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Risk. Reinsurance. Human Resources.
Aon Risk Solutions
Construction and Surety Market Update 2017It’s getting better – isn’t it?!
2 Construction and Surety Market Update 2017
Construction spending continued its gradual improvement throughout 2016. The seasonally adjusted
rate of 2016 growth was 4.2% for total construction according to the US Census Bureau. Private and
Residential are leading the way at annual growth rates of 6.3% and 3.6% respectively. Office (31%),
lodging (19.9%), and commercial (12%) are strongest growth markets with Public construction lagging
at a minus 1.8%. The Architecture Billing Index (ABI) is a leading indicator based on activity of architects
designing non-residential projects. A score above 50 is considered a favorable growth trend in the next
12 months. The index was in the 52-53 range in the summer of 2016, but slowed a bit in the 4th quarter
to end the year with a 51.3% average. The message is for a slightly neutral national growth picture,
with more favorable growth projected in the South, declining trends in the Northeast and Midwest
and the West projected to be mostly flat for the year. The construction unemployment rate according
to the Department of Labor is approximately 5.1%, indicating a relatively tight employment market.
Construction companies in general continue to report difficulty in finding high quality employees across
the spectrum, from the specialty trades, project management, and executive talent. In general we are
expecting construction activity to be modestly positive, without a dramatic swing in either direction
in 2017.
There are wide ranging predictions related to the Trump Administration, and that uncertainty is likely to
continue until the new administration establishes its own operating identity. The market generally seems
to be leaning towards positive trends driven by less regulation, lower corporate taxes, and infrastructure
investment themes. Interest rates are expected to increase slowly and modestly and the market seems
to be digesting the interest rate changes without alarm. Energy costs have also trended up slightly, but
again, not setting off any alarm bells. So all of this is telling
us the economy is getting better, albeit slowly, but better – isn’t it?!
Modest, steady,
growth forecasted
for 2017
Executive Summary
The construction unemployment rate according to the Department of Labor is approximately 5.1%, indicating a relatively tight employment market.
Aon Risk Solutions 3
The surety bond business continues its great run of profitability - surety underwriters have
made more money over the last ten years than in the previous 100 years combined! Despite dire
predictions of doom from surety companies and industry prognosticators, when the post housing
boom bubble burst, the losses never materialized. Notwithstanding that many contractors went
out of business and business has been tough, and even some sureties paid out over $100 million
in losses, overall, surety has been a profitability bonanza since 2006. The business has experienced
ten years of loss ratios in the teens and annual industry profitability in excess of $1.5 billion! There is
ample capacity – back in the early 2000’s, $250 million was the maximum bond the industry could
write and today, for certain JVs, the industry could potentially put up a bond of $2 billion, or more.
Rates have dropped to half, whereas an old rule of thumb was 1.2% of contract value was the bond
cost. Now 60 bps is the number. Surety industry top line is up 7% since 2009, despite a precipitous
drop in rates. In light of these data points, one would suppose contractors are making 3-5 % net,
net bottom line. That, however, is where this logic goes astray. Contractor backlogs are back to
record levels, but getting that revenue to the bottom line has been more elusive. Contractors are surviving, but not prospering to the extent the risk on the work deserves.
2017 Surety Market Update
Surety underwriters have made more money over the last ten years than in the previous 100 years combined!
4 Construction and Surety Market Update 2017
Texas is a great example with a strong economy and public spending led by the Texas DOT’s 2016
$33 billion Unified Transportation Program. Contractors who are active in Texas, however, have
struggled to do better than breakeven. So why is that? Is it just Texas? What about active markets
like New York City, Boston, Miami, Chicago, and LA? More of the same - more activity and yes,
better margins, but only enough if everything goes right. As this is the construction business, rarely
does everything go according to plan. The inherent risks in mostly lump sum work are large and
above market returns are warranted for the risk assumed; however, margins remain very tight in this
hard bid arena due to heavy competition.
Heavy civil work with high labor components warrant double digit gross margins, yet for most hard
bid, DOT type work, mid-single digit gross profits are more likely. Very often the low bidder’s gross
margin is 3-5%, which in many cases does not even cover overhead. The larger design-build, heavy
civil projects, where there has been a RFQ short-listing, are generally yielding low double digit
margin opportunities.
In the general building market where a much higher percentage, e.g. 80% plus, is subbed out,
margins and risk are lower, and gross margin in the 4-5% range is warranted. However, 2.5% to
3.5% is the average where the market is in competitive situations. A few low bidders on public GC
work are still looking at 2% and relying on buy-outs. GC profit opportunities on Subcontractor
Default Insurance (SDI) and Contractor Controlled Insurance Programs (CCIP) have largely been
squeezed by consultants, which puts more pressure on the pure construction margin.
What’s driving this? Strong balance sheets by big market players have stalled improving margins
more quickly. Balance sheets for major firms remain robust with significant equity and liquidity.
Surety capacity is readily available and the market is competitive. Contractor income statements
have only shown marginally satisfactory returns. The contractor’s Return on Equity (ROE) is
often disappointing, but surety ratios for working capital and net worth to bonded backlog
are high/conservative.
This often translates to favorable surety risk factors and low loss ratios. With still a lot of deep pocket
players around the table, however, there is some reluctance to trade volume for margin.
Contractors are surviving, but not prospering to the extent the risk on the work deserves.
The day in, day out
hard bid market is
still generally margin
deficient versus risk.
Aon Risk Solutions 5
Investment by global companies in the US continues to increase as they have been a continuity
solution to many US companies over the last 5 years. The Global ENR 250 has over $500 billion in
construction revenues from outside their home markets. Many see the US as a fair and stable market
as compared to other more dynamic emerging markets outside of the US. These additional deep
pocket players will seek market share and delay higher margin results.
