In South Attleboro, MA, police and federal agents allege they found a half-million dollars worth of heroin inside of a used car dealer’s place of business during a raid early last year. The auto dealer has disregarded city ordinances in the past and now because of the drug charges, is unable to renew its $25,000 surety bond which they need for their license.

Surety bonds help limit the amount of shady businesses because most of them are not willing to pay the license or bond fee in order to operate legally. In this case, the auto dealer did have a bond in the past, but now the city council is stepping in and won’t let them obtain a license because of the recent charges. The surety bond guarantees that the company with the bond will follow the rules and regulations that are set by the state; if a company does not honor the regulations set by the state and causes damages, a claim will go out on the bond which will be paid by the surety company who issued the bond. The surety company will then go to the individual(s) who obtained the bond for reimbursement.

According to the police, this company was not following state or federal law. The surety bond that the auto dealer had in place guaranteed that they would follow state law. In the state of Massachusetts, an auto dealer needs a surety bond to acquire a legal license, and the individuals here who seem to have a history of now following the rules will have a hard time of doing so.

The surety industry is still thriving in spite of a decrease in federal construction projects that require bonding. Though all seems well with the industry, more losses are expected in the next couple years.

“Government spending is down fairly significantly this year,” said Roland Richter, marketing VP for Liberty Mutual Insurance Group. He added, “If they’re not building, the contractors aren’t working and fewer bonds are being written.”

Being that the majority of the surety industry’s revenue is from government construction contracts, when federal construction jobs diminish so does the surety industry. As of now underwriter loss ratios have been promising according to the Surety and Fidelity Association of America (SFAA) stating that as of June 30, 2011, the loss ratio remained at 11.8%; this is down from 13.2% in 2010 (for the top 100 surety writers).

One should keep in mind that there is usually a lag before negative effects of a recession are experienced. Tax revenues running to state and local governments have about a 12 month period before they feel the negative impact on their revenue. Generally the surety industry has moved through a constant, predictable cycle which is a helpful.

“The way we look at it, the surety industry is a cyclical business,” said Drew Brach, Marsh USA Inc.’s U.S. surety practice. He said the cycle historically goes through four stages: crisis, recovery, boom and worsening.

“Right now, we are in the worsening stage, which typically leads to an increase in construction defaults,” he said. “While we haven’t seen significant increases in defaults yet, we’re seeing some early warning signs. There’s a tremendous amount of stress on financial statements, less work, and many contractors haven’t reduced their overhead enough to compensate for the changes.”

“When that happens, they have losses and they have cash flow issues,” said Mr. Brach. He said the surety industry is bracing for losses in 2012 and 2013.

If one had to guess, the predicted loss ratio for the surety industry will be around an even 16% for the 2012 year but only time will tell.

With loss ratio’s low and profits high, things look good for the surety world. Those who have been around for a while are familiar with the cyclical pattern and expect to feel the negatives in the coming years. The famous quote describes the surety industry pretty well, “the night is darkest just before the dawn.”