A Sure Thing?

The surety market continues to thrive, but recent developments--such as a series of losses combined with rating changes, restructurings and sell-offs--could mean the good times are near an end.

The small but profitable surety business has been an industry success story for more than 10 years. This venerable specialty business, which issues bonds for construction projects, generated just $3.3 billion in direct premiums written during 1999, a fraction of the property/casualty industry's total of $299.6 billion. But insurers know that surety usually can make money for them when times are tough for other lines. And lately, the surety market has never been healthier--fueled by a bustling construction industry basking in an era of economic expansion.

However, some surety experts are viewing recent developments-- notably a series of losses combined with rating changes, restructurings and sell-offs--as signals that the boom times may be winding down and a tightening of the surety market may be just around the corner.

"Currently, many major surety companies have midsize losses brewing in the $40 million to $50 million range," said David Moylan, managing director and regional surety practice leader for Marsh, the brokerage arm of Marsh & McLennan Cos. That, in turn, has tempered the aggressiveness of surety underwriters who formerly were eager to assume greater risk in their underwriting guidelines to win clients and grow premiums. "We're seeing a change in the appetites," Moylan said.

The frequency and severity of losses has increased in the past six months, a trend that began with smaller regional sureties more than a year ago, said Randal Temple, senior vice president and managing director of Aon Re's Surety and Fidelity Practice Group, Philadelphia. In recent months, he added, "many of the top 10 sureties have reported significantly greater loss activity, with much of this loss activity being ceded to the reinsurers."

James M. Maloney, deputy chairman, Willis Construction Practice, said the surety industry loss ratio has significantly increased in 2000, and reinsurers are not pleased with results and will probably change their financial terms with prime carriers.

Moylan said the losses appear to be coming from the contract surety side, one of the market's two separate product lines. A contract surety guarantees the performance of obligations covered by a written agreement between two parties. The most common types include performance and payment bonds. Performance bonds guarantee the owner of a project that it will be completed according to the plans and specifications, and payment bonds protect subcontractors and suppliers and guarantee that they will be paid for work that is completed and for the materials supplied and used.

Feast Not Famine

Despite the losses, this product line continues to show profitability because the economy is so strong and surety capacity is plentiful. "It's an issue of overextension--this is a feast or famine business and contractors can overextend themselves," Moylan said.

The other product line is commercial surety, which includes such bonds as court judicial, court fiduciary, public official, license and permit, and many bonds that include guarantees of financial performance. This category Moylan said, continued to fare well through 1999 with good premium growth and profit for all the major companies.

So far, reinsurers have borne the brunt of the recent losses, but they may soon be ready to apply some pressure on surety companies in terms of cost and information, bond experts say "Reinsurers now are asking more questions of primary insurers who, in turn, are asking more questions of contractors," Moylan said.

The industry has changed, and reinsurers are not happy with the results, agreed Maloney. "I think reinsurers are going to change financial terms with prime carriers and up their requirements," he said.

In some cases, that's already happening. Temple said that Aon Re recently completed a midyear renewal for one of its customers that had experienced an unusual amount of loss activity. As a result of those losses and resulting treaty deficit, the reinsurers were demanding significant changes to terms and conditions. Both the reinsurance treaty rate levels and retentions were under pressure, he said.

Reinsurers also want to see the sureties take a larger amount of risk and do not want to bear a disproportionate share of the liability, Temple said.

"I think what we saw at midyear will be a barometer for the Jan. 1 renewals," he said. "For those surety companies that have experienced an unusual amount of loss activity and that have collected more from their reinsurers than they have paid out, they can expect to have some very challenging renewal negotiations at year end."

Bill Reidinger, vice president and manager of the surety division of Near North Insurance Brokerage, Chicago, one of the largest independent brokers in the United States, observed that the market's good times are relevant to a lot of capacity. "Being able to purchase these financial instruments at rock-bottom prices is ending," he said, adding that he and colleagues are starting to see some higher prices for surety bonds.

The surety business usually lags the property/casualty industry, which, most analysts agree, is already encountering the hardening of a decades-long soft market.

