The Construction Surety Industry: Looking Ahead

This article also appeared on Construction Executive’s website on April, 10 2020.

The construction industry, along with the surety industry, started 2020 with the same momentum seen in 2019, with few signs of contraction prior to the COVID-19 outbreak. Today, even with the COVID-19 uncertainty taking center stage, construction backlogs are generally substantial and surety programs are fairly robust. However, recent trends and the impact of the novel coronavirus have indicated that the release of work into production has become unpredictable and subject to substantial delayed starts.

This trend is likely to continue due to a number of factors including, first and foremost, the impact of COVID-19. But there are other factors, including regulatory agencies releasing and permitting work, as well as the surety and financing needed for megaprojects.

For the best-in-class contractors, the construction surety market continues to be active, yet cautiously optimistic. In 2019, there was a level of surety credit tightening that is expected to continue into 2020, as fears of potential recessionary indicators in the construction marketplace and rumors of significant contractor defaults loom. In 2020, the fear of a true recession due to factors such as work stoppages caused by COVID-19 has caused a dramatic increase in the level of credit scrutiny. The current Federal Federal Reserve’s economic outlook and geopolitical issues have also raised concerns regarding credit underwriting.

According to data published by Aon Insurance, surety division, total construction industry surety losses in 2019 were fairly favorable at fewer than 20%. Initially, this trend was expected to continue into 2020, subject to any financial issues related to megaprojects currently in place. But the impact of COVID-19 has increased surety exposure to a much higher level, similar to other credit programs.

Megaprojects Fueling Growth

Throughout 2019, the construction market benefited from large construction “megaprojects,” like new campus facilities for high-tech giants such as Google and Apple or Amazon’s continued building of massive warehousing and distribution centers worldwide. As more of these influential companies continue to grow and expand in the market, the need for megaconstruction surety credit programs will take center stage to support these efforts, and the need for increased credit will become more prevalent.

During 2019 and into 2020, surety industry experts have viewed the megaprojects within certain sectors of the construction and development arena more favorably than others: Solar and power construction continue to improve and provide steady growth, while amusement and recreation construction spending have proven to be too unpredictable and challenging to underwrite due to the underlying project-credit risk. State highway funding continues to improve even with the uncertainty surrounding federal funding for megaprojects. Airports and train infrastructure continue to show signs of significant improvement.  Regardless of the sector and industry they serve, megaprojects have been, and will be, impacted by COVID-19, project funding, surety credit programs and political scrutiny.

Construction Surety Concerns

While there are signs of growth in the construction industry, the surety market still recognizes the fears, spurred by the below risk factors, that have caused some to proceed with caution.

• COVID-19
• political and regulatory uncertainty
• national and regional economic uncertainty
• rising material costs
• immigration employment protocol
• overall shortage of construction workers
• ownership transition

Fueled by a robust market in the last few years, construction firms and their surety providers have been forced to rethink their approach to the market and pivot resources to projects and construction firms that provide an acceptable financial return with a more controllable risk. As the quantity of opportunities continues to increase, so will the overall quality of projects available for bidding, and a firm’s ability to be more selective.

Many construction firms have been able to use the overall improved trends in the construction industry as a means to focus on what they do best, as opposed to simply accepting any project that comes along, regardless of the job’s ultimate strategic, surety and financial risks.

COVID-19

With the virus expanding in the United States and governmental protocols taking shape, construction industry experts are reporting that it is only a matter of time before COVID-19 has a profound impact construction companies and future projects.

As workers become infected and quarantined, labor shortages will become exacerbated. Construction claims and litigation will also rise and likely lead to a tightening of the surety credit market as well as an increase in scrutiny of surety underwriting due to the impact coronavirus will have on labor forces, project starts and delays and, ultimately, the availability of workers to satisfy project scheduling and other legal project obligations.

Labor Shortage

One of the single biggest issues the construction industry continues to face is the extremely tight supply of skilled workers. This labor shortage has been influenced by a number of factors such as COVID-19-related health issues and the negative stigma that younger workforce entrants face when choosing a career in the construction industry versus a traditional, white-collar profession.

With the baby boomer generation set to retire within the next five to ten years and the intense federal pressure to limit and reduce the immigrant labor force from Mexico and Central America, the construction industry is faced with the monumental task of finding workers.

The labor risk, especially its potential impact on domestic and international construction, has been a major focus during underwriting of surety credit. If labor is not available to support project production, there could be a likelihood of project margin deterioration and exposure to credit losses by the surety firm.

Material Pricing Pressures

The cost of building materials, like all other sectors of the economy, has also continued to increase for many reasons, including supply chain issues caused by COVID-19. Other factors include an overall high demand from the general increase in the construction industry and the price of specific trade products, which continue to rise in cost.

Steel prices have become particularly problematic due to the political pressures levied on the tariffs that have come into play among U.S. trading partners. In addition to steel prices, the varying fluctuation in the oil industry has continued to impact almost every component utilized in the construction industry and based on the commodity nature of oil, this is likely to continue into 2020. As a result, surety firms are challenging their customers to make sure they are protected from the unknowns in the marketplace and have systems in place to address supply chain issues that result from COVID-19.

Ownership Transition

A central issue in 2020 for the global surety market is the area of ownership transition. Changes in ownership and related equity redemptions have resulted in significant adjustments to the debt and capital structure of construction firms.

As two of the key credit underwriting factors in determining surety capacity include calculated net working capital and tangible equity, it is imperative that ownership transition deal structures are evaluated carefully to ensure a full understanding of potential changes to a surety program.

The Bottom Line

In 2020, surety firms will continue to provide bonding programs based on the “Three Cs” of credit evaluation (more on pg. 46), subject to the major unknown of COVID-19.

And, surety firms will continue to provide increased bonding programs to construction firms that exhibit the following best-in-class financial performance metrics:

• controlled COVID-19 issues and project release
• significant working capital and liquidity positions
• minimal line of credit borrowings
• significant equity positions
• positive job performance and low-project gross profit fade

While backlogs continue to be very significant for many contractors, the ultimate completion of this work in 2020 will be based upon the market’s ability to recover from the impact of COVID-19, develop a stabilized economy, improve international relationships, clarify political policy and, most importantly, find the workers to complete the project. The ability of surety bond producers to continue to provide substantial credit will be one of the key drivers in supporting the ongoing uptick in the construction marketplace in order to help make 2020 a reasonable year for the industry.