OUR PERSPECTIVE ON THE SURETY CLIMATE

Surety losses are expected to increase in 2012 and 2013, since the downturn in construction activity means more bidders fighting for fewer jobs yielding lower profit margins.  There has been no quarterly growth in construction spending since early 2006, and a prolonged period of anemic spending is expected for the construction industry; in the first four months of 2011 it was 8.4% lower than during the same period of 2010.  While reassurance from Federal Chairman Ben Bernanke lifted investor confidence, a slower “recovery over time” is still anticipated.

At mid-year, construction unemployment stood at a high average annual rate of 18.2%.   Private investments in construction projects have been few and far between because of difficult access and compliance to capital requirements.  The government stimulus spending on supposed “shovel ready” projects is often strung out by lack of financing.  Public fiscal restraints will continue due to the overwhelming need for a balanced budget.

The U.S. surety market is primarily concentrated on 25 top writers who handle 65% of the industry premiums.  The continuing industry consolidation is a concern for underwriting flexibility and conflicts in claims handling.  Still, the industry remains healthy.  As most sureties have evolved to excess-of-loss reinsurance with large deductibles, the underwriting shifts will be driven by the direct market results more than reinsurance restrictions.

Capacity is increasing for single bonds and maximum aggregate programs. Surety rates continue to follow an inverted pricing curve, where the largest capacity users pay higher rates than the middle market – because many surety companies are willing to write the middle market, but only about six will write the jumbo contractors ($500 million-plus work programs).  Despite the down economy, small contractors’ access to bonding may be at an all-time high. Several programs have been introduced specifically to assist in obtaining surety bonds.  The U.S. Small Business Administration (SBA) Surety Bond Guarantee Program continues to expand.  The Bonding Education Program (BEP) – a joint effort between the U.S. Department of Transportation and The Surety & Fidelity Assn. of America (SFAA) – aims to educate small businesses and assist them with obtaining transportation-related contracts.  SFAA’s Model Contractor Development Program (MCDP) continues to help small, minority and women contractors become bondable and increase their bonding capacity across the country.

Sureties are competing for the best contractors on capacity and service. However, struggling contractors will face more scrutiny; loss ratios are creeping up for sureties that specialize in writing smaller contractors.  These contractors have shorter backlog durations and are starting to more quickly feel the balance sheet erosion from unprofitable work.   Surety underwriters will want to meet with contractors to evaluate financials more frequently, look harder at the details, and confirm acceptable contract, bond form, and financing terms.  More often, sureties will require subcontractors to bond back to primes and generals.  Overall, sureties will be expecting a higher standard of conduct from contractors in the years to come.

Contractors need to look at operating profitability and maintain a history of completing contracts profitably.  Complete, accurate, and timely job costing and financial reporting is mandatory in today’s environment.  Communicating both good and bad news in real time to their surety business partners is the most important thing a contractor can do, enabling everyone involved to work through problems pro-actively.

Construction is cyclical, and contractors should prepare for the pent-up demand that will build during as we exit the recession.  Contractors need to protect their core resources and be ready to bid work when the economy rebounds.  Conserving capital, aggressively billing and collecting fees, procuring materials, and locking in prices are areas in which it’s important to stay vigilant.  It’s also necessary to have the right-size bank line of credit and a back-up bank in case of need.  Bidding the job, not the competition, is key; it’s better to adjust overhead than to “buy” a job to keep employees busy.   Subcontractors should also supply bonds to better manage risk. Subs should be bonded when they represent a key trade to the project, provide a significant portion of the work, are the sole source for anything, or are simply an unfamiliar resource.  Their sureties should be qualified, and bonds forms reviewed.

In times of economic uncertainty, a well-developed surety relationship is essential.  A professional surety bond producer and surety company underwriter are key players on a contractor’s team.  Sureties want a sound business partner who is rational, committed, honest, and knows how to run a successful construction company – one that will continue to grow and be profitable.

Governor Brown’s 2012-13 budget proposes significant structural change for transportation and guarantees funding availability and new projects

For years the Associated General Contractors of California (AGC) has advocated that infrastructure spending has been inadequate to allow for growth and business in the state. AGC fully supports investment in California’s transportation programs as a necessity for the construction industry. Governor Jerry Brown’s budget released Thursday contained welcomed news for transportation as it proposes a significant structural change to transportation agencies, funding during budget deadlines, and continuation of Proposition 1B projects.

