Widespread financial distress in construction is one of the biggest issues surety providers are seeing right now. The upward trend in loss severity for contractors is reflected in the surety industry’s increasing loss ratio over the past year.
This upward trend in loss severity ties to the challenging economic conditions over the past several years. Even though the biggest inflationary impacts, like supply chain issues, seem to have worked their way through claims, and even though job completion prices have normalized relative to contract balances, those positives aren’t outweighing other factors.
Snowballing
It’s common for past-due payables to result in payment bond claims and typically, during a claims investigation, a contractor’s financial strain is revealed early on and is easily managed. But not lately. Like a snowball rolling downhill, what appears to be a small issue quickly grows into a massive one. At first, many of the surety claims appear to be relatively benign payment bond claims, but the surety’s investigation of the initial claim is revealing severe financial distress within the company – to the point the principal can no longer fund its operations or pay subcontractors and suppliers. Ultimately, what began as a small payment claim is resulting in a large payment and performance bond loss.
Cash crunch
Cash flow issues appear to be widespread – spanning all contractor types and geographic locations. In many of these instances, principals request financial assistance in order to fund continued performance on bonded projects. Surety claims professionals are receiving requests for both direct and indirect financing. Direct financing is where the contractor requests the surety’s payment of payroll and operational costs. Indirect financing is where the principal requests the surety’s payment of their outstanding bills and the resolution of payment bond claims. While the circumstances require a surety’s use of all “tools in the toolbox” to mitigate loss, sureties historically have been – and remain – reluctant to provide direct financing. Indirect financing is far more common. Also, in many of these instances, the contractor’s borrowing capacity with its lender is maxed out. In a growing number of cases, contractors have turned to factoring receivables as an additional source of working capital – which complicates matters in the event of claims and losses. In addition to direct and indirect financing, sureties are using joint check arrangements and funds administration more often in their effort to mitigate the contractors’ cash flow issues.
Good news/bad news
The good news is many key performance indicators (KPI) for the surety industry are trending in a positive way. New business growth is expected to continue, bolstered by demand for surety bonds related to public infrastructure. Over the last year, construction surety premiums rose consistently and claims frequency actually remained relatively low. Growth and fewer claims should decrease losses, but again, it’s the severity of the losses that is driving the negative trend.
Stay mindful
The takeaway for contractors is to be mindful of these trends in assessing their own operations as well as those of subcontractors and suppliers. Contractors who partner with a surety that demonstrates a proactive and common sense approach to underwriting, and when trouble strikes, in claims, will fare better in the long run. The right surety partner will seek to bring value to the relationship by working with contractors to avoid claims, and if the situation is unavoidable, to mitigate the severity of them.