INS101 -- Understanding the Importance of Surety

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					    Understanding the
   Importance of Surety
  Ray Batistoni, Hertz Global Holdings
 Stephen Haney, ACE Professional Risk
Robert McDonough, AON Risk Solutions
The Broker:
Robert McDonough, Surety Regional Managing Director
Aon Risk Solutions’ Construction Services Group

The Underwriter:
Stephen Haney, Executive Vice President
ACE Professional Risk - Surety

The Risk Manager:
Ray Batistoni, Risk Manager
Hertz Global Holdings
The Underwriter:
Stephen Haney, Executive Vice President
ACE Professional Risk - Surety

  Any positions or opinions expressed are the presenter’s own and not necessarily
                             those of any ACE company.
   Surety is NOT Insurance
1. Three Parties
   •   Obligee
   •   Principal
   •   Surety
2. Indemnity
3. No Losses
4. Pricing
        Characteristics of Surety
Surety Bond
• Independent instrument
• Conditioned on an underlying contract, ordinance or obligation
Risk of loss in bonding
• Failure to perform assumed obligations
Surety bond is not a risk transfer mechanism for the principal
If Surety sustains loss due to default on part of principal, loss
is recovered from principal and/or any Indemnitor(s)
          Classes of Bonds

    Construction               Commercial
• Bid                    •   Court Bond
• Performance & Supply   •   Customs
• Maintenance            •   License & Permit
                         •   Public Official
                         •   Miscellaneous
    Examples of Surety Obligations
Fiduciary Bonds:     Be an honest employee (e.g., Tax Collectors)

                     Allow importation of goods without the
Customs Bonds:       immediate need to pay taxes

Performance Bonds: Comply with contract’s terms and conditions

                     Pay those supplying goods and services in
Payment Bonds:       performance of a bonded contract

                     Meet all conditions of an ordinance or statute in
License and Permit: the performance of licensed trade or business
  Alternatives To Surety Bonds
Letters of credit
• Ties up borrowing facility
• Can trip covenants
• Not conditional
• Reduces balance sheet liquidity
• Cost of capital
Treasury securities
• Cost of capital
Sometimes, there are no alternatives
• Public funds typically require surety
• Certain federal court obligations mandate surety
          Underwriting Considerations:
Identification and         • Cancelable
Evaluation of Obligation   • Demand vs. conditional forms

                           • Market driven
Pricing                    • Credit sensitive
                           • Obligation sensitive

                           • Ultimate parent vs. subsidiary
                           • Captive arrangements
      Underwriting Considerations:
        Financial Underwriting
                     • Liquidity
Balance Sheet        • Leverage
                     • Debt maturity

                     • Earnings predictability
Income Statement
                     • Interest coverage

                     • Free cash flow vs. no cash flow
Cash Flow Analysis
                     • Capital expenditure needs
The Broker:
Robert McDonough, Surety Regional Managing
Aon Risk Solutions’ Construction Services Group
  U.S. Surety Industry: Strong Profitability,
         Default Concerns Continue
                             2009              2010    YTD 9-30-10 YTD 9-30-11
Earned Premiums             $5.24B            $5.27B     $3.96B      $3.87B
Loss Ratio                  19.5%             13.2%      16.7%        12%
Paid Losses                  $1.0B            $694M     $654.5M      $465M

  Through 9/30/11 top 20 surety companies accounted for:
   • 82.6% industry-earned premiums
   • 85.9% losses

  Industry results were profitable, but:
   • Largest surety provider results are inconsistent
   • Industry fears greater contract default experience

Source: The Fidelity & Surety Association of America
                           Surety History Premium / Loss Results
                 6                                                                                                                              80.00%



Dollars in Billions

                                                                                                                                                         Loss Ratio
                 3                                                                                                                              40.00%




                 0                                                                                                                              0.00%
                      1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

                                     Direct Written Premium                    Direct Losses                 Loss Ratio
    Adapting to New Market Realities
    Underwriters expected increased loss activity in 2011.
    Fortunately, companies made rapid changes to adapt.

Reduced overhead: Many contractors implemented financial
model with lower backlog and smaller margins
Increased liquidity:
– Slowing down capital expenditures
– Negotiating new contracts with better payment terms
– More modest M&A activity
– Replacing letters of credit with surety bonds
Result: Stronger balance sheets collectively improved credit
risk portfolios of the underwriting companies
       Six Years Consecutive Commercial Surety
          Profitability Leads to New Capacity
  2010 premium placements:                             2011 New Commercial Surety Capacity ($M)
    • Approx. $1.5B:                                       Company          Single    Aggregate
    • 28.3% of $5.3B total industry
       premium                                    Aspen Re                       $5          $50
  New capacity developed through:                 Arch                          $25          $50
    • Hiring new commercial surety                XL                           $200         $200
    • Current writers expanding capacity          Hanover                       $10          $25
    • New capital entering the sector             Argo                          $15          $35
 Excess capacity and increased                    Main Street America           $25          $25
 competition provided:                            Philadelphia Insurance        $10          $30
   • Better credits/improved pricing
    • Lower credits access to                                     TOTAL       $290         $415
      previously unavailable credit                Aggregate expansions for established markets:
                                                   ACE $100M; Chubb $250M; Liberty $1B
Source: The Fidelity & Surety Association of America
Market Discipline Challenged by Premium
              Growth Plans
Given finite universe of statutory risks, Sureties expanding writings
through financial guarantee obligations (e.g., insurance program bonds)
 2012: A record year for bankruptcies?
 – On pace for 60: 5 U.S. and 6 global companies currently in default
 – S&P: 39 US defaults in 2011 vs. 58 in 2010

Companies that refinanced maturities instead of reducing debt and those
faced with refinancing significant debt maturities in 2012 may risk default

Bankruptcy isn’t sole barometer for commercial surety losses – the
confluence of soft market and potential increased defaults may reverse
trends in the space in 2012

Expect continued “flight to quality” within the commercial surety segment
  Construction Surety Sector Slow to Increase
   New Capacity – Despite Profitable Results
Contract Surety Earned   • Approximately $3.8B in 2010
Premium Placements       • 21.7% of $5.3B total industry earned premium
                         • Weak construction spending & margins
Underwriting Concerns    • Increased subcontractor payment claims
                         • General contractors managing sub contractor default

                         • Continues to grow
Underlying Sector Risk   • Must navigate industry issues to avoid far-reaching
                           impact of contractor default

                         •   Health of existing backlog
In extending credit,
                         •   Timing of payment from owners
underwriters continue
                         •   Rising subcontractor failures/impact on profitability
to consider:
                         •   Require more frequent financial updates
                         •   Onerous bond forms/contracts shifting risk to customer
Higher Loss Activity = More Questions for
            Project Approval
Greater financial reporting requirements
More stringent capital and liquidity retention requirements
Heightened discussions around surety indemnity language
and credit facility documents
Rate increases for higher-risk clients and projects
Contractor default insurance may become a less viable option
due to risk and cost
Varied Impact of Current Industry Trends

Clients consider alternate collateral structures to support
unique transactions
Surety bonds can serve as viable alternatives to letters of
Holistic view of client internal cost of capital driving more
opportunities to surety
Larger capacity available for investment grade type companies
Surety capacity a critically important credit tool for
construction companies
  A Risk Manager’s View of Surety
The Risk Manager:
Ray Batistoni, Risk Manager
Hertz Global Holdings
  Keys to a Successful Surety Program

Reputation of the backer
Working relationship
Administrative efficiency
– Ease of application
– Turn-around time

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