition to cash flow issues, contractors in many markets continue to struggle with weak margins. The impact of the low bid mentality, which encourages cutthroat price competition, has been augmented by the scarcity of work. Margins are up modestly in the private general building market, 10 but increased competition for less work has kept margins below prerecession levels. Among the least profitable businesses in America are construction industry NAICS codes 2372 (Land Subdivision), at a 2.1 percent net profit margin for the twelve months ending July 1, 2014, and 2373 (Highway, Bridge and Street Construction), at a 2.2 percent margin, according to Sageworks, a financial information company. 11 Adding further pressure to margins is higher material costs. While showing some improvements in the last quarter for some raw materials, prices are up for many raw materials 3 April 2015 Advisen Ltd.

4 As the supply of qualified construction workers tightens, compensation levels are rising, putting yet more pressure on margins. as compared to a year ago and engineered components continue to see increases. The Turner Building Cost Index which measures costs in the non-residential building construction market in the United States increased 1.09 percent in the First Quarter 2015 as compared to the Fourth Quarter 2014 and 4.75 percent from the First Quarter Additionally, material lead times continue to be extended as a result of increased demand and reduced production facilities another outcome of the recession. 12 Construction firms forced to reduce overhead during the recession now need to rebuild their teams. More than three quarters of contractors responding to the ACG of America survey, however, reported difficulty in finding qualified craft workers to fill vacancies. Many companies now find it more difficult to recruit younger workers, and the pipeline of new workers has diminished over time with a reduction of vocational programs. 13 As the supply of qualified construction workers tightens, compensation levels are rising, putting yet more pressure on margins. Since 2009, labor costs have been increasing at 2.5 percent to 3.5 percent per year, according to the Mortenson Construction Cost Index, which measures costs in six major markets: Minneapolis, Milwaukee, Chicago, Denver, Seattle and Phoenix. 14 In some segments of the market, subcontractors are in short supply, with one impact being that the costs of subcontractors is rising even faster than the cost of directlyemployed workers. 15. The good news for contractors is that surety capacity is abundant. Sureties are placing bigger bets with a dramatically smaller construction industry. In fact, during recent years, the market has seen some of the largest individual mega-project bonds ever written. But though the surety market is competitive, underwriting standards remain conservative. Contractors who are struggling through the recovery are finding the market tight. Capacity may be available to contractors with subpar credit, but they will be under constant scrutiny from underwriters and risk being jettisoned if they fail to improve their risk profile. As the economy improves and construction picks up, many of the largest and most profitable opportunities will go to bondable contractors. This includes not only government projects, which have long required bonding, but also a growing number of private projects: many banks and private owners have started requiring bonding where they had not before. Subcontractors also are increasingly required to post bonds. Contractors struggling to recover from the ravages of the recession are at a disadvantage and will not be able to fully take advantage of the improved business environment unless they can convince surety underwriters that they represent good risks. 4 April 2015 Advisen Ltd.

5 Struggling contractors who are still eligible for bonding can anticipate heightened scrutiny from sureties. Underwriters may want to meet with contractors and evaluate financials more frequently. Solutions: The underwriter s perspective With thousands of contractors filing for bankruptcy, it would be reasonable to assume that the credit crisis and recession drove up surety losses. That did not prove to be the case, however. Despite the downturn, results were strong from , with lower than average loss ratios, and the line continues to be profitable. Additionally, a competitive and well-capitalized reinsurance market has benefitted sureties. As a result, capacity is abundant. Surety may be profitable, but underwriters are nonetheless wary and are operating cautiously. One reason for this caution is an anticipated uptick in both claim frequency and severity especially among special trade contractors and subcontractors, but also among larger general building and engineering contractors as cash flow issues and several years of low margin work at tough terms wear away at contractor solvency. 16 Many surety underwriters continue to re-underwrite their books of business and eliminate those firms that do not meet more robust underwriting standards. Well-run firms of all sizes presently have no problem finding adequate, readily available surety capacity. In fact, for mega-projects, capacity is at an all-time high: bonds in excess of $2 billion are now available for joint ventures. 17 At the other end of the spectrum, many contractors simply are too damaged to be bonded. Some may be beyond salvaging, but others could eventually meet the underwriting requirements for surety credit. Many of those firms would benefit from working with a financial advisor with industry expertise to develop a turnaround plan. The plan should address such things as backlog production, collection of accounts receivable, and payment of contract accounts payable, operating expenses and other financial obligations, including bank debt. 18 Struggling contractors who are still eligible for bonding can anticipate heightened scrutiny from sureties. Underwriters may want to meet with contractors and evaluate financials more frequently. Areas of particular focus by underwriters include project financing structures and terms, contractual risk allocation, collection of account receivables, over-billings or underbillings, access and use of bank debt, and exposure to subcontractor default. Sale of unused equipment or other fixed assets, personal borrowing by the owners to infuse cash into the business, subcontractor bonding or improvement in internal management reporting systems are among the steps that may be recommended to make a contractor more acceptable to underwriters. 5 April 2015 Advisen Ltd.

