No sure thing: once tranquil, the surety business has been rattled by a series of storms in recent years that left insurers searching for the way back to profitability.

The surety market is hoping for better times. For the past three years, this small but venerable specialty business that deals in construction bonds has registered losses industrywide. Moreover, for the past decade, capacity has been shrinking as the number of primary and reinsurance companies dealing in surety has decreased through consolidations or decisions to exit this line.

The Sept. 11 terrorist destruction of the World Trade Center, the collapse of energy trader Enron Corp. and the bankruptcy of retail giant Kmart have highlighted just how tough it is to operate in the surety market these days. Enron's collapse, in fact, hit a number of insurers, with estimated exposure exceeding $4 billion. And Kmart, explaining its financial woes, cited the "evaporation of the surety bond market" as one reason it filed for Chapter 11 bankruptcy protection.

"As far as performance, the industry is on a downhill slide right now," said Joseph Dhuey, senior vice president of Arizona-based Lovitt & Touche Inc. insurance agency. Annually, this industry generates about $3.5 billion in direct premiums written, according to the Surety Association of America. But association figures for 2001 showed overall losses of $2.7 billion, and in 2002, $2.3 billion. Deep into 2003, things were looking even worse; six-month results showed a 60% loss ratio, compared with 40% for the first six months of 2002, Dhuey said.

Surety is a type of insurance similar to an extension of credit. There are many types of surety bonds, but the two general categories are contract and commercial.

Contract surety guarantees the performance of obligations covered by a written agreement between two parties. The most common types are performance bonds, which guarantee the owner of a project that it will be completed according to the plans and specifications, and payment bonds, which protect subcontractors and suppliers and guarantee that they will be paid for work that is completed and for the materials supplied and used.

Commercial surety includes such bonds as court judicial, court fiduciary, public official, license and permit, and many bonds that include guarantees of financial performance.

Cycle Time

Many perceive this market's high-profile losses in recent years as precursors or abnormal loss events in the real surety cycle, said Mark Stubbs, vice president and surety practice leader for North America with Benfield Group Ltd. "A lot of the losses that hit the industry were not the normal source of losses," he said. "The normal source and the volatility in our industry comes from contract bonds typically, and we did have some contract losses in the 2000-2002 period. But many of the high-profile losses came from the emerging financial guarantee/commercial surety sector."

Enron and other corporate scandals hit at a time when the insurance market and the overall economy were changing as well, Dhuey said. "So everything came falling down together," he said.

In the late '90s, surety companies were extremely competitive in terms of rates and liberal underwriting, said Harry C. Rosenberg, chairman of Rosenberg & Parker Inc., Philadelphia, an agency that sells only surety bonds. These days, surety companies have become much more conservative and have returned to traditional underwriting, he said.

With the soft market, surety writers aggressively pursued business, Dhuey said. There was waiving of personal indemnity, limiting of corporate indemnity in some cases, and rate wars. "There were things being done that would have provided incentives for agents and brokers to place more business with them," he said. "In many respects, they relaxed the rules of the game, or changed the rules or amended the rules to attract dollars and business into the company because they could get it in the marketplace and earn the investment income."

From the early 1990s until 2002, contractors were allowed to become overextended in surety credit, Stubbs said. Accustomed to large lines of credit based on their financial capability, it's difficult for contractors to adjust to the change now. "The underwriters are going to have to convince them to accept smaller lines of credit on that same financial capability," he said.

Eye on Underwriting

David Smith, chief executive officer of Smith, Gatta, Gelok, a New Jersey insurance agency, said the underwriting process for surety has increased substantially. "As tar as underwriting is concerned, the evaluation of the risk, the official documentation that's being required in order to qualify a contractor for bonding, is much greater now than it has been in recent years," he said.

Another sign of the tightened underwriting: Surety companies customarily have required the principals of construction companies to sign financial guarantees personally. It now has become commonplace for their spouses to be required to sign as well, something that wasn't always done before, said Smith, whose agency does about $3 million annually in surety premium. "Also, collateral was required much less often for surety bonding in the past, and it's becoming more and more common to see an insurance company that's issuing surety bonds to require collateral."

