Whose Line is it Anyway? Surety

1. Whose Line is it Anyway?Surety Casualty Actuarial Society Seminar on Ratemaking The Tampa Marriott Waterside Tampa, Florida March 7-8, 2002 James Elicker, ACASZurich North America Surety

2. Surety Introduction What or who is a Surety? • one who has become legally liable for the debt, default, or failure in duty of another What is a Surety Bond? • a bond guaranteeing performance of a contract or obligation

3. Three-party agreement Surety Principal Obligee

4. Surety vs. Insurance • Risk transfer • Premium determination • Cancellation rights

5. Commercial Bonds Types • Court / Fiduciary • Public Official Bonds • License, Permit, and Miscellaneous

6. Contract Bonds Types • Bid • Performance • Payment • Maintenance

7. Contract Surety Example: PennDOT awards Bridgebuilders, Inc. a $25,000,000 contract to construct a new bridge across the Allegheny River. Surety Bonding Company bonds Bridgebuilders by issuing a $25,000,000 performance bond. Bond guarantees that the bridge will be built according to the contract specifications.

8. Why have contract bonds? • Required by law • Federal Miller Act of 1935 • State and local “Little Miller Acts” • Relieve owners from risk of financial loss • Ensure satisfaction of contract provisions • Provide owners a pool of qualified bidders

9. Surety Underwriting • Prequalification - takes the job owner out of the business of contractor evaluation • contractor’s financials • credit history • business operations • company history • past performance • other current projects • necessary experience/equipment

10. Surety: Unique Characteristics • Theoretically possible to underwrite to a zero loss ratio • Indemnity is generally available to the Surety • Importance of exposure per principal, not per bond • Bond forms are generally statutory

11. Surety: Pricing Considerations • Premium earning pattern • Many P&C information systems require earnings pro-rata between coverage effective and expiration dates. • Earn premium over period estimated at bond issuance. • Take down any unearned premium reserve remaining when the bonded obligation is met.

12. Surety: Pricing Considerations • Assignment of “accident” date • When does a contractor fail to meet an obligation? • Information systems often constrain accident dates to be within coverage effective dates. Therefore, there may be a “massing” of losses assigned to the last day of coverage. • Losses on multiple contracts for a single principal should carry the same accident date.

13. Surety: Pricing Considerations • Exposures are inflation sensitive or immune • Many contract bonds use “contract price” as the basis of rating. As inflation raises contract prices, exposures keep pace. • Many non-contract bonds have defined “penalty” amounts that are used for pricing. These penalties do not change as a function of the CPI but are typically mandated by statute or regulation.

14. Surety: Pricing Considerations • Payment patterns are long-tailed and often go “negative” • In contract cases, at times it is in the best interest of all parties for the surety to provide assistance to the principal. The surety may provide financing, for example. • Assuming the contractor gets back “on its feet”, indemnity agreements can come into play and the surety collects over a number of months or years until it becomes whole. • Litigation to recover funds from third parties (including job owners) also leads to money coming in to offset payments made earlier.

15. Surety: Pricing Considerations • Booking of “contract balances” • In contract, not all funds are dispersed from the job owners to the principals at the inception of the work. Often contracts call for several payments coincident with certain contract milestones. • These funds are generally available to the surety once the job has become a claim situation.

16. Surety: Pricing Considerations • Macroeconomic issues • The general economic cycle, through its impact on the business cycle, affects the frequency of contract surety claim situations. • Start of recession in spring of 2001 resulted in decreased construction volume. • Marginally operating firms may fail to meet obligations. • Subsequent poor results trigger industry consolidation.

17. Enron • Enron entered into pre-paid forward contracts to deliver natural gas and oil to Mahonia Ltd., an energy-trading business created by J.P. Morgan & Company. • Surety bonds were written to guarantee the deliveries. • Contracts were entered into at year-end. Earnings from the contracts would offset Enron’s other losses, in effect deferring losses to future period. • Through use of complex derivative transactions, deliveries of natural gas and oil were often sold right back to Enron.

18. Enron • Initially a tool for managing tax liabilities, over time, as the size of the transactions and prepayment periods grew, the contracts became a major source of financing for Enron • After Enron filed Chapter 11, J.P. Morgan sued 11 insurers who did not make payment on $1.1 billion worth of guarantees. • Insurers are denying the claim alleging that Mahonia was a fabrication meant to disguise loans in the forms of commodity trades. Therefore, there was never an intent to make delivery.

19. K-Mart • Enron losses and the economy in recession lead to shrinking surety bond capacity. • With a self-insured workers comp plan, K-Mart was required by regulators to post surety bonds guaranteeing payment of benefits. • K-Mart identifies high bond prices as a contributing factor leading to bankruptcy.