State of the Industry

In 2009, the surety industry in Canada enjoyed its 15^th consecutive year of positive results. This happy trend began in 1996 and followed on the heels of a calamitous five year period fueled by the real estate recession of the early 90’s.

Looking at the pure numbers, 2009 was a year to be celebrated with direct written premium of $457 million and a loss ratio of only 17%. Surety writings were up 3% over 2008 levels, marking the 13^th consecutive year of increases in DWP.

Indeed the recent growth in surety volume has been nothing short of phenomenal. At the beginning of the new century the surety industry in Canada wrote just over $195 million which adds up to a growth rate of 132% over the last decade. This stands in stark contrast to the ten year period ending in 1999 when the industry grew only by 18%.

It is notable as well that the market share of the top five writers who traditionally account for approximately 70% of the total DWP has inched downward. In 2009 the “big five” dropped to 64.3% of total writings; eight percentage points lower than in 2006. It seems that this is at least partially due to the increase in infrastructure spending on large projects which would explain the market share growth of companies like Chartis and Zurich Canada.

Perhaps the most surprising aspect of the 2009 results is what we didn’t see. Following the collapse of the U.S. financial markets in last quarter of 2008 most industry soothsayers were calling for a sharp decline in ICI construction leading to a corresponding drop in surety writings. It was expected that this would be followed by an increase in claim activity by the third of fourth quarter of 2009.

That neither of these predictions came to pass begs the important questions of what mitigating factors (if any) kept the 2009 results in positive territory and what does this bode for 2010 and beyond?

Surety 1996-2009: The Endless Summer

There are several contributing factors surrounding such an unprecedented period of good fortune. Obviously, the burgeoning economy was a huge factor as it always is, but there were several dynamics taking shape within the economy and the marketplace that also had an impact.

In the early years following the market correction of 1989 through 1995 as the industry regrouped it proceeded very cautiously. Underwriting mandates were strictly enforced and the painful lessons of lax underwriting were very fresh in the minds of senior surety people. Also, the marketplace had consolidated during the early 90’s and the much of the overly aggressive competition had vanished. In 1991, 12 companies accounted for a 70% share of the market. By 1994 that same 70% was written by only five firms.
From the late 1990’s into the early part of this decade as the Canadian market was recovering nicely, the U.S. results deteriorated significantly as a result of a long term decline in underwriting standards. The generally poor results were exacerbated by several extraordinary events as well (e.g. 9/11 and the collapse of Enron).
These U.S. generated problems had a profound impact on the Canadian marketplace; particularly in the reinsurance sector. Reinsurers began to reevaluate their books and become very selective with their capacity across the board, including Canada where the results had now been positive for several years. Reinsurers diligently scrutinized the underwriting activities of Canadian cedants and imposed strict guidelines and often restricted capacity. This drove underwriting standards upwards as sureties protected their reinsurance arrangements and conformed to the requirements set out by the reinsurers.
By the mid 2000’s, governments at the federal and provincial level with surpluses to spend discovered the political upsides of investing in infrastructure improvements. During the next several years, governments across the country established crown agencies (e.g. Infrastructure Ontario; May ’05, Partnerships B.C.; January ’05, Partnerais Quebec; March ’06, etc.) and provided them with a mandate to undertake high profile infrastructure mega projects
- These efforts were spurred on by other extraordinary factors:
- Rising oil prices led to much development work in Alberta in centres such as Fort McMurray.
- The 2010 Olympics in Vancouver spawned not only Olympic construction but support/infrastructure work; the Canada Line, the Sea to Sky Highway, etc.
Much of this work was bonded but even when it wasn’t, the glut of opportunities allowed contractors in the ICI sector to obtain work at healthy margins, thus maintaining strong balance sheets and shielding surety companies from loss.
With the onset of the U.S. financial crisis in late 2008, governments faced the prospect of a worldwide recession of a magnitude unseen since the 1930’s. Reading the writing on the political wall, the federal government pledged further concentrated investment in infrastructure as an economic stimulus; $4 billion in 09 and another $4 billion in 10.
It’s been suggested that government investment in infrastructure may have simply postponed the inevitable and that we may be “on borrowed time”. Indeed the economic signposts for the next two years are disconcerting and SAC members are already reporting a spike in claims activity, particularly in western Canada.
That said these current economic challenges; while serious, are a short term problem and the good news is that our industry seems to be well poised to manage them. Member companies have had ample warning of the coming slow down in ICI construction investment and most have been extra diligent in risk selection and in reducing exposure in high risk areas. While we still see a spike in claim activity over the next two to three years, many suggest that it will not be as serious as previous economy driven downturns.

