2019 Surety Outlook – Good news or Concerning News

April 10th, 2019

Good news or concerning news?

By the end of 2018, the construction and surety industries remained robust and resilient. For most contractors, backlogs are as strong as they have ever been over the past decade, margins have returned to pre-recession highs and work is abundant. Profits are at an all-time high, loss margins remain low, and demand for bonding continues to grow across the nation. The industry does not appear to be slowing down any time soon, with direct written premiums estimated at more than $6.5 billion in 2018.

The continued results and positive forecast for both underwriters and contractors have many wondering when the market will reach its boiling point and how to prepare for the inevitable decline. Many subcontractors, overextended with work opportunities and thin on resources, have started to show signs of struggling and there has been an increase in defaults. This growing frequency of defaults has resulted in some the industry’s largest sureties experiencing significant general contractor failures both domestically and internationally.

As a result, reinsurers are beginning to institute firmer underwriting compliance standards. Surety underwriters are depending even more on their clients and surety partners to proactively manage their operation and the risks associated with growth in an expanding economy. Those using best practices are taking advantage of the market’s positive trends to intelligently grow their backlogs rather than over-extending by taking on work far outside of their abilities and capacities.

During this growth cycle, three main questions continue to be the focus: labor shortages, material costs and governmental policies.

LABOR SHORTAGES: The ability to attract and retain skilled labor is the number one concern of general contractors, subcontractors, suppliers, and vendors. Although the quantity of skilled labor has increased in recent years, it has not kept up with the increase in construction spending. As a result, the industry is experiencing one of the largest labor shortages in history – in 2018 we saw the biggest gap in growth between new construction employment and construction spending since the recession. To meet demand, many companies are hiring new employees who might not have the experience required, or simply don’t meet the company’s standards for employment. Regardless, these employees are needed to ensure that companies can take advantage of the current market and meet their growth plans. This is a principle issue and underscores the importance of employing a high-level human resources professional to ensure the hiring of the right employees — people who will be retained and developed into future leaders. It’s up to business owners to hire and develop the right talent. If they fail to do this, the industry could experience a wave of subpar construction with significant long-term consequences.

RISING MATERIAL COSTS:  The cost of materials has always been a key concern for contractors, but in today’s market it seems to carry even more weight. Even without rising tariffs, material costs have increased significantly over the past 12-24 months. Securing material and trade buy-outs, post project award, has become critical to the economic success of contractors. Once a contract is in place and a project has begun, contractors have little to no ability to bill material cost escalations to a job. Proactively managing costs and changes can have a significant impact on success and profitability. That means anticipating price increases and having a comprehensive understanding of specific contract terms and conditions. Contractors need to lock in fixed prices with their vendors and suppliers before starting projects. In addition, billing for materials upon purchase and storing them onsite or in a secured location allows the contractor to be paid upfront for the purchase as opposed to upon install. This allows the contractor to manage cash flow more effectively and sustain the profit margin throughout the job.

GOVERNMENTAL POLICIES:  Interest rates will have a major monetary impact on contractors. As the Federal Reserve has been increasing the interest rate, tightening in construction lending from banks and a decrease in overall investment could be the result. This will have a direct negative impact initially on residential projects and overall spending in the building industry. However, there should conversely be a flow of infrastructure spending to support the Trump administration’s plan to implement growth in the public sector.

To prepare for the rising interest rates, companies should continue to be aggressive with their lenders by locking in low rates, paying down interest-bearing debt, and avoiding the use of operating lines of credit. As always, “cash is king” in the construction industry. The ability to finance costs and retain liquid paying power will continue to be one of the most important factors in the success and growth of a contractor.

In addition, many will experience the impact from the new revenue recognition requirements. Private firms must report their revenue compliant with ASC 606 starting with the first quarter of the year. Challenges include setting up the right performance obligation contracts, handling one-time set up costs, and factoring in the costs of acquiring and tracking contracts. Credit relationships with both sureties and lenders will be tested. Producing CPA financial statements in 2019 will not be as easy as in the past.

In conclusion, construction is cyclical in nature, and the current upswing will not last forever. However, there is little to suggest that the end is near. This past year has seen strong growth in construction despite a weakening labor pool, increasing material costs, and uncertainty surrounding governmental policies.

Wise contractors will continue to capture acceptable profit margins by proactively growing, developing and managing an appropriate level of highly skilled work force while continuing to achieve the best operating, accounting, and cash management performance standards.