Preparing for a Potential “Hard” Surety Market

BY ROBERT P. O’LINN, ESQUIRE FLORIDA SURETY BONDS, INC.

Construction backlogs have grown with the expanding economy, and contractors have enjoyed a soft surety market in recent years. The soft market accommodated growth with more flexible rates and underwriting requirements. The fallout from COVID-19 threatens to hard en the surety market, but you can still take steps to succeed.

We Know Nothing Lasts Forever, But Who Expected Things to Change So Fast

On February 20, 2020, a crowd of construction industry leaders gathered at the Hard Rock Casino in Hollywood, Florida, to hear construction economist Anirban Basu deliver his 2020 economic forecast. Basu was decidedly upbeat about Florida’s economy, which boasts low unemployment and some of the fastest-growing metropolitan areas in the country, but he indicated the risk of recession in the next 18 months was the highest since 2007.

Basu cited uncertainty in global markets and the upcoming 2020 presidential election as factors pointing toward potential economic pullback. Unbeknownst to all, the stock market was about to drop over 30 percent in a few short weeks 1 and tens of millions would lose their jobs as COVID-19 spread across the globe. 2 The risk of recession is no longer abstract, and the Congressional Budget Office has revised its forecast, predicting a 5.6 percent decrease in GDP for 2020 and unemployment rising above 14 percent – a level not seen since the 1930s. 3

The State of Surety Before COVID-19

The unexpectedly sharp economic downturn comes at a time when contractors in Florida are carrying record backlogs 4 and sureties have enjoyed a historic run of profitability stoked by low contractor failure rates and an expanding construction economy. In the past decade, new sureties and reinsurers have piled into the surety market seeking a share of strong profits. 5 The increased capacity, competition, and readily available reinsurance created a soft surety market where contractors could obtain bonds on less stringent terms, with lower rates and larger aggregate programs. 6

In general, the recent soft surety market allowed contractors to take on larger work programs with less working capital and at lower bond rates than ever. Despite some

large losses in recent years, including catastrophic international surety losses 7 , the surety market has remained soft. Now there is growing concern that the current economic shock will cause losses to contractors and sureties, causing the surety market to harden, meaning surety credit will be issued on less liberal terms.

We Are Lucky to be in Florida Where Construction Continues, but Surety is Global

We are fortunate that Florida’s state leadership recognized construction as an essential service and that many transportation projects have continued uninterrupted, un like in states like Pennsylvania. 8 The surety markets, however, are international. Sure ties guarantee projects in all segments of the construction industry around the globe and across the country.

Temporary shutdowns and cancellation of construction projects in other areas in crease the risk of surety claims when delayed projects resume. Many contractors who have been forced to sit idle during the pandemic or whose cash flows have slowed are still sitting on record backlogs. Contractors with insufficient working capital and limited available bank credit may struggle to remo bilize on suspended jobs and prosecute their backlog, especially if they face accelerated schedules.

It’s not hard to imagine some surety loss es. How sureties will react to those losses remains to be seen, but we expect some sureties will stay the course when underwriting new business, but others will falter. Thank fully you can take steps to protect your surety credit against changes in the surety market.

What Can You Do to Prepare for the Potential Hardening Surety Market?

1. Preserve working capital and raise cash: As you work through your backlog, save as much profit as you can to bolster your balance sheet. Focus on timely collec tion receivables, since receivables over 90 days are discounted by the surety. Collect related party loans and receivables. Cash is the best asset for a construction company in a hardening market, as sureties discount many other current assets including inven tory, related party receivables, and investments in stocks, bonds and other securities. Raise and hold cash. 2. Maximize available bank credit: You’ve probably been in contact with your banker regarding a PPP loan; stay in touch with them and work on getting an increase in your bank line of credit. Explain your plan to retain working capital; your banker should appreciate that you’ll be keeping more cash in the bank than in previous years.

If you are already into your bank line of credit, consider getting the balance of the line converted to a term loan. To the extent you drew on your line of credit to cover ex penses after the disaster was declared, you might be able to pay down the line with the Federal Economic Injury Disaster Loan of up to $2 million at a 3.75 percent interest rate, and repayment periods of up to 30 years, with the first payment due one year after origination. The loan, however, cannot be used to refinance pre-existing debts or costs that are covered by a PPP loan. 9 Refinancing won’t improve your debt-to-net-worth ratio, but it will improve working capital in the short term, lower your interest expense and free up your line of credit for emergency use. 3. Audit your overhead: Whether your work is slowing down or not, having a lean business with low overhead will help protect your balance sheet in the coming months. Equipment is a long-term asset sureties don’t count toward your working capital. If you have excess equipment, selling the re dundant equipment for cash makes sense.

You may want to rent equipment in the near term. While renting equipment can be a double-edged sword, you get more flexibility and avoid the immediate depletion of work ing capital that occurs when you pay cash or take on debt to buy equipment. Although unimaginable a few months ago given the limited labor pool, you might consider rightsizing your workforce while retaining key employees, especially if jobs have been can celled outright. You also might want to implement technologies and modify processes to reduce costs and inefficiencies that you were too busy to address in recent years. 4. Review your contracts: Make sure you understand the force majeure provisions in your existing construction contracts and provide notices concerning COVID-19 if you haven’t already done so. On new contracts, negotiate force majeure provisions that pro vide time and cost allowances against future delays due to COVID-19 and other epidemic events in the event of a resurgence in the virus this fall and winter. Have your lawyer look at your insurance policies to see if you can get coverage for any losses you’ve in curred during the pandemic. If you are negotiating private work, be sure to confirm financing on bonded and unbonded jobs. 5. Keep your CPA involved: Successful contractors know the importance of getting timely CPA statements. As the surety market hardens, CPAs continue to be integral in your plans to maximize working capital and en sure timely information flow. 6. Call your surety agent: A surety agent is supposed to be a trusted advisor. Your agent makes sure your needs stay front and center with your surety and can provide spe cific guidance to keep bonds flowing in a hard surety market.

References

1. www.cnbc.com/2020/03/23/this-was-the-fastest-30percent-stock-market-decline-ever.html 2. www.wsj.com/articles/states-strugglewith-coronavirus-unemployment-claimssurge-11588239004 3. www.cbo.gov/system/files/2020-04/56344-

CBO-presentation.pdf slide 3 4. ABC Construction Backlog Indicator for South

Region reached 11.4 months in December 2019, which was the highest for any region in the last decade. https://abc.org/News-Media/

News-Releases/entryid/17037/abc-s-construction-backlog-indicator-rebounds-in-january 5. www.cavignac.com/wp-content/uploads/Q4- 2017-Construction-Newsletter.pdf 6. www.constructionexec.com/article/2020- surety-outlook-capitalizing-on-capacity 7. ontarioconstructionnews.com/ontariocontractors-massive-surety-default-largestloss-in-canadian-history-says-broker; www. constructionexec-pageviewer.com/cem/november_2018/MobilePagedArticle.action?articl eId=1438964#articleId1438964 8. www.post-gazette.com/news/transportation/2020/04/27/PennDOT-COVID-19-restarting-road-projects-May-1-Allegheny-Beaver

Lawrence-County/stories/202004270130 9. See 13 CFR § 123.303 (b)(1) “loan proceeds may not be used to refinance indebtedness which you incurred prior to the disaster event”

About the Author

Robert P. O’Linn, Esquire, is a surety agent at Florida Surety Bonds, Inc., an independent, bondsonly agency in Maitland. Florida Surety Bonds has been helping contractors negoti ate competitive surety programs in hard and soft surety markets for over 20 years. He can be reached at (407) 755-6354 or bob@floridasuretybonds.com.