Surety Bonding: 2023 Outlook

BY DUNCAN STANAGE

As we turn the calendar to 2023 the construction industry is holding its collective wallet a little tighter. We are seeing widespread financial struggles from construction clients across the province. Complex projects and difficult owners, lack of work, fluctuating input costs, rising wages and high employee turnover are the main drivers which have led to low profit margins, high competition, and dwindling cash reserves. Bonding companies, facing increased bond claim noise and anticipating contractor defaults are upcoming, are tightening their underwriting. We surety brokers are turning to more creative solutions and leaning on experience and outside the box thinking in order to help contractors get the bonds they require to achieve their business plan.

This was what we expected to see in 2020 in the early stages of the pandemic. Bonding companies held their breath, concerned the unprecedented climate would lead to contractor defaults, delay claims due to widespread worker illness, and legal battles over Force Majeure clauses. None of this transpired in any significant manner. Owners, contractors, and the industry as a whole acted collegiately and collaboratively, problem solving and moving projects ahead despite rising COVID case counts and overstuffed hospitals. Many contractors had ample work and were performing it profitability. For those companies who ran into difficulties or were not obtaining enough work to keep their employees busy, the Canada Emergency Wage Subsidy (CEWS) kept them afloat while also boosting those contractors who were achieving profitable results.

Then, as COVID case counts dropped so did contractors balance sheets. Government budgets constricted leading to limited municipal work, input costs rose dramatically due to worldwide supply chain issues, wage subsidies were wound down, and the industry faced a labour shortage exacerbated by workers reliance on government handouts.

We are seeing projects continue to rise in price, complexity, and length. Project owners push risk down on contractors with onerous contract terms. The $20 million project you performed five years might cost you $40 million now. These rising prices have not been accompanied by a proportional increase in contractors’ financial positions. Leveraging (total backlog divided by working capital or net worth) is being pushed higher and higher. All of these things are risks that bonding companies contemplate and analyze. Underwriting from sureties has become tighter and speaking their language is as important as it ever has been.

It is realistic to expect contractor defaults in the coming year. A lagging indicator, the depleted balance sheets and project losses will eventually catch up and some contractors who have not adapted will fall. Bond claims are likely to increase substantially so from the 14 per cent loss ratio the Surety Association was reporting last year (14 cents of each dollar of premium paid in claims), which will lead to more stringent underwriting.

In the coming year we are seeing a rocky road ahead for contractors and the industry as a whole. You can expect more questions and stricter underwriting from your bonding company. Inquiries about price escalation clauses, critical subcontractors and suppliers, and comfort with size and scope of projects have become more commonplace. Working with a specialized surety broker is a differentiator for your firm. Someone who understands your business plan is crucial. Those generalists and middlemen will struggle in the current climate and do your firm a disservice. Experienced and creative brokers can find innovative ways to solve the challenging bonding problems the industry is facing. There are solutions out there.

You may want to consider obtaining surety bonds from your critical path subcontractors. The bond you provide to the owner of the project is for their benefit, but if you ask your subcontractors for bonds this will protect you from their potential default and you know they have been prequalified for the job and they have the experience and financial strength to perform their component of the work. We always recommend you look to bonds subs you are either unfamiliar with, are performing a complex or unique scope of work and would be hard to replace should they default, and/or are performing a significant size subcontract.

We have recently seen some changes within the surety market due to some consolidation and purchasing of bonding companies. This happens occasionally as they jockey for market share. New entrants typically push hard for new business, trying to establish themselves as problem solvers and creating their niche in the marketplace. This push for business is contrasting the general hesitancy in the industry due to the economic outlook.

On a positive note, the bonding industry has made some headway on technology. The past couple years have seen the emergence (finally) of digitally signed indemnity agreements, far more frequent acceptance of electronic bonding by owners, and brokerage platforms allowing contractors to request bonds, update tender results and view premium calculations much easier than was previously available.

Despite the challenges, there is light at the end of the tunnel. We are seeing those thoughtful and calculated contractors succeed and post record breaking numbers in seemingly impossible contrast to the market as a whole. There are lots of talented underwriters who continue to understand their clients and help them secure larger bonds and find success, and some new entrants look to push the industry to think outside the box and rethink some of the old ‘we have always done it this way’ underwriting philosophies.

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