“We applaud the Governor for his proposal and effort to protect transportation programs,” said Associated General Contractors chief executive officer Tom Holsman. “It appears the governor is moving in the right direction in putting California on a path to recovery.”

As part of a major reorganization effort to streamline and consolidate state agencies, the governor has proposed moving non-transportation departments within the Business, Transportation & Housing Agency (BTH) to other existing state cabinet agencies, leaving a standalone Transportation Agency, which would include Caltrans, DMV, CHP, the Board of Pilot Commissioners, and the California High-Speed Rail Authority. This will allow transportation policy to be developed and implemented at the cabinet level. The next step will be for the Governor to appoint a permanent Secretary of Transportation and Director of Caltrans.

Another important change for transportation is the Governor’s proposal to eliminate the annual “hold” on highway funds under a late budget, which threaten work stoppage on projects funded through the state highway account. This proposal would permit Highway Users Tax Account (HUTA) funds to flow in the event of a late budget and specifies that highway funds may be used for limited, short-term transfers/borrowing to ensure that either cash flow is there for transportation programs or on occasion, to provide cash flow back up to the general fund. This proposal is consistent with the intent of Proposition 22.

The budget also continues the state’s commitment to completing Proposition 1B. The budget proposes $2.8 billion in a combination of earlier appropriated funds and new funds to continue ongoing construction and implementation of projects.

“AGC took several leadership roles in securing Proposition 1B bonds, and has even sponsored legislation to accomplish these goals in previous legislative sessions,” said Holsman. “The Governor’s support on these items is welcomed.” There are many other issues contained in the proposed state budget which will be reported on in the coming weeks.

House and Senate leaders agree to terms for extending authorization for highway, transit and aviation programs

Late Friday, House and Senate leadership came to an agreement on a six-month extension for Federal Transportation programs. The agreement allows highway and transit programs to be funded at the current year’s funding through March 31, 2012. If approved, this would be the eighth extension of SAFETEA-LU, which expired in 2009. AGC and our members have been very active contacting both the House and Senate to ensure that any extension of the surface transportation programs is done at current levels.

In addition, Federal Aviation Administration (FAA) programs will be extended for four months until January 31, 2012. FAA’s Airport Improvement Program would be funded at $1.18 billion (one third of current year’s funding).

Both extensions will be bundled into a single bill and is likely to be voted on this week. The extension allows time for the House and Senate committees to continue working on a long-term authorization bill. Differences over spending levels and federal transportation policy continue to beleaguer the ongoing discussions. Failure to pass a long-term authorization bill will cause California highway and transit programs to come to a screeching halt. State and local construction are extremely reliant on the $4 billion the industry receives annually in highway and transit funds through the federal program. AGC has urged congressional leaders to refrain from making any additional cuts to construction accounts when considering a transportation authorization bill.

Since the recession began in 2008, surety companies have encouraged their agents and clients to focus on developing strategies to manage the downturn.  Although competition has been fierce, those that had developed a strong financial position during the previous years have been able to secure the bonding credit they need to support their plans.  

But a strong balance sheet is not enough; a strategy for controlling expenses and preserving capital is essential.  Surety companies place great emphasis on strategic planning.  Not only has it reduced their exposure to loss, it has contributed to stability in the industry.  Several issues characterize the market for the near term:

• Contractors should expect an impact to their bond credit if their company’s financial strength has weakened. 
• Federal deficit issues will likely hamper critical funding.   Most states also must manage carefully to avoid financial crisis, and that dynamic may hinder construction spending.
• The banking industry is more willing to extend credit to acceptable risks, and the pool of qualified borrowers has shrunk due to more stringent credit criteria.
• Good financial reporting remains a very important factor in establishing surety credit.
• Surety clients are being asked to work with owners to establish fair terms and conditions for construction contracts.  Risk selection, contingency planning, and contract administration are the focus.
• Government set-aside programs for disadvantaged businesses represent significant opportunity, but you must understand all of the rules and regulations of the programs.  Fines and penalties for violations are significant. 
• Surety companies can create solutions for difficult and challenging situations by using techniques such as collateral or funds control.  Including your CPA and attorney in the document review will help you avoid problems; your bank agreements may restrict the use of alternative surety underwriting techniques.
• Be careful with whom you do business:  fraudulent bonds, unlicensed surety companies, and nefarious operators still flourish.
• As bonds become difficult to secure, owners may propose bond waivers or threshold increases on public work.   All interested parties need to be mindful of legislation in this regard.  
   

