Surety – Insurance or Assurance?
CAS Ratemaking Seminar
Philadelphia, Pennsylvania
March 2004
Gary Shook, FCAS
Zurich North America
Surety 101
• Surety bonds guarantee performance
• Surety bonds are 3 party agreements
– Surety guarantees that
– Principal will perform for the benefit of
– Obligee
• Obligee no longer needs to ask “Can you do
it?” only “For how much will you do it?”
(Miller Act and Little Miller Acts)
Surety 101
• Contract Surety - The Miller Act
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–
–
–
–
federal contracts over $100,000
performance and payment (labor and materials)
first and second tier subcontractors protected
bonds not required for military contracts
many states passed “Little Miller Acts”
Surety 101
• Surety underwriters are professional
“capability evaluators”.
• Target loss ratio is 0%
– do not bond principals that will not perform
– u/w must know a great deal about the principal
and the obligation
Surety 101
• Traditional industry segments include
– contract Surety
– commercial Surety
•
•
•
•
•
court
fiduciary
official
license and permit
miscellaneous
Surety 101
• Contract Surety
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–
–
–
–
bid
performance
payment
maintenance
supply
• U.S. infrastructure construction runs at
about 10% of GDP
Surety 101
• Commercial Surety
– court
• generally protect opposing litigant
• coverage is statutory, bond forms must comply w/
statute
– appeal - to stay execution of court order pending appeal
from the judgment
– bail bonds
– mechanics lien (discharges a lien against real estate)
Surety 101
• Commercial Surety
– fiduciary
• fiduciaries administer property held in trust
• bond guarantees faithful performance of duties as
ordered by the courts with jurisdiction
• also includes conservators and liquidators
• coverage is statutory
• any and all parties with interest can file claim against
the bond (obligee is usually the state or the U.S.A.)
Surety 101
• Commercial Surety
– fiduciary (cont’d)
• protects against embezzlement, improper
disbursements, loss on investments
– executors of estates of deceased persons (or those presumed
dead)
– estates of incompetents
– estates of minors (guardian bonds)
– bankruptcy proceedings
Surety 101
• Commercial Surety
– official
• covers loss of public funds
– faithful performance of duties
– failure of depository institution
– burglary, robbery, forgery
• federal and non-federal
• treasurers, tax collectors, sheriffs and deputies,
agents(fishing and hunting license sales), notaries
Surety 101
• Commercial Surety
– license and permit: bonds are often required
prior to obtaining a license or permit
• properly collect and remit duties, taxes
– customs duties
– sales and excise tax collection
• properly discharge obligations under the law
– return of illegally imported merchandise
– statutory penalty for failure to comply with laws governing
the business or activity
Surety 101
• Commercial Surety
– miscellaneous
• statutory bonds that do not clearly fall into one of the
other categories
• U.S. immigrant bonds
– payment of fines imposed under Immigration Act
– maintenance of status and departure of non-immigrant alien
– alien will not become dependent upon the state
• voluntary bonds
Surety 101
• Commercial Surety - Miscellaneous Bonds
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–
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depository bonds
financial guarantees - traditional
financial guarantees - credit enhancement
income tax bonds
lease bonds
lost securities bonds
workers compensation bonds
Surety 101
• Commercial Surety
– compliance
• cigarette tax
• notary
• public official, court fiduciary, court guarantee
– financial
• WC Self-insurance
• insurance premium payment bonds
• sale and delivery of raw materials
Loss Costs
• Surety Association of America
• Contract Surety
– bonds classified by type of contract
• primarily a function of complexity and duration
– large building construction, dams, subways
– bridge construction, curbs and gutters, elevators
– fire escapes, guard rails, paving, mosquito control
• supply, maintenance, completion, miscellaneous
• bid
– classification codes are also supported but loss
costs are based more so on type of contract
Loss Costs
• Commercial Surety
– primarily segmented using classification codes
– myriad types of bonds are grouped by relative
risk into a manageable number of loss cost
classifications (i.e. risk groups)
– separately done for court and fiduciary, official,
license, etc.
• Many surety loss costs are structured to
support waning average loss/exposure ratios
Individual Risk Considerations
• Commercial Accounts
– 3 Cs
• character
• capital
• capacity
– collateral - amount and quality
– financial health
– expected volume of bonds
Individual Risk Considerations
• Commercial Accounts
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–
–
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credit rating (e.g. Moody’s, S&P)
experience of management
time in business
stability of earnings
• firm
• industry segment
Individual Risk Considerations
• Contract Accounts
– 3 Cs
• character
• capital
• capacity - experience, expertise, hardware
– financial well-being
• quality of financial statements (e.g. CPA reviewed)
• net worth (value and volatility)
– geographic spread
– bonded work vs. unbonded work
The Three Party Agreement
• This ain’t your father’s HO liability cover
• Surety bonds principal in favor of obligee
– the target loss ratio is zero
– principals usually must execute general
indemnity agreements in favor of the surety
– often includes personal indemnity
– after payment is made by surety to obligee, then
surety seeks recovery from principal (read
customer)
Contract Surety Claims
• Options for Surety
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capital infusion
takeover the contracts
litigate (deny coverage)
allow owner to complete
provide for others to complete (tender the
contracts)
• Early intervention can save $$$$$$
Ground-up Incurred Severity
1,000,000,000
100,000,000
10,000,000
1,000,000
100,000
10,000
1,000
100
Ground-up Incurred Severity
13,000,000
11,700,000
10,400,000
9,100,000
7,800,000
6,500,000
5,200,000
3,900,000
2,600,000
1,300,000
0
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
Severity - Claims over 1 Million
14,000,000
12,000,000
10,000,000
8,000,000
6,000,000
4,000,000
2,000,000
0
90%
91%
92%
93%
94%
95%
96%
97%
98%
99%
100%
Accident Year Incurred Development Pattern
130%
120%
110%
100%
90%
80%
70%
60%
1
2
3
4
Commercial
5
6
7
Contract
8
9
Report Year Payment Patterns
120%
100%
80%
60%
40%
20%
0%
0
2
4
Commercial
6
8
10
Contract
12
14
Contract Surety Claims
• Performance
– completion costs in excess of job funds
– delay damages
– marginal fees (engineers, lawyers, architects)
• Payment
– labor and materials
– extra work
• Case Reserving is very complicated and
therefore volatile
Contract Surety Claims
• Accident date?
