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.”

Senate Bill 392 requires any contractors who want to start a LLC to obtain a $100,000 surety bond in addition to the $12,500 contractor bond that’s already required. The new bond is for the benefit of any employee affected by an LLC’s failure to pay wages or fringe benefits.

In the past, contractors starting LLC’s were not able to get a contractor license in the state of California. Now the only way to do so is to obtain the $100,000 bond on top of the $12,500 contractor license bond that is already required of California contractors. If all goes as planned, the CSLB (Contractors State License Board) should be accepting applications from LLC applicants by the January 2012 deadline.

Any contractors aspiring to start an LLC will not be taking this new $100,000 bond requirement lightly simply because it will be costly. Surety bond pricing is based off a percentage of the bond amount (roughly 2-20%) which is calculated by the contractor’s credit history and financial strength. Even if a contractor is financially sound and qualifies for a low rate e.g. 2%, they will still have to pay $2,000 for the bond!

Although it’s unclear why California contractors have been unable to open an LLC in the past, they will be able to in the near future; but it could very well end up being costly which may drive contractors from even considering the option of an LLC at all.