The widespread financial distress in construction is one of the biggest issues that surety providers are seeing right now. The upward trend in loss severity for contractors is reflected in the surety industry’s rising loss ratio over the past year.
This upward trend in the severity of losses is related to the difficult economic conditions of recent years. Although the major inflationary impacts, such as supply chain issues, appear to have been overcome through claims, and although work completion prices have normalized relative to contract balances, these positives do not outweigh other factors.
snowball
It is common for overdue payments to result in payment bond claims, and typically during a claims investigation, a contractor’s financial strain is revealed early on and easily managed. But not lately. Like a snowball rolling downhill, what appears to be a small problem quickly turns into a big one. At first, many of the bond claims appear to be relatively benign payment bond claims, but the bond investigation of the initial claim is revealing serious financial problems within the company, to the point where the principal can no longer fund its operations or pay subcontractors and suppliers. . Ultimately, what started as a small payment claim is leading to a large loss of payment and performance bond.
Cash crunching
Cash flow problems appear to be widespread, spanning all types of contractors and geographic locations. In many of these cases, directors seek financial assistance to fund continued performance on related projects. Bail claims professionals receive both direct and indirect funding applications. Direct financing is when the contractor requests payment of payroll and operating costs against the guarantor. Indirect financing is when the principal requests the guarantor to pay their outstanding invoices and resolve payment bond claims. Although the circumstances require the use of all the “tools in the toolbox” by a guarantor to mitigate losses, guarantors have historically been (and remain) reluctant to provide direct financing. Indirect financing is much more common. In addition, in many of these cases, the contractor’s borrowing capacity with its lender is maxed out. In an increasing number of cases, contractors have turned to accounts receivable factoring as an additional source of working capital, complicating matters in the event of claims and losses. In addition to direct and indirect financing, underwriters more often use joint control and fund administration arrangements in their effort to mitigate contractors’ cash flow problems.
Good news/bad news
The good news is that many key performance indicators (KPIs) for the surety industry are trending positively. New business growth is expected to continue, bolstered by demand for public infrastructure-related surety bonds. Over the past year, construction warranty premiums have steadily increased and the frequency of claims has remained relatively low. Growth and fewer claims should decrease losses, but again, it is the severity of the losses that is driving the downtrend.
Stay tuned
The starting point for contractors is to consider these trends when evaluating their own operations, as well as those of subcontractors and suppliers. Contractors who partner with a surety that demonstrates a proactive, common-sense approach to underwriting, and when problems arise, to claims, will fare better in the long run. The right surety partner will seek to add value to the relationship by working with contractors to avoid claims and, if the situation is unavoidable, mitigate their severity.