Veterans in the business recall that, as recently as the mid-1980s, surety was not all that profitable. Maloney, for one, remembers it as a time when many construction companies were encountering financial troubles. "Then contractors rehabilitated themselves: They watched their overhead; they watched their growth patterns," he said. Meanwhile, inflation remained low and there was no increase in interest rates.

The success of the surety business by the end of that decade brought in additional capacity in the surety-reinsurance market. "Many new reinsurers were attracted to surety reinsurance to avoid the volatility of the property reinsurance market and the prolonged softness of the casualty reinsurance market," Temple said.

The surety market's extended success contributed to a reduction in the cost for surety reinsurance, as well as a general loosening of terms and conditions of these treaties. "The reinsurers sought to protect and expand market share and aggressively competed for a finite pool of dollars," Temple said. "They appeared hungry for premium income and were looking for top-line growth."

"The surety industry had 10-plus years of great profits," Maloney said. "New underwriters appeared who had never experienced the bad times."

Then, in 1999, with construction booming nationwide, contractors were doing more volume with less profit, their profit margins remained low, their overhead was rising, and they became spread out geographically Maloney said. Furthermore, they began facing severe labor problems. "I've never seen such cutthroat recruitment," he said.

Small Start-Ups

While it's conceivable that one major construction failure could bring down a surety company, there's a recent development that could make that less likely.

Blake Pfister, principal owner of The Bond Connection, an insurance agency and brokerage in Newport Beach, Calif., said he's noticed the emergence of more small, home-based construction businesses. These contractors "have computers, fax machines, and their businesses are lean and mean," he said. "The bond companies representing contractors have accounts for a lot of small guys."

For the surety business, providing bonds to these customers "is like spreading your eggs in a lot more baskets so your chances of a big loss are a lot less," Pfister said.

At CNA Surety for example, the minimum premium in the commercial surety business is in the $50 to $100 range, said Mike Dougherty executive vice president, chief marketing officer. He noted that it's difficult to find efficiencies in such low-premium, high-volume transactions. The company profitably processes more than 1.2 million of these transactions a year with the average premium $80.

Industry Consolidation

One of the dynamics of this market has been its considerable consolidation in recent years. Five of the top 10 surety companies for calendar year 1990 have merged or exited from the business. The Surety Association of America says the top five writers of surety for 1999 controlled approximately 38% of the total surety market compared with 28% in 1990. And these leading companies continue to gain a higher market share, Dougherty noted.

"With the consolidation in the marketplace, companies are looking around asking who is going to be a long-term survivor," Dougherty said. Agents and brokers look at that, too, when they consider where to place their business, he added.

CNA Surety is a prime example of the consolidation trend. The company was formed when Capsure Holdings Corp. merged with the surety operations of CNA Financial in 1997. In March, Continental Casualty Corp., which is owned by CNA Financial Corp., was considering the purchase of the portion of CNA Surety Corp. it didn't akeady own. But Continental withdrew its proposed tender offer in May, saying the cost to buy the company, whose shares had risen considerably in price since March, outweighed the return Continental would get on the investment.

This year, financially troubled Frontier Insurance Group Inc. and Reliance National Group Inc. chose to sell off some of the jewels in their organizations, including their strong surety operations. After suffering widening operating losses, Frontier was down-graded to a C++ rating by A.M. Best Co. The insurer put its surety business, which ranked seventh in direct premiums for 1999, up for sale as part of a restructuring plan. On July 20, Gulf Insurance Group, a member of Travelers Insurance, and Frontier said they had reached agreement for Gulf Insurance Co. and its subsidiaries to acquire the renewal rights to Frontier's environmental, excess and surplus lines casualty businesses and certain classes of surety.

In 1999, Reliance ranked fourth in the nation in direct premiums written for surety, according to A.M. Best data. In May, Reliance completed the $580 million sale of its surety unit to Travelers Property Casualty, a member of Citigroup. Reliance also was downgraded by A.M. Best, first in June to B++ (Very Good) from A- (Excellent), and then in July to "Vulnerable," after Leucadia decided not to acquire the company.

