Keeping House.

As the U.S. economy spirals downward, surety writers are hoping the construction market remains strong to avoid huge losses.

The U.S. stock markets, and the economy in general, have been on a hair-raising roller-coaster ride over the past two quarters, and among those seated in the front car are surety insurers. Backing everything from construction bonds to securities offerings and global shipments of goods, surety writers have a huge stake in a strong economy. How will they fare in the coming months?

Alice Schroeder, an analyst with Morgan Stanley Dean Witter, commented in a report on the property/casualty market that the "volatile surety line may be the next big area to blow up." Schroeder said an economic downturn is the "quake event" for surety writers, and they have seen loss frequency rising.

Many surety executives said they consider the construction market to be the key to surety's health. Performance bonds, which guarantee completion of construction projects, are most vulnerable, said Mike Koziol, senior director and counsel of the National Association of Independent Insurers. "In an economic downturn, the number of bonds out there would tend to be less," Koziol said. "The construction segment is probably the most important for surety. But even though we've had a downturn in the economy over the last several months, the housing sector is still strong."

Tom Gorke, senior vice president in charge of the surety division for Atlantic Mutual Insurance Co., also said the vital construction market is so far not showing much weakness. "Most surety business is written for public construction," he said. "Funding is generally placed well in advance. Our business lags the general economy in that respect, so right now, I don't see any immediate or traumatic effect on public construction."

Private construction, however, has seen some downturn, Gorke said, as companies see their stocks and sales decline and pull the plug on planned building projects. "If the private side dries up, that will force more contractors back into the public sector, where there will be more competition," he said. "Then it could be an issue."

Jeff Wurst, a partner in the Mineola, N.Y.-based law firm Ruskin Moscou Evans & Faltischek, said he believes that surety lines will feel the effect of the downturn in the economy. "In the construction trade, I would expect that we will see incidents where costs override and the general contractors--who themselves become hurt as a result of the downturn--will default on their obligations, giving rise to an increase in claims being made by beneficiaries of surety bonds," he said.

"We have recently seen a number of situations where surety bonds were used to guarantee payments in situations where letters of credit were previously used--surety bonds to assure payment obligations, "Wurst said. "These are likely to be called as well."

Fewer New Homes

According to the U.S. Department of Housing and Urban Development, permits for construction of new housing units were up 3% in the fourth quarter of 2000 at a seasonally adjusted annual rate (SAAR) of 1.55 million units, but they were down 7% from the fourth quarter of 1999. One unit permits, at 1.2 million units, were up 3% from the level of the previous quarter but down 5% from a year earlier. Multifamily permits (five or more units in a structure), at 311,000 units, were 2% above the third quarter of 2000 but 14% below the fourth quarter of 1999.

The Federal Reserve Bank's Beige Book summary of economic activity for March 7, 2001, reported that commercial construction activity eased in most of the districts that reported on this sector. Declining commercial contracting was noted by Cleveland, Atlanta, St. Louis and Kansas City, Mo. New York reported an increase, and public construction was up in the Cleveland and Chicago districts. Commercial vacancy rates were generally reported to be steady, although Atlanta and Chicago noted some increases. More space has become available for sublet as Internet and high-tech firms have closed or reduced operations. Reports of such availability came from Boston, New York, Philadelphia, Kansas City and San Francisco.

Fed reports on residential construction were generally positive. New York, Atlanta, Minneapolis, Dallas and Richmond, Va., reported increases in home building, although gains were modest. Residential construction activity was steady in Philadelphia and Kansas City but down in St. Louis, mainly because of adverse weather.

Mark C. Vonnahme, president and chief executive officer of CNA Surety, said most executives in the industry knew there would be a downturn sooner or later, given the shifting nature of the construction industry. "We've gone through the greatest economic expansion in history, and surety was a part of that," he said. "But construction is cyclical, and to that extent we knew there would be leaner times."

Vonnahme added, however, that all indications from CNA Surety's construction clients show no slowdown in business so far. "In general, when we talk to our contractor accounts, most are still doing well," he said. "There is generally a lag time of 12 to 24 months between an economic downturn and its impact on surety, but indications thus far are that construction is strong."