Challenges: 2010 and Beyond – The Chill sets in

As we move into the second decade of the 21^st century, the surety industry in Canada faces a number of daunting, but surmountable challenges. These can be loosely grouped into five broad categories:

Economy

As suggested, the coming 24 to 30 months will be challenging times for our industry as economic, political and market forces converge to impede our efforts at maintaining a positive return.

Recently, Prime Minister Harper confirmed that the federal Infrastructure Stimulus Program will expire in March 2011. Declining government investment in infrastructure work will create that much more construction capacity in an already over saturated market
A stubbornly slow recovery in the U.S. coupled with the strong Canadian dollar continues to put pressure on the manufacturing/exporting/tourist sectors and stifles private investment and building initiatives; particularly in central Canada.
Concerns that the European debt crisis could fuel the dreaded “double dip” and put the recovery on hold.
Contractors with distressed balance sheets may become overly aggressive in their efforts to obtain work; thus creating the vicious downward cycle which leads to insolvency.

Personnel/Work Force

Like most industries, surety confronts the ongoing challenge of obtaining and maintaining qualified staff and potential management. The uniqueness of our industry and the particular challenges of the times create some special human resources challenges however:

The relative youth of our surety industry workforce; particularly in relation to experience in cycles presents us with a unique challenge. The length of the current peak cycle has created an experience gap among people who are now moving into senior positions. Our ranks include veterans with 10 or more years of experience who have had no first-hand exposure to the disruption and chaos that a construction crash can bring upon the surety industry.
This problem is exacerbated by the upcoming retirement of management from the baby boom generation. This is an issue that bedevils all industries and sectors across the board and we will soon confront the prospect of a wealth of experience leaving the industry over a relatively short period.
Recruiting: Let’s be honest, surety by its nature isn’t a “sexy” line of business and is rarely on the career choice list of new entrants to the work force. The challenge will be to attract qualified young people into our business and provide them with sufficient challenges and advancement opportunities to keep them.

Keeping Product and Process Current and Relevant

Arguably, this is the area that poses the biggest challenge, and; if not dealt with adequately, poses the most serious threat to the ongoing prosperity and even existence of the surety industry in Canada. Much of what follows comes as no surprise to anyone working in the surety industry and most of the points shown here are interrelated.

Ø The Demand for Certainty: Surety bonds and the suretyship process continue to be perceived as unresponsive; or certainly less responsive than competitive products such as letters of credit. However, the hard truth from the perspective of our industry is that this is not simply a perception. The nature of the product itself does not lend itself to quick turnaround response that is typically demanded by construction buyers. SAC recently spoke with one frustrated owner who put it in an interesting light. He freely admitted that a bond provides much better and more comprehensive protection than any other alternative but then added: “At least with a letter of credit I know what I’m getting. When I claim under a bond, I never know if, what, when or how much”.

Ø Evolution of the Product and the Adoption of a Service Mindset. Unfortunately our industry continues to be plagued by inconsistencies in the approach and diligence of claim service provided by its member firms. Again, professional and responsive claim service will be critical to our industry over the next two to three years as we deal with a spike in claim frequency. A real concern is that the lack of minimum claims standards inevitably creates the unfortunate scenario where the best and most responsive are tarred with the same brush as the worst and least responsive. Poor or inconsistent claim performance can prompt owners to seek out alternatives to surety bonds for their contract security needs.

Ø Competition by Alternatives: Competitive products like Contractor Default Insurance (CDI) have managed to obtain traction because they are (or are perceived to be) more responsive to the needs of end users. It’s interesting that while SAC and the industry have developed effective counter-arguments to the sellers of the alternatives, we need to be more diligent in addressing the broader picture. Personally, I’m less concerned about CDI which is really a niche product than about what the future may bring in terms of products that will compete for a share of our prime market.

Technological

Ø Coming to grips with technological advances in areas such as analysis and communication

Ø Technological advances on the construction side such as Building Information Modeling (BIM) (see below).

Alternative methods of project delivery

As we move forward, changes in the manner in which construction services are packaged and delivered will have a profound effect on surety providers who will struggle with the demands that some of these alternatives make on a traditional bonding arrangement. For example:

Ø BIM – a potentially exciting new “holistic” construction approach that applies automated construction data to develop a complete picture of the end product. However, some of the risks associated with moving down this road are just starting to be understood.

Ø P3’s – the concept of bringing private partners including the contractor into the ownership picture has many advantages but also carries risks that we haven’t yet faced head-on. For example, life cycle risks and the potential for future demands that a project be guaranteed across its entire useful life.

Again, while these challenges can be intimidating they are in no way insurmountable. Over the course of recent history, our industry has faced down far more daunting threats and moved on to more prosperous times. To paraphrase Mark Twain, rumours of the coming demise of the surety industry are greatly exaggerated.