Surety companies expect their clients and agents to communicate in a timely and comprehensive manner, and they are very willing to contribute to developing strategies.  The contractor who helps facilitate this process will benefit greatly through the understanding of how to secure the surety’s prequalification of his business, gaining or maintaining the surety credit for success in these economic times.

Because construction is a labor intensive industry, low productivity rates can result in substantially diminished profits. While some construction productivity variables can’t be controlled, others can be managed by implementing certain strategies.

Focus on Planning and Communication

Wasted labor hours and lost equipment time drain productivity and profits. Contractors can minimize the effects of these factors by focusing on planning both before and during a project. Initial plans should incorporate the budget for the project, along with anticipated production rates, materials, and number of workers. Once work begins, it will be important to minimize the hours that crews are left waiting for materials and equipment to do their work. Plans for a project may need to be revised when supply bottlenecks and other issues arise that threaten to reduce productivity.

Regular communication between supervisors and workers regarding the work that must be accomplished on a project can help reduce down time. Crews should be aware at the start of every day what their goals are and what steps they need to take to achieve those goals.

Review and Measure After Each Project

Going over just completed projects with foremen and project managers provides an opportunity to identify what worked well and what did not. An in-depth review of a project can provide information that can serve as a blueprint for future projects. If a project came in on time and within budget, the factors that contributed to the successful result can be discussed. For projects that lost money, it’s critical to identify the source of the problems. Review the estimate to determine if it was too low and look to see if labor or material costs spun out of control. Getting a handle on what went wrong will suggest steps that can be taken to prevent similar problems on future projects.

More effective use of labor and faster completion of projects can lead to lower costs and greater profitability. Time spent on project planning and communication, coupled with review and measurement of results upon completion, will be time well spent.

Despite sporadic signs of life in certain regions and sectors of the economy, the construction industry overall still faces a challenging environment. A proactive approach that focuses on cash flow, controlling costs, and staying flexible can help contractors overcome this tough business environment.

Make Cash Flow a Priority

If you are not already preparing cash flow forecasts for every job, then now is the time to start doing so. Cash flow planning allows your company to make smarter decisions regarding budgeting, capital expenditures, financing, compensation, and growth. With proper cash flow planning, your company will become more efficient and find it easier to deal with lenders, sureties, business partners, and owners. In fact, lenders want to see detailed cash flow forecasts from contractors to assure themselves that cash is being generated and used carefully.

Project planning is at the heart of a cash flow analysis. You should have a clear idea of when you are going to perform various activities that comprise a project and what cash will be received and disbursed. Decide in advance how you will bill the job and be sure to forecast both regular and periodic expenses, such as insurance premium payments.

Control Costs

Look for places your business can reduce expenses. Are there areas where you can reduce or cut unnecessary overhead to boost your cash position? Are your general and administrative expenses in line with other contractors of your size and area of business?

An energy audit may reveal areas for immediate and long-term savings. Also look at your inventory. If you are warehousing materials for future projects, you are consuming much-needed cash. And be sure to perform regular cost analyses for all of your trucks, loaders, dozers, and other pieces of large equipment. At some point, it becomes more cost-effective to replace a piece of equipment than to continue to repair it.

Screen Customers’ Credit Histories

Always screen new customers for a good payment history before you do any work for them. You may find warning signs that customers are having financial problems if they’re taking a long time to settle invoices. Send bills out for work and materials as you complete each stage of a project. And send friendly reminder letters when a customer doesn’t pay on time.

Look into Alternate Sources of Work

Right now, government contracting and green construction are robust and could offer opportunities. Doing government work can be a good source of income.  Federal law requires every federal agency to post information about their contracts, so reviewing their websites can be a good first step.

Many owners, as well as architectural and engineering firms, are now insisting that some or all aspects of their projects meet certain environmental and energy efficiency benchmarks. If you are unfamiliar with these requirements, it may be beneficial to learn what these standards and requirements are. Federal and state government agencies and industry groups are a good source for information on green construction.

“If you are not already preparing cash flow forecasts for every job, then now is the time to start doing so.”

Following Governor Brown’s veto of the state budget last week…and no apparent movement in negotiations so far this week…Caltrans executives are making plans for another forced cutback in construction.

As things stand now, Caltrans can continue to run the 793 projects (worth $10.6 billion) currently under construction…through August of this year.

The nation’s largest state department of transportation will stop advertising new projects or awarding most new work if a budget solution is not reached in nine days.

The only new work that may continue would be projects entirely funded by Prop. 1B bond and local funds–a very small number of projects.

