Surety Market Update - Aon

1 1 Surety Market Update Strength & Turbulence Autumn 2010 Surety results over the past eighteen months have been strong and competitive, with additional capital available for commercial Surety clients. The construction sector has yet to show the anticipated increased loss activity, but extraordinary weakness in project backlogs and limited capital expenditures increases uncertainty Market Overview The Surety industry posted mixed results in 2009; while total revenues declined, the overall loss ratio remained relatively low. According to the Surety & Fidelity Association of America, total Surety written premium decreased by last year to $ billion. Year Premium Change % Loss Ratio 2009 $ billion < > 2008 $ billion 2007 $ billion The industry s direct loss ratio was , with total incurred losses slightly exceeding $1 billion.

2 This ratio is generally considered positive, as Surety loss ratios under 30% 40% typically indicate underwriting profitability. Total losses increased by 51% from 2008, although this figure is skewed by two large commercial Surety losses exceeding $100 million, both with one Market . These losses are fully recoverable through insurance, which will positively impact the company s and the industry s loss results in future years as the recovery amounts are collected. Of the $ billion in Surety premiums, $ billion (75%) is attributable to contract bonds, with commercial Surety bonds comprising the remaining $ billion (25%). Losses on commercial Surety bonds accounted for 52% of all losses, impacted disproportionately by the losses mentioned previously. Surety History Premium / Loss Results01234561987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Dollars in RatioDirect Written PremiumDirect LossesLoss Ratio In the first half of 2010, written premiums increased from the first half of 2009.

3 The overall loss ratio was reported at , continuing the Surety industry s string of sub-30% quarterly loss ratios, now at eighteen consecutive quarters. Loss cycles of the Surety industry, however, have traditionally lagged the overall economic cycles by six to eighteen months. It is widely expected that the results will begin to deteriorate in the second half of 2010 through 2011. The higher-margin backlogs acquired prior to the recession are now being worked off and are widely being replaced with lower-margin work, or in some cases are not being replaced. With the ongoing lack of funding availability causing postponements or cancellations of numerous projects - both in the public and private sectors - competition for the remaining work has intensified. The resulting margin squeeze has and will continue to hurt smaller and less liquid contractors. Many of these companies will find it difficult to survive on work acquired at lower margins.

4 2 Larger and more liquid contractors, on the other hand, will survive in this environment until the construction economy begins to recover, likely in 2011 to early 2012. The weeding out effect will ultimately benefit well capitalized contractors, as competition in the future will be reduced, but will negatively impact overall Surety industry results in 2010 and 2011. Surety Underwriting and Capacity Anticipating that loss frequency will increase in the late part of 2010 through 2011, many sureties are reducing available single bond and aggregate program capacities for certain accounts. They have also tightened their underwriting guidelines, particularly for their financially weaker and lower credit-quality accounts. Aside from more stringent financial underwriting, sureties are more closely reviewing contract terms and conditions than in the past. Difficult provisions that, in better economic times, may have been overlooked are now being discussed or are subject to change.

5 Focal areas include: Liquidated and actual / consequential damages Efficiency / performance guarantees Payment terms Project financing arrangements Long-term warranties Requests for reductions to or release of retainage Bid results / bid spreads Bond form language Contract Surety Capacity should continue to be readily available for well-capitalized and qualified contractors and corporations. With more Surety capacity chasing fewer premium dollars, stronger contractors are benefitting. Surety company growth goals and budgets have been set conservatively, with mostly modest to no growth expectations. Nevertheless, sureties will, at a minimum, be expected to replace last year s revenues. Additionally, the newer sureties that emerged during the past few years are aggressively pursuing new business, as they lack legacy loss issues and are motivated to grow their smaller books of business. They, too, are focusing primarily on the stronger, more liquid companies, intensifying competition within the industry for this business.

6 Insurance industry consolidation is another factor that has traditionally impacted Surety capacity, typically for the negative. While the past two decades have been characterized by significant consolidation, no large acquisitions or mergers were announced or completed in the industry in 2009 or to-date in 2010. In fact, the percentage of premium written by the top ten writers of Surety decreased last year to , down from in 2008. In the past twelve years, this percentage has increased in eight years, remained the same in one year and decreased in only three years. Percentage of premium written by the top ten Sureties The lack of insurance company acquisition activity mirrors that of the overall financial marketplace in the first half of 2010. This lag is likely to reverse course once the economy is on more solid ground and more attractive financing becomes available. The recent uptick in overall M&A activity could indicate renewed consolidation in the insurance industry in 2011.

7 3 A continuing trend in the construction industry is the move toward larger projects and the combining of smaller projects to create fewer and larger projects. This approach tends to provide cost savings to the owner but can limit the pool of capable contractors and the availability of bonding support. Obtaining bonds with favorable terms for these large and very large, or jumbo, construction projects presents unique challenges best suited to an experienced broker with the skills to structure and negotiate these types of placements. This expertise is particularly important when a single Surety cannot provide the needed capacity for the bond on its own, necessitating a co- Surety arrangement. Co- Surety bond programs include two or more sureties participating on a company s Surety program and on individual bonds, written on a joint and several basis. This structure obligates each Surety to the full bond amount, should one or more of the other sureties participating on the bond become insolvent.

8 Due to this counter-party exposure, Surety companies are very selective with which other sureties they will participate on co- Surety bonds. Currently, only a handful of sureties will do so, limiting the availability of capacity industry-wide for the bonding of very large projects. Many of the larger Surety programs for contractors and other businesses are now structured as shared- Surety relationships that include two or more sureties, wherein each Surety writes individual bonds within the program. This type of structure is often used for Surety programs that require large aggregate capacities but with bonds that can be written by the individual sureties, without co- Surety support. In such programs, the counter-party exposure of the other Surety is not an issue. Commercial Surety Today s commercial Surety underwriting terms positively reflect the impact of the additional capacity that has entered the marketplace in the last several years. While many companies are posting smaller profit margins and facing more expensive credit costs as their bank credit facilities are renewed, Surety companies have generally been hesitant to impose more restrictive terms on them, particularly on their stronger accounts.

9 In fact, many companies have been successful in having bank letters of credit replaced with Surety bonds, thereby reducing borrowings and taking advantage of more favorable Surety pricing. The Surety industries flexibility with their commercial Surety terms is in part due to the development and requirement of indemnity agreements more favorable to their own interests, leaving them in a more protected position than in the past. Most current commercial indemnity agreements now contain Place-in-Funds language, which allows for the Surety to demand collateral from the Indemnitor if the Indemnitor is unable to remove or replace the Surety s liability within a specified number of days. In the past, sureties frequently did not have a defined right to collateral and were often left in an inferior position to other creditors. Sureties also have become more proactive with their indemnity rights, attempting to stay ahead of other creditors by reacting aggressively to early signs of financial problems.

10 In many situations, sureties are making collateral calls at the first signs of financial distress, ensuring that the collateral will be available to them before it is used for other purposes, used by other creditors, or withdrawn by the banks. As in the contract Surety marketplace, commercial Surety clients with ample liquidity, positive operating results and strong credit are able to obtain the bonding support they require with favorable terms and pricing. Many of the larger accounts are currently utilizing multiple sureties to meet their bonding requirements under shared- Surety program structures. Conversely, those companies with more stressed metrics and weaker results are subject to more difficult Surety terms and reduced capacities, both for single bonds and aggregate programs. Lastly, certain classes of bonds are being restricted or eliminated by individual sureties based upon their poor loss experiences with these specific bond types.