For Travelers, the Reliance surety acquisition has created the largest surety and fidelity business in the industry, more than doubling the size of Travelers' surety business on a pro- forma basis to between $400 million and $500 million in annual revenues, said Joseph Kiernan, president and chief executive officer of Travelers Bond. With the acquisition, Travelers' surety and fidelity business represents about 5% of the company's total revenue of $10 billion, while before the Reliance acquisition, surety had provided almost 2.5% of all revenues, Kiernan noted.

Buying Reliance Surety is an indication of just how bullish Travelers is on the surety and fidelity business, he said. "We are satisfied with our results," Kiernan said.

In the past year or so, Travelers Bond has seen "a slight uptick" in surety losses, he said. "But I don't think it's systemic or a pattern. There are individual and specific reasons why contractors are having difficulties, and generally, they're on the lower end of our book," Kiernan said.

"Whether overall good results will continue will depend on the economy," he said. "With a hard landing, the impact on construction as well as on underwriting results will be greater than with a soft landing."

To Pfister, these are "turbulent times" for the surety business.

"Every time there's a consolidation cycle, knowledgeable industry professionals get booted asider he said. "And that leaves fewer and fewer people in the industry."

An even greater concern, however, are the restrictions Pfister said he faces as a result of merger-and-acquisition activity. "With fewer companies to work with, it limits the markets I can go to" to secure surety bonds for clients, Pfister said. "I'm also concerned about the level of service--these companies have consolidated, and you've got the big guys out there like General Motors."

New Players Arrive

But amid these consolidations, a few new players have arrived on the scene. Atlantic Mutual Cos., for one, launched a new division, Atlantic Mutual Surety in January. The division is mainly focusing on writing contract bonds for construction companies seeking to guarantee that a project will be completed. Thomas P Gorke is Atlantic Mutual Surety's new senior vice president. He brings more than 25 years of experience in the surety business, most recently as executive vice president for Seaboard Surety, a subsidiary of St. Paul Cos.

In a merger last year, the specialty insurer, Intercargo Corp., Schaumburg, Ill., became a wholly owned indirect subsidiary of Bermuda-based XL Capital Ltd., an international insurer and reinsurer. Through its surety division, Intercargo provides contract and commercial surety products.

Some firms that had surety operations have decided to build on them. For example, Kemper Insurance Co. completed the purchase in January of an 80% stake in New Jersey-based Universal Bonding Insurance Co., an underwriter of small contract surety bonds, for an undisclosed amount. Kemper, based in Long Grove, Ill., said the acquisition was part of its strategy to expand its property/casualty product mix.

In a complementary move to strengthen its presence in this field, Kemper purchased an 80% interest in Lou Jones &Associates Inc., a Los Angeles-based managing general agency that specializes in the production, underwriting and adjusting of contract surety bonds for developers and building contractors. Terms of that transaction also were not disclosed.

Kemper said it has targeted contract surety bonds as an area that could provide "significant profitable growth."

"You're going to see more acquisitions, but I'm somewhat comforted to see new players come on the scene in companies staffed with good people," said Willis Construction Practice's Maloney. "They have good reputations and underwriting skills."

Temple of Aon Re's Surety and Fidelity Group said he, too, foresees even fewer surety companies in five years. "The big keep getting bigger and alliances are being formed," he said, citing the recent examples of St. Paul Cos., USF&G and Seaboard; Liberty Bond, Wausau and Peerless; and Zurich, Fidelity & Deposit and Mountbatten.

"The big question is whether or not the larger surety companies will be able to demand greater bond rates in return for the security of their balance sheets and the capacity they offer," Temple said. "If they can achieve that, then the market will have officially turned the corner."

The arrival of a harder market will present even more challenges to surety brokers.

"As brokers, we're in the middle," Near North's Reidinger said. "We need to negotiate a common ground on behalf of our clients and markets."

He thinks brokers need to differentiate now between those clients who solidly qualify for surety bonds under current market conditions and those who don't. "Some clients that have qualified for surety bonds at the prices they pay now have gotten bonds because the market has been so aggressive," Reidinger said. "But the people who qualified for bonds in the past, may not do so in the future. And some qualified parties may get thrown into that mix. We have to be astute enough to make sure that doesn't happen."

On the reinsurance side, simply delivering the amount of capacity that clients need will be tougher, Temple said. "With a consolidating and tightening reinsurance market, it may become more difficult to fill out the entire reinsurance program," he said. "As a result, sureties may be asked to co-participate more in the excess-of-loss programs."