The bottom line is that it's gotten harder for brokers to place these bonds.

"Agents are being requested to dot the I's and cross the T's," Rosenberg said.

Marjorie Young, an account executive at E. G. Bowman Co., a commercial insurance brokerage firm with business lines including fidelity and surety coverages, said some primary companies now want to meet with surety clients first, then drill down from the applications. "They're really digging just to find out what kinds of controls the clients have, and they're taking more of a loss-prevention attitude," she said. "They want more involvement from the company side on how to reduce loss."

The process is leading to more extensive negotiations, Young said. "A lot of clients aren't all that happy, because they're not used to being grilled in essence on their practices and procedures for internal controls," she said.

Reinsurers, too, have grown stricter in their agreements, with the list of exceptions increasing in recent years, Dhuey said. In some cases, these have doubled in terms of classes and types of business they are unwilling to accept, he said.

"You've got reinsurers dictating some things, as well as senior management of some insurance companies, because many sureties are departments or divisions of an insurance carrier," he said. For years under this arrangement, as sureties were making money, the bond department fell outside the executive radar screen, Dhuey said. "Now, all of a sudden, losses start coming in and they're on the radar screen," he said. "It really heightens everybody's awareness of what the risk could be."

But many middle-market surety writers that feel they haven't been the problem nevertheless find they are being charged for the overall industry's losses, Stubbs said. "To some extent, that's probably true, only because reinsurers have such deep deficits they have no choice but to gain some profitability somewhere," he said. "Reinsurers are now more focused on exposure than experience rating, and that change will impact the middle-market sureties also."

Business Changes

As primary insurers have decreased in number, so, too, have reinsurers. Ten years ago, there were probably a couple of dozen major reinsurers in surety, but now that's down to about a dozen, Dhuey said. "So the sureties out there all have to funnel into a limited number of reinsurers," he said.

Rosenberg said he has learned from surety companies that the remaining reinsurers are charging more as well. "Their rates are higher, the limits are less and the retentions have been increased," he said. In the past, primary companies could cost effectively reinsure a large portion of the risk, but now they must assume a larger portion, if not, in some cases, all of the risk, depending upon the surety and underwriting standards, Rosenberg said.

A number of reinsurers have backed away from surety because it's a relatively small product in the world of U.S. insurance, Rosenberg said. "And it's a product based on a severity model, not a frequency model, so it's been a difficult thing for the reinsurers to understand how to get their arms around it," he said.

These days, clients are asking for more value than simply cheap price, said Stubbs, who solicits primary companies to act as their reinsurance consultant and to find and place participations in the reinsurance community. "Clients recognize that in some cases they were buying a bill of goods," he said. "You can only drive the price so low, and then the seller goes out of business. That's what's happened to some of the surety reinsurers--they got out of the market or segments of it."

Chubb & Son

Some companies in the surety business have done well despite the industrywide downturn. In early 2001, Chubb was hit hard by the Enron failure, then bounced back. "We've come out of that and have had two very strong, profitable years, and we've grown our book of business," said Terry Cavanaugh, managing director, senior vice president of Chubb & Son and worldwide surety manager. "But we need to have strong underwriting profit over a number of years because eventually we will have loss activity--we follow the broader economic cycle in the U.S. and global marketplace," he said. "To manage a successful surety operation, you need scale while maintaining good credit standards and disciplined expense management that produce cumulative strong profits to sustain the organization when losses do occur."

Chubb's biggest segment in surety is writing performance bonds for middle-to high-end market construction companies both in the United States and abroad. On the commercial surety side, Chubb writes for manufacturing businesses and service and financial organizations. The insurer had slightly more than 4% of the surety market in 2002, making it the sixth-largest surety company in North America and the fifth-largest globally, Cavanaugh said.

Chubb always has been a very good individual credit underwriter, he said. He attributed the surety line's recent success to improved discipline with regard to its portfolio management--that is, understanding what the total global risk is in its surety unit by contractor, manufacturer, industry, bond type and geography. "We have much greater discipline now in terms of how much capacity we're willing to risk in any one of those parameters," he said.