This annual threat is so unnecessary.  SCCA sponsored legislation (AB 1308) this year to allow continuous appropriation of the Highway User Tax Account (motor fuel tax), but it was bottled up in the Assembly Appropriations Committee to force our industry to support potential budget “solutions.”

State gas taxes are collected every day as motorists and truckers fuel their vehicles, but under the state’s archaic funding mechanism cannot be used without legislative approval–i.e. passage of the budget.

To illustrate the absurdity of the situation, Caltrans’ union employees are guaranteed payment of their wages under continuous appropriation through a bill passed earlier this year.  This means the workers will be paid, whether there is any work to do or not.

To compound the problem, if contractors are ordered to stop work on their projects, Caltrans will be on the hook for shutdown, security and restart costs–estimated at $600 million of dead waste at the current levels of construction.

This issue is equally important to the state’s struggling economy and unemployment issues. If work is shutdown it will mean the loss of 190,000 construction jobs; the delay on new projects will mean 82,800 new jobs will not be created.

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Thanks,
Bill

William E. Davis, Executive Vice President
Southern California Contractors Association

After consulting with a number of surety markets, we see 2011 as a critical year for contractors and their surety partners.  The number one observation heard,   is the expectation for increased contractor failures particularly in the small general, and subcontractor segment.  This increase is driven by a decreasing amount of work, as well as lower margin work that has been acquired over the course of the past two years.  The general consensus among the surety markets, however is a sense of encouragement that the industry has not suffered the losses anticipated a year or two ago.  Additionally the overall economy is improving, albeit modestly.    The public works area will continue to be under tremendous pressure due to budgetary issues.  Private works is not expected begin a significant rebound until mid 2012 and slowly at that.  The housing market appears to be stabilizing and getting better.  A few bright spots for contractors continue to be in the military, healthcare and a limited amount of educational work.   These opportunities come with a price however, which is the proliferation of delivery methods (MATOC, MACC, design build, lease/leaseback, etc.) required to perform this work.

The largest projects (over $350,000,000.) are relatively abundant however require considerable capital or joint venture participation. This segment is subject to continued tightening of contract terms and conditions as well as risk transfer to the contractor and away from the owners. Close scrutiny and review of contracts and specs is the norm and not the exception.    Surety capacity for contractors in this segment, who are strong financially, is not an issue.

The market for subdivision bond business will continue to be limited, mirroring the real estate development business.

The surety industry will face considerable challenge in 2011.  Underwriters are anticipating an increase in claims and as such will move quickly to minimize their risk.  While there have been new surety markets established in 2010, the overall underwriting process will require closer scrutiny of a contractors financial condition.

Your surety relationship is critical to your economic survival in 2011.  As surety only brokers our focus is on understanding the marketplace and assisting contractors acquire the surety credit necessary. We encourage frequent communication with your broker and surety underwriter.  Avoid financial surprises, particularly negative ones, at all cost.

Philip E.Vega, President
Contractors & Developers Bonding

We are your link to the right surety bond company to handle your business growth goals!

• Think about the market from a long-term perspective: Bid the job, not the competition.  There must always be adequate profit in your work to cover unexpected contingencies.  Chasing after work at a lower margin just to keep the firm busy will slowly eat away your financial base.  Do not spend precious time on jobs that do not provide enough of a return to your company.
• Be selective when bidding projects.  Look for those which offer your company a competitive advantage such as geographical location, familiarity with the owner/architect, or experience on similar projects.
• Prepare for executing less work by reducing variable and fixed overhead or reducing staff.  Sell non-essential equipment, trucks and real estate.  Consider outsourcing payroll and other services, and leasing equipment versus owning it.
• Retain and reward your indispensable people:  The core operational team is critical and will be essential to being well positioned for the recovery.
• Offset escalating costs of materials and services by engaging in early commitments.  While bidding a project, make commitments to key suppliers and subcontractors to purchase their equipment and services in exchange for their commitment to freeze quoted prices if your company wins the contract.
• Consider the owners.  The stressed banking and financial sectors will make it difficult for them to finance work.  Offer good service by providing creativity and quality, improving plans when possible with value-adding ideas.
• Maintain strong cash positions with minimal institutional debt.  Changes in bank ownership or management can cause unexpected changes in lending practices.  As interest rates increase, paying off debt obligations will become more difficult.

An experienced SURETY PROFESSIONAL is vital to the overall success of your business.  For more information on how to best handle these challenging times, contact the SURETY PROFESSIONALS

Philip E.Vega, President
Contractors & Developers Bonding