But one of the greatest challenges for brokers will be managing their clients' expectations, Temple said, noting that after years of price decreases for reinsurance, they may be asked to pay more for their reinsurance capacity.

"For a class of business that already bears a high expense ratio, this news is never received very well," he said.

Surety Industry Direct Premiums Writter
($000)
1995  $2,691,069
1996   2,737,699
1997   2,886,117
1998   2,988,232
1999   3,327,876
Source: A.M. Best Co.

Guaranteeing Electronic Documents

St. Paul Surety, a division of St. Paul Cos., is under writing a new policy that guarantees the authenticity of electronic original documents used in mortgage and leasing transactions. Although St. Paul and other insurers have become involved m insuring risks associated with e-commerce, this may be the first program of its kind focused on guaranteeing that major contracts and critical records that were created electronically will be admissible as evidence in court.

Although the program, managed by Kemark Group, Pearl River, N.Y., was written for a specific company that creates electronic original documents the new federal law enabling digital signatures is likely to increase the number of completely electronic financial transactions and the demand for similar types of insurance, said Paul K. McKeon, president and chief executive officer of Kemark Marketing Group.

Blending Surety With Liability

The program, which blends surety and liability insurance, is similar to one that St. Paul wrote for a company that uses imaging technology to create electronic copies of stock certificates for use by stock transfer agents and issuing companies, said Jim Monroe, vice president of St., Paul Surety. The new program was designed specifically for eOriginal Inc., and Still, has no immediate plans. to market it to anybody else. Still, Monroe agreed that demand for similar types of programs will grow as people become more comfortable with electronic signatures.

A the way people do business changes, the old coverages that were provided may not be applicables," he said.

eOriginal, a 4-year-old Baltimore-based company, has a patented process for creating, executing and storing legally binding electronic documents that were not first created on paper. Examples include stock certificates, promissory notes, medical patient files and deeds. On July 25 in Fort Lauderdale, Fla., eOriginal working with mortgage-industry technology companies, completed the first paperless, fully electronic mortgage loan and home purchase in the United States. The loan was closed, recorded and delivered to the secondary mortgage market in less than three hours. A title insurer, Attorneys Title Insurance Fund Inc., also participated.

To build confidence in its system, the company decided to insure the enforceability of the records its system creates.

A Pre-Emptive Strike

We took pre-emptive action to go ahead be ore the issue was raised by others," said Stephen Bisbee, president of eOriginal. "This is the first instance that an underwriter is looking at underwriting the efficacy of digital signatures, authenticating parties to a transaction and underwriting the enforceability of the documents."

The policy covers monetary damages up to $1 million for electronic mortgage transactions and up to $2 million for leasing transactions. There is no aggregate limit of liability, and St. Paul may provide additional limits at the request of an eOriginal client.

Under the policy, all mortgage records created under the system will be insured for the full term of the mortgage, up to 30 years, and lease records will be insured for the term of the lease, up to 10 years, according to eOriginal.

The coverage may apply to a record if it cannot be retrieved or reconstructed; if a court won't admit it as evidence solely because it is an electronic record; or if it is admissible in court, but it's found not to be legally enforceable because it is an electronic record. The policy pays the user the unpaid principal, interest or lease sum due under the terms of payment.

The policy is limited to mortgage and lease documents in the United States and Canada, but eOriginal hopes to expand to other types of transactions and to other countries.

"We're not guaranteeing the signature is good. We're not guaranteeing the document is legal. We are guaranteeing it is the original," Monroe said. "We are insuring its acceptability to a court of law in the U.S."

Not all courts in the United States recognize the enforceability of electronic records. "More and more courts are changing their laws and regulations to admit electronic records, but some are still gray," Monroe said. "The federal legislation probably will encourage more and more to accept them."

A New Frontier

While there is a tremendous amount of case law concerning the chain of evidence for a piece of paper, "here you are talking about a new frontier," eOriginal's Bisbee said. "You have to rely on strong control elements over the information and objects."

As businesses, particularly in the financial-services industry, recognize the advantages of electronic documents for even the most critical transactions, they also will want to transfer the risks involved, Bisbee said.

