Surety – Insurance or Assurance?

CAS Ratemaking SeminarPhiladelphia, PennsylvaniaMarch 2004

Gary Shook, FCASZurich North America

Surety 101

• Surety bonds guarantee performance

• Surety bonds are 3 party agreements– SuretySurety guarantees that– PrincipalPrincipal will perform for the benefit of– ObligeeObligee

• Obligee no longer needs to ask “Can you do it?” only “For how much will you do it?” (Miller Act and Little Miller Acts)(Miller Act and Little Miller Acts)

Surety 101

• Contract Surety - The Miller Act– 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

– 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– 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– 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– 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

100

1,000

10,000

100,000

1,000,000

10,000,000

100,000,000

1,000,000,000

Ground-up Incurred Severity

0

1,300,000

2,600,000

3,900,000

5,200,000

6,500,000

7,800,000

9,100,000

10,400,000

11,700,000

13,000,000

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%

Severity - Claims over 1 Million

0

2,000,000

4,000,000

6,000,000

8,000,000

10,000,000

12,000,000

14,000,000

90% 91% 92% 93% 94% 95% 96% 97% 98% 99% 100%

Accident Year Incurred Development Pattern

60%

70%

80%

90%

100%

110%

120%

130%

1 2 3 4 5 6 7 8 9

Commercial Contract

Report Year Payment Patterns

0%

20%

40%

60%

80%

100%

120%

0 2 4 6 8 10 12 14

Commercial Contract

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

0

50

100

150

200

250

300

350

400

Job 1 Job 2 Job 3 Job 4 Job 5 Job 6 Job 7 Total

Complete On-hand

Work on Hand

0

50

100

150

200

250

300

350

400

Job 1 Job 2 Job 3 Job 4 Job 5 Job 6 Job 7 Total

On-hand Contract Balance

PML

Surety Reinsurance

• 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– 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– 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)Continental Casualty (CNA)

Federal Insurance (Chubb)Federal Insurance (Chubb)

Fireman’s Fund (Allianz)Fireman’s Fund (Allianz)

HartfordHartford

Liberty MutualLiberty Mutual

Lumbermens Mutual (Kemper)Lumbermens Mutual (Kemper)

National Fire (CNA)National Fire (CNA)

Safeco

St. Paul

Travelers (2)

J.P. Morgan Chase Settlement

Principal $ 965 million

Settlement 654

- Rights Purchase 86

= Net Payments 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”

– 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)

• 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

K-Mart

-5

0

5

10

15

20

66 71 76 81 86 91 96

0

10

20

30

40

50

60

70

80

90

Sure

ty L

/R

Prime Rate Avg Chg CPI GDP Chg (96 $'s) Surety L/R

Economic Trends

Source: U.S. Department of Labor; Federal Reserve Board Release; Bureau of Economic Analysis, AM Best

Public Construction Spending v. Surety Industry C/R

50%

75%

100%

125%

150%

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

Indu

stry

Com

bine

d R

atio

50

80

110

140

Publ

ic C

ontru

ctio

n 19

96 $

's ($

Bil)

Industry C/R Public Construction Put in Place (1996 constant $)

Source: AM Best’s Aggregates & Averages; U.S. Census Bureau.