6 Contractors posing higher than average risk are likely to be required to accept various protections for the surety, such as a more expansive indemnity clause with provisions such as the right to evaluate the principal s financial records (the books and records provision), restrictions on changes in control, and collateral security obligations. Surety losses are often an outcome of liquidity issues, so cash flow is an area of particular emphasis by surety underwriters. As the construction market improves, cash flow will continue to be one of the most critical factors in the success or failure of contractors. For more marginal contractors, underwriters may look for improvements in cash management, focusing on areas such as accurate internal tracking and reporting, payment and retainage scheduling and terms, billing and collection policies (including overbilling practices), change orders and expense management. Underwriters also will want to see evidence of a strong banking relationship with the capacity to borrow. Additionally, they will be focused on contractors overextending themselves by expanding outside their areas of expertise or beyond their usual geographic regions, which can cause unexpected strain on resources. A contractor may be approved with limitations depending on the outcome of the underwriting process. Contractors posing higher than average risk are likely to be required to accept various protections for the surety, such as a more expansive indemnity clause with provisions such as the right to evaluate the principal s financial records (the books and records provision), restrictions on changes in control, and collateral security obligations. Posting collateral may be the only way a contractor can be bonded, but it comes with potentially serious consequences. In addition to the challenges of coming up with the collateral, the contractor is forced to operate without this asset, and, under extreme circumstances, may not even have access to it to assure the survival of the firm. Positive momentum of jobs, spending, and housing growth bodes well for the construction industry, and economists predict steady growth over the next several years. 19 Contractors that gain and retain the confidence of a surety will be positioned to compete for attractive public sector projects as well as the growing number of high-quality private jobs requiring bonds. Even for jobs not requiring a bond, being bondable may be a prequalification some owners rely on sureties to vet the strength and qualifications of a contractor. Additionally, the fact that a contractor takes the steps to be bondable may be viewed as an indication that they value their clients and are willing to take the necessary steps to protect the client s interests. The discipline of qualifying for bonding assures a contractor of being in peak form and positioned to thrive, whatever the challenges of the market. 6 April 2015 Advisen Ltd.

7 1 Construction Industry to See More Balanced Growth in 2015 According to Dodge Data & Analytics, press release Construction Industry Forecast, Wells Fargo Equipment Financing com/constructionforecast 3 Industry Market Confidence Hits Record High, ENR,con quarterly_cost_reports/2015/0330-industry-market-confidence-hits-record-high.asp 4 Construction and Engineering Industry Update, Spring 2012, SRR - construction-and-engineering-industry-update#sthash.lu303bgo.dpuf 5 Capital IQ, cited in Construction and Engineering Industry Update, Spring 2012, SRR - srr.com/article/construction-and-engineering-industry-update#sthash.lu303bgo.dpuf 6 US construction spending likely showed modest gain in January, Associated Press foxbusiness.com/markets/2015/03/02/us-construction-spending-likely-showed-modest-gain-in-january/ 7 Ready to Hire Again: The 2015 Construction Hiring and Business Outlook, AGC of America agc.org/sites/default/files/files/executive/2015%20construction%20hiring%20and%20business%20 Outlook%20Report.pdf8 8 Surety Outlook 2015: It s Still About Cash Flow, Construction Executive constructionexec.com/riskmanagement/2014/11/surety-outlook-2015-its-still-about-cash-flow/ 9 Ihab Adel Ismail, Financial Cash Flow Determinants of Company Failure in the Construction Industry, PhD Dissertation, University of Michigan, p. 3 PhDDissertation.2014.pdf 10 Surety Market Update and Forecast: 2015, Aon Surety-Market-Update-Forecast.pdf 11 The Least Profitable Businesses In The U.S., Forbes sageworks/2014/08/31/the-least-profitable-businesses-in-the-u-s/ 12 Construction Activity in Urban Areas Continues to Drive Cost Increases, Turner turnerconstruction.com/news/item/6e51/construction-activity-in-urban-areas-continues-to-drive-cost- Increases 13 Construction Industry Struggling To Fill Growing Number Of Job Openings, Texas Public Radio tpr.org/post/construction-industry-struggling-fill-growing-number-job-openings 14 Construction Costs Are Rising as Economy Improves, The Wall Street Journal developments/2015/02/10/construction-costs-are-rising-as-economy-improves/ 15 Builders See Shortages of Labor and Especially Subcontractors, National Association of Home Builders 16 Surety Outlook 2015: It s Still About Cash Flow, Construction Executive constructionexec.com/riskmanagement/2014/11/surety-outlook-2015-its-still-about-cash-flow/ 17 Aon 18 How to Deal With a Company in Financial Distress, Construction Executive constructionexec.com/articles/tabid/3837/entryid/2571/how-to-deal-with-a-company-in-financial-distress. aspx 19 Steady Construction Growth in the Forecast, The American Institute of Architects practicing/aiab April 2015 Advisen Ltd.