CNA Surety does a lot of surety business in public works--involving government entities on all levels--and that area also appears to be strong, Vonnahme said.

Charles Brian Schmalz, president of Kemper Insurance Cos.' Kemper Surety unit, said the banking community will react to an economic slowdown by tightening credit. "This could impact the contractor's ability to obtain short-term credit to finance work." he said. "In addition, profit margins have not significantly increased. The reduced avail ability of work, particularly work propelled by the high-tech industry, could result in further deterioration of profit."

"I don't think the sky's falling, but it is a good time for getting back to the basics," Vonnahme said. "We're doing the activities that are important from the standpoint of managing risk."

The long economic cycle has led to very successful results for the surety companies, Schmalz said. "Competition has created a subsidy, driving rates lower with an excess capacity," he said. "There is a tendency toward fewer players as a result of consolidation."

Leading Writers

The surety market in the United States consisted of $3.3 billion in direct premiums in 1999, according to A.M. Best Co. data. That represented 1.1% of the total U.S. insurance market, in premiums. The top writers of surety in 1999 (the latest year for which full data were available) were St. Paul Cos., CNA Insurance Cos. and American International Group Inc. (See "Surety Leaders," left.)

None of those companies is likely to suffer much if the surety market heads south, as surety represents a fraction of their total premiums writ ten--7% for St. Paul, 2.7% for CNA and 2.4% for AIG. But there are smaller companies with a much bigger stake in surety, and reinsurers with significant exposure.

"Primary companies that are the leaders in the surety market generally have low reinsurance retentions and are not subject to severity risk," Schroeder said in her report. "So far, it appears the reinsurance market will bear the brunt of this potential loss."

Although Schroeder sees problems ahead for the surety line, she doesn't believe U.S. reinsurers have "meaningful exposure." But she does believe that "surety is likely to become a drag on results for U.S. writers."

Schmalz agreed. "Extended favorable results in the surety market have driven the reinsurance rates down," he said. "The preponderance of excess-of-loss structures further reduces their chance for profit."

Regional Impact

The surety market could see greater fallout in certain regions or industries, as an economic slowdown produces uneven results. The bankruptcy of Pacific Gas & Electric in California offers a good example, said Atlantic Mutual's Gorke. "There are guarantees, compliance bonds, self-insured workers' compensation bonds and other types of commercial guarantees that could be affected by an economic situation like that he said.

"Regionally, you could see some trouble spots," the NAII's Koziol said. "If an area is overly dependent on one type of industry--say, high tech--and that industry is depressed, the surety market there would be affected. You could see some regional distinctions."

Vonnahme said hot growth regions, such as the Southeast and Southwest, should be fine for surety writers. "You may see some slowdown in the old core areas, such as the Midwest and Northeast, but the Sunbelt is holding up very well," he said.

The global impact of the economy on surety markets is a little more uncertain. "Another possible problem would be customs bonds, which are linked to global trade," Koziol said. "If you have a slowdown in global trade, there would obviously be less business."

Schmalz is somewhat optimistic on the global surety market: "The global surety market will grow to the extent customers will be introduced to global markets in their respective industries. Foreign guarantees tend to be controlled by the banking system, but opportunities are opening."

One area where surety business could be hurt, Koziol said, is so-called "blue-sky bonds," covering securities offerings. "Of course, this is directly tied to the equity market," he said.

Gorke said the surety market consists of two primary sectors: contract bonds, covering construction; and commercial bonds, covering everything else.

On the commercial side, there are licensing bonds, covering myriad licensed professions such as brokers, agents and tradespeople. Koziol said any or all of these lines could be affected by a faltering economy. "You could see fewer people in any of these businesses, people going out of business, fewer people coming into certain businesses," he said.

Surety Leaders
The top five surety writers based on
1999 direct preminums.
($ Millions)
                            Direct      % of
Company                   Premiums  Premiums
St. Paul Cos.               $352.6       7.0
CNA Insurance Cos.           271.6       2.7
American International       266.0       2.4
Reliance Insurance Group     225.1       5.6
Zurich U.S. Group            176.6       3.5
Source: A.M. Best Statement Products