We are encouraged by a steady, modest, economic growth trend. Many see the new Trump
administration with optimism with regards to investment in infrastructure. Both sides of the
Congressional aisle seem to favor infrastructure investment leading to job growth. There are
different approaches to how to finance the work so we do not see easy solutions, but we expect
some creativity, e.g. P3, design-build-finance, and a bi-partisan populist support for investment in
construction activity.
The subcontractor market has heated up and many are at full capacity. Margins in this segment
appear to be firming more than in the GC and civil segments with double digit margins being
achieved in some major markets. What runs counter to this trend is the poor experience
Subcontractor Default Insurance (SDI) markets are reporting. The Surety and Fidelity Association
of America (SFAA) and SDI underwriters experience is vastly different. SFAA surety loss results
have been between 15% and 20% for several years. The 2016 SDI market has had a noted “hard market” environment with higher deductibles, tighter coverage endorsements, tougher
underwriting, and increased pricing, which is directly related to the SDI underwriters reacting to
higher losses. So why does the surety market have such good results while subcontractor default
insurers are experiencing poor loss results? While there are no definitive answers, there are some
theories. Since SDI had long been a product with only one market, there was little competition.
Over the last few years, new markets entered, leading to movement of specialized underwriters,
more competition, and a general lowering of underwriting standards, at a high default risk time
for subs - a rapidly growing market. We have also heard of subs with bonding difficulties targeting
work with GC’s with SDI programs, thereby creating some adverse selection. Some believe after
GC’s were initially diligent in pre-qualification of subs in their SDI programs, they simply got lax as
the marketplace heated up and allowed poor quality subs into SDI programs. Finally, some simply
believe that SDI products have garnered such a large share of the subcontracting bond market
that SFAA results are more insulated from subcontractor defaults and the SDI markets lack the
diversification enjoyed by SFAA. SFAA benefits from having GC and heavy civil and commercial
surety exposures in addition to subcontractor risk. In any event, it is a marked difference and we
expect to see more subcontractor bonds in the surety market while the SDI programs sort out the
market changes.
Investment by global
companies in the US
continues to increase
6 Construction and Surety Market Update 2017
Talent remains a high priority concern for contractors, surety underwriters, and brokers. Projects
are larger and procurements are more complicated. Underwriting requires reviewing hundreds of
pages of technical RFP documents. Estimators need to price new and increasing risk for exposures
that owners are pushing onto contractors. Organizations are stretching their A team as the number
of large, complex and higher risk projects continue to grow. Public owners face talent issues as
well with complex, large projects being managed by people that lack the experience necessary to
manage multi-year, billion dollar projects. This often translates into more challenges for
the contractors.
Good times can be breeding grounds for complacency. Since the last “hard” surety market more
than 15 years ago, project size has increased, backlogs have increased and more surety capacity is
necessary to support business plans. During this period of time sureties have enjoyed profitable
results, strengthened reserves, found reinsurance readily available and total industry capacity has
out grown the increased demand for capacity. However, the aggregate need for capacity is higher
today than 15 years ago. The surety market is fairly concentrated with about 6-8 markets catering to
the surety needs of contractors doing $100 million or more in annual volume.
The number of co-surety deals have increased for contractors needing more than $1 billion in
aggregate surety capacity as co-surety arrangements are very common above that level. Given
larger single project sizes, longer project completion schedules, and longer procurement processes,
generally speaking a contractor needs at least 2 to 3 times their annual revenues in surety capacity.
So increasingly contractors need more capacity. Contractors also more often need more than one
surety, and the largest need three or more. So if a very large contractor needs three co-sureties and
there are only seven large contractor markets, there are not as many options as one might think. If
the market experiences a major surety with a strategy change, or if we see a consolidation of markets,
it could quickly impact available capacity, particularly if a major loss develops in the market. It is
understandable to be relaxed about easy surety credit, but given the much higher capacity needs of
today, a drop in capacity would be challenging to replace. Contractors with a large surety program
are advised to maintain their senior level surety relationships with their incumbent sureties. They are
also advised to be familiar with a few back-up options. It is always best to develop relationships and share knowledge in good times, before an urgent need arises. Aon is ready to assist you with a
relevant and reliable surety program.
Challenges in the talent pool
Aon Risk Solutions 7
Aon’s Construction Services Group is the preeminent provider of risk and
human resources solutions to general and specialty contractors, project
owners, and industry stakeholders. As the segment leader, Aon provides
an unparalleled platform to serve the risk management needs of global
contractors, an expansive network of offices to support service delivery
for specialty firms and infrastructure projects, and the risk management
industry’s leading global capabilities, delivered through colleagues who
specialize in risk management for construction.
About Aon Construction Services
Surety ContactsGlobal SuretyMichael [email protected]
Contract SuretyPaul Healy1.617.457.7719 [email protected]
Greater New YorkEd [email protected] Nancy [email protected]
Mid-AtlanticDoug [email protected]
SoutheastMarisa [email protected]
CentralRich [email protected]
SouthwestRicardo [email protected]
West Paul [email protected]
Risk. Reinsurance. Human Resources.
About Aon Aon plc (NYSE:AON) is a leading global provider of risk management, insurance brokerage and reinsurance brokerage, and human resources solutions and outsourcing services. Through its more than 72,000 colleagues worldwide, Aon unites to empower results for clients in over 120 countries via innovative risk and people solutions. For further information on our capabilities and to learn how we empower results for clients, please visit: http://aon.mediaroom.com.
© Aon plc 2017. All rights reserved.The information contained herein and the statements expressed are of a general nature and are not intended to address the circumstances of any particular individual or entity. Although we endeavor to provide accurate and timely information and use sources we consider reliable, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act on such information without appropriate profes-sional advice after a thorough examination of the particular situation.
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