November 2016

The outlook for surety in Canada is healthy, but a number of developments are introducing increased risk that need to be taken into account and properly managed, speakers suggested during the Toronto Risk and Insurance Education Forum last week in downtown Toronto. Likely, “80% or so of the bonds issued are these approved (by Canadian Construction Document Committee, CCDC) forms of bonds,” said James MacLellan, a partner with Borden Ladner Gervais LLP in Toronto. MacLellan noted there are three main types of bonds: bid bonds, which guarantees the contractor who submits a bid will enter into a final contract; performance bonds, which can guarantee any underlying contractual obligation and are likely the most common bonds; and labour and material payment bonds, which guarantee that sub-trades and suppliers will be paid. Despite the vast majority of bonds being CCDC-approved, “more and more, owners are drafting their own forms of bonds and imposing them on sureties,” MacLellan, part of the Technical Review and Risk Allocation panel, reported to attendees. “These bonds are designed to download risks onto sureties that sureties typically don’t accept and typically don’t cover,” he explained. “So more and more, your sophisticated owners are creating their own bond form, which significantly expands the risk profile for a surety.” Surety bonds are “an on-default instrument; it is not an on-demand instrument,” said Stuart Detsky, assistant vice president of surety and warranty claims for Trisura Guarantee Insurance Company. However, “there is a push from certain owners to make certain parts of bonds on-demand,” Detsky noted. “I think we’ll see this change over the next five to 10 years as more and more companies from outside of Canada come into Canada to do contracting,” he explained. The push will not be so much from the United States – which has a very established surety history and where most states require bonding for public projects – but more so from Europe and other parts of the world, Detsky said. It is from Europe and other areas “where you’re seeing contractors, especially larger contractors, come into Canada,” he said. Not used to the surety manner of risk mitigation used in Canada, instead, they usually use “guarantees, letters of credit, those types of things,” he reported. “So I think we’ll see a shift to bonds that are a little bit more partially on-demand, but that remains to be seen,” Detsky predicted. Of course, others in the construction chain are also taking on increased risk in the wake of the changing environment. In the public-private partnerships (P3) space, for example, “it’s very prominent that the contractors take on a tremendous amount of risk compared to what would have happened 20 years ago,” said Devon Maltby, field vice president of surety for Travelers Canada. But the development need not be a problem. “They just have to be very good and adept at managing that risk. It’s not necessarily a bad thing,” Maltby emphasized. Typically in Canada, surety buyers are public entities such as municipalities, provincial bodies and the federal government, said Dan Calderhead, managing director and branch manger of the construction division at Jardine Lloyd Thompson Canada. “They request about 80% of the bonds in Canada,” Calderhead noted, with the remaining approximately 20% being private owners. Here, again, some changes are under way. Since a private owner will often need to borrow money for the project from finance company, the finance company will likely require the contractor to be bonded to offer protection should a job go sideways, Calderhead said. While those trying to get a bond are often contractors, sub-contractors and road builders, anyone who qualifies for a bond can get one, he explained. Consider a guy and his pick-up truck. “In the old days, he would have a hard time getting a bond, but these days, the thresholds have come down a bit. I think it’s not a bad thing because these guys need a chance to start off their companies.” Bonding companies “have made it easier these days to set up bond facilities for the smaller operator,” Calderhead noted. “The thresholds are quite low these days. That’s not a bad thing as long as it’s handled responsibly,” he said. With contract forms – much like the bond forms – “if you look at the U.S. marketplace 10 or 15 years ago, it was extremely aggressive,” Maltby said, noting firms in Canada may not have considered bonding some such projects. “It’s becoming more and more commonplace here. So, again, a downloading of risk,” he explained. “Risk is fine. I think the contractors have to be adept at understanding it, pricing it, and I think that’s where you can find problems these days is where people are assuming risks that they didn’t necessarily understand,” he cautioned. Citing numbers from the Surety Association of Canada, Maltby reported that over the last six years, surety “has been growing and we expect it to continue to grow. Construction, for Canada, is an extremely important part of our GDP (gross domestic product).” Estimating “the average surety expense ratio could be in the mid-40s, a bit higher for some,” he pointed out that this is attracting capital and new entrants. “At the primary level, we’re seeing a tremendous