– loss is not typically “fortuitous”
– claim files can open before a claim is made
– can be outside the “policy period”
• Multiple jobs typically affected
– bonded and unbonded
– various stages of job completion
Contract Surety Claims
• Probable Maximum Loss (PML)
– possible to incur a loss in excess of the “limit”
of the bond
– typically a function of “work on hand”
• Offsets include contract balances,
indemnity, salvage, and subrogation
– personal indemnity is not uncommon
– recovery can extend for years
Work on Hand
400
350
300
250
200
150
100
50
0
Job 1
Job 2
Job 3
Job 4
Complete
Job 5
Job 6
On-hand
Job 7
Total
400
PML
350
300
250
200
150
100
50
0
Job 1
Job 2
Job 3
On-hand
Job 4
Job 5
Job 6
Contract Balance
Job 7
Total
Surety Reinsurance
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•
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•
•
•
•
Cosurety is not surety reinsurance
Quota share vs. excess of loss
Typically on a losses discovered trigger (XS)
Aggregation
Cash flow
International issues
Total risk includes capital market exposure
Surety Reinsurance
• Many P&C company information systems
do not support some of the important surety
statistics
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–
–
–
–
post expiration “accident date”
collateral
contract balances
credit rating
net worth
Surety Reinsurance
• Many P&C company information systems
do not support some of the important surety
statistics
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–
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claim counting can be different
true exposure is difficult to maintain
contract prices will change
recoveries come in many forms
Surety Reinsurance
• Many P&C company information systems
do not support some of the important surety
statistics
– work on hand (high maintenance stat)
– customer number (aggregation issues)
• exposure
• incurred losses
• contract and commercial
– exposure (e.g. performance vs. payment)
Enron
• Bonds guaranteed delivery of oil and
natural gas
• $2B loss to insurance industry (includes
asset write downs)
• Enron loss amount
– $1.1 billion in bonds
• Payback
• Pricing implications?
Enron
• Mahonia pays $200 to Enron today for $210
of gas to be delivered in 1 year
• Mahonia buys a surety bond guaranteeing
delivery on the paid-forward contract
• Enron (secretly) contracts to buy $210 of
gas from Mahonia in 1 year.
• Enron has $200 cash, Mahonia has a
guaranteed payment of $210 in a year
Enron
• Mahonia had no terminals, no storage tanks
– contracts back-and-forth usually executed the
same day
– bond underwriters argue there was never intent
or ability to use gas
• One effect of the loss was many surety
writers dramatically reducing capacity
– e.g. from $250 million to $25 million
per principal
J. P. Morgan Chase vs.
Continental Casualty (CNA)
Federal Insurance (Chubb)
Fireman’s Fund (Allianz)
Hartford
Liberty Mutual
Lumbermens Mutual (Kemper)
National Fire (CNA)
Safeco
St. Paul
Travelers (2)
J.P. Morgan Chase Settlement
Principal
Settlement
- Rights Purchase
= Net Payments
$ 965 million
654
86
568 (60%ish)
Enron
• For the record
– J.P. Morgan also had to sue for recovery of
millions in LOC obligations
– hundreds of millions of dollars were paid by
surety companies on legitimate paid-forward
bonded contracts
K-Mart
• K-Marts “Perfect Storm”
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a nation in recession
intense retail competition
poor holiday sales 2001Q4
liquidity problems
bad press from securities analysts
Enron collapse
lenders, insurers, and suppliers thought K-Mart
sounded a lot like Enron (everyone wanted cash
that K-Mart simply did not have)
K-Mart
• Bonds guaranteed workers compensation
and liability self-insurance plans
• As financial condition deteriorated, bond
prices rose plus...
• Collateral (cash) was required and this
exacerbated the situation of cash strapped
K-Mart
Economic Trends
90
20
80
15
70
10
50
40
5
30
20
0
66
71
76
81
86
91
96
10
0
-5
Prime Rate
Avg Chg CPI
GDP Chg (96 $'s)
Source: U.S. Department of Labor; Federal Reserve Board Release; Bureau of Economic Analysis, AM Best
Surety L/R
Surety L/R
60
Public Construction Spending v. Surety Industry C/R
Industry Combined Ratio
140
125%
110
100%
75%
80
50%
50
66 67 68 69 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00
Industry C/R
Source: AM Best’s Aggregates & Averages; U.S. Census Bureau.
Public Construction Put in Place (1996 constant $)
Public Contruction 1996 $'s ($Bil)
150%