Also, Chubb has developed better pricing models, Cavanaugh said. "We didn't have a great appreciation for the risk reward in this business--this is not an insurance product; this is a credit product that is embedded in the insurance industry," he said. "As a result, you have to have completely different pricing models than you would utilize on the insurance side." Chubb's proprietary models are similar to the ones that banks use to determine how to price letters of credit or how to price spreads on mortgages, Cavanaugh said.

The surety business requires capital, he noted. "This is not a risk-free business, and when you apply the appropriate amount of capital, it then gives you discipline and the recognition that you have to charge the right price to maintain an attractive return for the larger insurance enterprise," he said.

While Chubb hasn't changed its individual underwriting, it has changed its pricing, Cavanaugh said. But customers and potential customers appreciate that there's greater discipline in the marketplace overall now, he added. "They see the fact that a lot of weaker contractors who have been able to get bonds over the past 10 years are now having their work programs restricted and may be having much more rigorous credit standards applied to them" he said.

Cavanaugh said that surety writers continue to need transparency in the numbers they receive from customers. Chubb, for example, works hard to make sure it has very good underwriting talent engaged with the right people at the customer's office to obtain extensive information on the customer's financial and operational capability, he said. "This is a business where we visit every one of our customers," Cavanaugh said. "This is not like insurance where you can take an application, look at the application and issue a quote. When you're issuing bonds to the tens of hundreds of millions of dollars, you need to be in front of that customer and understand their business very intimately."

But good underwriting talent is scarce these days, prompting Chubb to become more aggressive in its hiring practices, he said. "We have re-energized our hiring and our learning and development capabilities to retain and improve our employee capabilities in credit analysis, portfolio and pricing management and sales focus," Cavanaugh said.

Future Challenges

To Rosenberg, the trend toward stricter underwriting is simply a case of getting back to basics. "Like most industries, the surety industry is cyclical, or it has been at least in the span of my 40year career," he said. "If you look at where the market was in the late '90s and where it is now, it's like night and day. But we're back to where the industry was in the '70s, when I first got into the business, which is traditional surety underwriting, and that is a good trend. Unlike insurance, surety is underwritten with the expectation of no losses."

Still, he has concerns about the current state of the market, namely, its lack of capacity--with fewer primary and reinsurance companies--and underwriting that doesn't always analyze the objective and subjective information on a balanced basis.

Cavanaugh said he's concerned about the health of the economy. Surety providers such as Chubb write individual bonds based on the needs of customers who, in turn, are impacted by economic activity. Unlike a property policy or a workers' compensation policy that is in steady demand, surety bonding will decrease if, for example, a state reports huge deficits and is less able to build new roads or other public works. "Therefore the need for bonding goes down, and the profit opportunities for our customers go down," Cavanaugh said. "So we're very tied to the economy from that standpoint."

Stubbs predicted continuing consolidation in the market because the surety line is having difficulty obtaining price lift from its primary product. Insurance companies' managements are reluctant to extend capital to departments that can't produce a solid return on equity, he noted. "If sureties don't get their underwriting under control or don't get their pricing back in line with where it should be, they could have difficulty competing for that capital within their own companies, and that could cause some more consolidation," he said.

Dhuey said he wants to see the surety industry return to stability and profitability. "Underwriting is tightening, but I don't know if everything is being done," he said. "My biggest concern is where tiffs whole thing is going to end. Are more companies going to get out of the market?"

Since surety seems to be in the sights of top managers these days, they might decide there's too much risk in surety and exit that line, Dhuey said. "Our marketplace is shrinking, and the appetite for capacity is shrinking, which means you're seeing a lot more co-sureties on the larger accounts," be said. "And there are limitations in terms of job size that companies are willing to take on by themselves before going to co-surety."

A number of changes have taken place recently within the primary companies and within the reinsurance marketplace, and that might pave the way for a better outcome for the surety business in 2004, Dhuey said. "We've just got to get back on track," he said.