amount of support from the reinsurance community,” Maltby said, adding that the number of surety players in the space has grown to about 40. “That has increased the availability of capacity and is leading to what, I think, many folks believe is probably one of the most aggressive surety markets in history,” he told attendees. On the flip side, however, increased capacity is one possible determinant “that can cause the next loss. Excess surety capacity can trigger a higher level of defaults going forward,” Maltby cautioned. “The underlying assumption is that we underwrite to a 0% loss ratio,” Maltby told attendees. “I think relative to the premium that we’re able to charge increasingly in this aggressive marketplace, those losses are big. So it’s a bit more like a catastrophic scenario compared to

The outstanding results of the surety industry over the last 10 years are beginning to make some buyers question the value of surety bonds. However, there are dynamics going on in the construction industry and commercial markets that indicate the need is greater than ever for their use. For decades, the construction industry did not see the pace of change and productivity gains other industries generated, but this is no longer the case. From Public Private Partnerships (PPP) to alternative delivery methods, including Integrated Project Delivery (IDP), the construction industry is changing rapidly, and projects have become more complex and difficult to build, pushing the construction industry to adapt. But like any industry experiencing increased change, some firms are quicker to adjust than others. According to the 2016 AGC/FMI Risk Survey, conducted by the Associated General Contractors of America (AGC) in collaboration with consulting firm FMI, the risk for subcontractor default now ranks as one of the top three risks within the construction industry along with skilled craft labor shortages and onerous contract language. A key product for an owner looking to transfer performance or payment guarantee risk is a surety bond. By purchasing a surety bond, owners seek to ensure their projects reach completion within the terms of the contract. Additionally, sureties conduct an in-depth review of their clients, giving owners an increased level of assurance that they are doing business with contractors that can get the job done. The good news for owners is that the surety industry has recognized the changing construction risk landscape and has responded. The teams of surety experts that brokers and companies have built over the last few years have gotten larger and more sophisticated and generally have a deep knowledge and understanding of today’s construction risks. Construction owners are able to tap into this knowledge to help mitigate the performance and payment risks on their projects. Surety still a buyer’s market From a pricing perspective, the overall surety marketplace remains a buyers’ market, driven by a few key factors. First, the gross written premium for the surety industry declined from 2007 to 2012 paralleling the downturn in construction. At the same time, loss ratios remained on average during this period below 25 percent for the industry, making it a very profitable line of business for insurers. So insurers were looking to increase gross written premium in a declining market. And finally, new surety companies have continued to enter the market. Therefore, the amount of capital dedicated to the surety line has increased significantly faster than the revenue growth of the surety market. Even though the surety market may be soft, however, it doesn’t mean surety bonds no longer provide value. To the contrary, surety bonds are more important than ever in helping to bring projects to completion. While new construction delivery methods and performance guarantees will continue to test the surety industry, those members of the surety community that find thoughtful solutions that help clients become more successful will maintain their relevance, and, of course, those that don’t, risk becoming irrelevant. It is an exciting time to be a part of a dynamic business. http://www.propertycasualty360.com/2016/11/08/more-complex-construction-risks-test-surety-market

Arch Coal will use traditional insurance to guarantee that nearly $400 million in cleanup work eventually happens at its Wyoming mines, according to a restructuring plan approved Tuesday by a federal bankruptcy judge. The plan moves the coal giant away from self-bonding, a contentious practice that allows companies to forgo traditional insurance for cleanup, backing up their promise to pay for reclamation with their financial strength. The restructuring plan signals a win for both sides of the self-bonding debate in Wyoming. Arch will emerge from crippling debt with a healthy balance sheet in a coal market that is showing signs of stabilizing. Meanwhile, environmentalists view the plan as another step toward ending self-bonding in the state. Arch, which operates the Black Thunder mine near Wright, filed for bankruptcy Jan. 11, with about $6 billion in debt. Arch has shed $4.7 billion of what it owed when it filed for Chapter 11, it said in a statement. “We will emerge as a strong, well-positioned natural resource company with a compelling plan for