Understanding the Importance of Surety

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Understanding the Importance of
Surety

• Ray Batistoni, Hertz Global Holdings
• Stephen Haney, ACE Professional Risk
• Robert McDonough, AON Risk Solutions

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Presenters

• The Broker
• Robert McDonough, Surety Regional Managing
  Director
• Aon Risk Solutions Construction Services Group
• The Underwriter
• Stephen Haney, Executive Vice President
• ACE Professional Risk - Surety
• The Risk Manager
• Ray Batistoni, Risk Manager
• Hertz Global Holdings

3
Underwriting

• The Underwriter
• Stephen Haney, Executive Vice President
• ACE Professional Risk - Surety

Any positions or opinions expressed are the
presenters own and not necessarily
those of any ACE company.
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Surety is NOT Insurance

• Three Parties
• Obligee
• Principal
• Surety
• 2. Indemnity
• 3. No Losses
• 4. Pricing

OBLIGEE
SURETY
PRINCIPAL
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Characteristics of Surety

• Surety Bond
• Independent instrument
• Conditioned on an underlying contract, ordinance
  or obligation
• Risk of loss in bonding
• Failure to perform assumed obligations
• Surety bond is not a risk transfer mechanism for
  the principal
• If Surety sustains loss due to default on part of
  principal, loss is recovered from principal
  and/or any Indemnitor(s)

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Classes of Bonds
Construction
Commercial

• Bid
• Performance Supply
• Maintenance

• Court Bond
• Customs
• License Permit
• Public Official
• Miscellaneous

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Examples of Surety Obligations
Fiduciary Bonds
Be an honest employee (e.g., Tax Collectors)
Allow importation of goods without the immediate
need to pay taxes
Customs Bonds
Performance Bonds
Comply with contracts terms and conditions
Pay those supplying goods and services in
performance of a bonded contract
Payment Bonds
Meet all conditions of an ordinance or statute
in the performance of licensed trade or business
License and Permit
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Alternatives To Surety Bonds

• Letters of credit
• Ties up borrowing facility
• Can trip covenants
• Not conditional
• Cash
• Reduces balance sheet liquidity
• Cost of capital
• Treasury securities
• Cost of capital
• Sometimes, there are no alternatives
• Public funds typically require surety
• Certain federal court obligations mandate surety

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Underwriting Considerations
Non-Financial
Identification and Evaluation of Obligation

• Cancelable
• Demand vs. conditional forms

• Market driven
• Credit sensitive
• Obligation sensitive

Pricing

• Ultimate parent vs. subsidiary
• Captive arrangements

Indemnity
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Underwriting ConsiderationsFinancial
Underwriting

• Liquidity
• Leverage
• Debt maturity

Balance Sheet

• Earnings predictability
• Interest coverage

Income Statement

• Free cash flow vs. no cash flow
• Capital expenditure needs

Cash Flow Analysis
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Broker

• The Broker
• Robert McDonough, Surety Regional Managing
  Director
• Aon Risk Solutions Construction Services Group

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U.S. Surety Industry Strong Profitability,
Default Concerns Continue

• Through 9/30/11 top 20 surety companies
  accounted for
• 82.6 industry-earned premiums
• 85.9 losses
• Industry results were profitable, but
• Largest surety provider results are
  inconsistent
• Industry fears greater contract default
  experience
• Source The Fidelity Surety Association of
  America

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Surety History Premium / Loss Results
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Adapting to New Market Realities

• Underwriters expected increased loss activity in
  2011. Fortunately, companies made rapid changes
  to adapt.
• Reduced overhead Many contractors implemented
  financial model with lower backlog and smaller
  margins
• Increased liquidity
• Slowing down capital expenditures
• Negotiating new contracts with better payment
  terms
• More modest MA activity
• Replacing letters of credit with surety bonds
• Result Stronger balance sheets collectively
  improved credit risk portfolios of the
  underwriting companies

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Six Years Consecutive Commercial Surety
Profitability Leads to New Capacity
2011 New Commercial Surety Capacity (M) 2011 New Commercial Surety Capacity (M) 2011 New Commercial Surety Capacity (M)
Company Single Aggregate
Aspen Re 5 50
Arch 25 50
XL 200 200
Hanover 10 25
Argo 15 35
Main Street America 25 25
Philadelphia Insurance 10 30
TOTAL 290 415
Aggregate expansions for established markets ACE ?100M Chubb ?250M Liberty ?1B Aggregate expansions for established markets ACE ?100M Chubb ?250M Liberty ?1B Aggregate expansions for established markets ACE ?100M Chubb ?250M Liberty ?1B

• 2010 premium placements
• Approx. 1.5B
• 28.3 of 5.3B total industry premium
• New capacity developed through
• Hiring new commercial surety leadership
• Current writers expanding capacity
• New capital entering the sector
• Excess capacity and increased competition
  provided
• Better credits/improved pricing
• Lower credits access to previously unavailable
  credit

Source The Fidelity Surety Association of
America
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Market Discipline Challenged by Premium Growth
Plans

• Given finite universe of statutory risks,
  Sureties expanding writings through financial
  guarantee obligations (e.g., insurance program
  bonds)
• 2012 A record year for bankruptcies?
• On pace for 60 5 U.S. and 6 global companies
  currently in default
• SP 39 US defaults in 2011 vs. 58 in 2010
• Companies that refinanced maturities instead of
  reducing debt and those faced with refinancing
  significant debt maturities in 2012 may risk
  default
• Bankruptcy isnt sole barometer for commercial
  surety losses the confluence of soft market
  and potential increased defaults may reverse
  trends in the space in 2012
• Expect continued flight to quality within the
  commercial surety segment

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Construction Surety Sector Slow to Increase New
Capacity Despite Profitable Results
Contract Surety Earned Premium Placements

• Approximately 3.8B in 2010
• 21.7 of 5.3B total industry earned premium

• Weak construction spending margins
• Increased subcontractor payment claims
• General contractors managing sub contractor
  default issues

Underwriting Concerns

• Continues to grow
• Must navigate industry issues to avoid
  far-reaching impact of contractor default

Underlying Sector Risk

• Health of existing backlog
• Timing of payment from owners
• Rising subcontractor failures/impact on
  profitability
• Require more frequent financial updates
• Onerous bond forms/contracts shifting risk to
  customer

In extending credit, underwriters continue
to consider
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Higher Loss Activity More Questions for Project
Approval

• Greater financial reporting requirements
• More stringent capital and liquidity retention
  requirements
• Heightened discussions around surety indemnity
  language and credit facility documents
• Rate increases for higher-risk clients and
  projects
• Contractor default insurance may become a less
  viable option due to risk and cost

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Varied Impact of Current Industry Trends

• Clients consider alternate collateral structures
  to support unique transactions
• Surety bonds can serve as viable alternatives to
  letters of credit
• Holistic view of client internal cost of capital
  driving more opportunities to surety
• Larger capacity available for investment grade
  type companies
• Surety capacity a critically important credit
  tool for construction companies

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A Risk Managers View of Surety

• The Risk Manager
• Ray Batistoni, Risk Manager
• Hertz Global Holdings

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Keys to a Successful Surety Program

• Price
• Reputation of the backer
• Working relationship
• Administrative efficiency
• Ease of application
• Turn-around time

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Questions?