"It's going to be the traditional underwriters who are going to have to map the risk of e-commerce against the traditional scales for these to be accepted by consumers," he said.

In underwriting this type of program, risk management is key. Monroe said that in looking at a risk like this, the people who are running the operation are more important even than the idea and the product itself.

Leslie Werstein Hann

Streamlining Surety Online

Historically, forging surety bond deals and managing them have involved mounds of paperwork and much time. But in an effort to wring greater efficiencies from surety transactions, more companies and organizations are turning to technology.

In July, GE Corporate Treasury said it had streamlined the management of its global surety bond portfolio by using an Internet-based software system called BondMaster, which was developed by GE's surety broker, Near North Insurance Brokerage, Chicago. The system enables users in the company's offices around the world to request and print bonds at their desktops. All bonds are stored online, allowing users to instantly track the status of every bond in the portfolio and eliminating the need to store hard copies, Near North Group said.

The basic BondMaster was developed 15 years ago and has been continuously enhanced since, Near North said.

In April, the Insurance Services Office Inc. and Surety 2000 Corp. announced a strategic alliance to provide what they called the first paperless, electronic verification of the authenticity of surety bid and performance bonds.

The electronic verification through the Internet is designed to eliminate the submission of fraudulent surety bonds by construction contractors to government agencies and other customers.

Reducing Labor

Without Surety2000, agents would issue paper authentication of bonds to contractors, the company said. The contractors then would include that proof and the insurer's corporate seal with their bids, a labor-intensive process that makes it difficult for government agencies to verify that a bond was properly issued by an authorized agent or that the corporate seal is legitimate, the company said.

The Surety2000 system is designed for surety-bond agents, insurers, federal, state and local governments and other contracting agencies. Surety insurers also can use the system to monitor their overall exposure resulting from bonds issued by agents on their behalf to track bonds and their amounts issued by a particular agent or to a particular contractor and to flag unauthorized transactions.

At least one company recently launched online services that it says will help insurers and buyers complete these transactions faster, cheaper and with less paper.

In May, E-Surety.net, a software-development company based in Orlando, Fla., presented a fully interactive surety bonds site that allows for application, payment, underwriting and issuance or rejection of the bond, all via the Web.

Earlier this year, CNA Surety adopted the use of personal credit reports and risk-scoring technology to simplify the process of underwriting small contract bonds. This change has cut the approval time for these bonds to hours instead of days, said Mike Dougherty, executive vice president, chief marketing officer. Web enabling this process should further increase its efficiency, he said.

Marsh, the brokerage arm of Marsh & McLennan Cos., has been using an automated system for five years to manage bonds and provide Web site access. Beginning this fall, Marsh is planning to upgrade that system to allow for even broader access, said David Moylan, managing director and regional surety practice leader at Marsh. Revenue from its surety line is about 1% of Marsh's total annual revenue of $4.5 billion.

Income Opportunities

"It's a small piece but a unique piece in that it drives a lot of other insurance placement for companies," Moylan said. One example is Marsh & McLennan's construction group unit and the ability to place difficult bonds out of that unit. "When you start to think about the different income opportunities a surety bond touches, it's fivefold or more" within Marsh & McLennan's total business, he said.

Along with technical developments, experts see movement on other fronts for sureties.

"I think we're going to have growth in the surety business in foreign countries with new types of surety-bond forms that are going to replace bank letters of credit," said James M. Maloney, deputy chairman, Willis Construction Practice. "Banks are not as interested in writing for contract as they have been in the past." That's due, he added, to rates and changes in banking laws regarding financial reporting of letters of credit.

A letter of credit, for example, can be used to guarantee a contractor's performance, with a bank--not an insurance company--standing ready to pay over the amount of the letter to the owner of the project in the event of default.

Also, Maloney noted, more underwriters want entry into the alternative surety market.

Alternative surety products, such as subcontractor or contractor-default insurance, have been developed to compete with surety bonds in the construction industry.

This alternative market "will force some standard surety companies to look at their product and make sure they handle claims better," Moylan said. "It allows insureds to take a more hands-on control of a project and see that project to completion. I think this is going to take hold."