value creation,” said John W. Eaves, the company’s CEO. “We have accomplished a great deal through the restructuring process and are confident that we have established a solid foundation for long-term success, built on our strong metallurgical and thermal franchises and our core commitment to safety and environmental excellence.” Arch originally argued that the expense of securing third-party insurance instead of self-bonding would hurt its liquidity upon emergence. But the St. Louis-based company has changed its tune. “In evaluating surety bond markets, we found that there was more than sufficient capacity available to us, with reasonable rates and collateral requirements,” the company said in a statement Monday. “The fact that the surety markets offered this strong support to us is a clear indication that surety providers have great confidence in the quality of our assets and in our future prospects.” Self-bonding opponents cheered the decision. Environmentalists argue that self-bonding puts the taxpayer at risk of picking up the tab if companies go bust, particularly in light of the current coal market. Three of the largest coal companies operating in the state fell into bankruptcy in 2015 and 2016 after they saddled themselves with billions in debt. The debate is further exacerbated by the uncertain future of coal. The assumption that coal will continue to provide the bulk of U.S. electricity has been undermined by looming federal regulations on emissions and competition from natural gas. Coal companies maintain the worth of their commodity as a competitive, reliable resource in the country’s energy portfolio, and Wyoming regulators have maintained their right to allow self-bonding under certain circumstances. Opponents to the practice hoped the bankruptcy exit plan for Alpha Natural Resources, now Contura Energy, approved this summer would set a precedent in the state on the issue of self-bonding. The firm made a similar agreement to replace $411 million in self-bonds when it exited bankruptcy in July, after a federal agency refused to transfer mineral rights to the newly formed company until Alpha/Contura had addressed reclamation obligations. Contura now has $264 million in collateral or surety bonds in the state of Wyoming. An ideal time However, emergence from bankruptcy is an ideal time for these companies, which have successfully shed billions in debt, to purchase stronger reclamation bonds, said Shannon Anderson, of the Powder River Basin Resource Council. The council has been outspoken in its opposition to self-bonding. It does appear that Arch is in a stable position moving forward, said Monica Bonar, an analyst for Fitch Ratings. That is partly due to a slowly stabilizing market, she said. The company is going to lose cash through 2016, by its own projections. But it’s likely the firm will be able to manage spending going forward and have more flexibility. About half of its coal production into 2017 is already accounted for in contracts, Bonar said. “They are going to have more cash than debt,” she said. “That sounds like a really easy to believe story that they would generate cash [by] ‘17.” For environmentalists, Arch’s decision to replace its bonds adds weight to the argument that the practice has had its day. “It’s good news that the company is committed to do this, and it’s a sign that it’s possible,” Anderson said. “We hope that it sends a signal to Peabody, who’s next.” Peabody Energy, which operates the North Antelope Rochelle mine near Gillette, filed for bankruptcy in April. Environmentalists are hoping the company will follow Arch and Alpha’s example and reduce or eliminate self-bonds in the state. The international company has yet to exit its bankruptcy period or waver on its self-bonds. “The company is continuing to provide assurances to states through a variety of forms including self-bonding, third-party surety bonding, letters of credit and superpriority claims,” said Peabody spokeswoman Beth Sutton. “We are pleased to reach agreement with four states where we self-bond that provides additional security toward our reclamation obligations, and look forward to ongoing discussions regarding Peabody’s reclamation bonding long term.” The company maintains that its commitment to reclaiming disturbed land is well documented, citing the $560 million the company has paid into the federal Abandoned Mine Lands program, and restoration of 4,700 acres in 2015 alone, according to the company. The combined bonding amount for all three coal companies in Wyoming is $1.38 billion, much of that unsecured. An ongoing story The self-bonding debate is likely to continue. Federal regulators are attempting to force states away from the practice. Wyoming has so far resisted that pressure. The Office of Surface Mining Reclamation and Enforcement issued an Aug. 9 advisory for states to limit self-bonding practices given the uncertain coal market and immediately reevaluate the financial solvency of companies currently self-bonded. Though the advisory is not mandatory, it does place pressure on states to comply. The federal regulators followed up on Aug. 16 with an announcement that they would begin rule making on coal mine bonding, continuing the heated debate over what states are allowed to do.