The Snowball Effect: What’s Driving Contractor Loss Severity?

Understanding Financial Distress in Construction

Widespread financial distress is becoming a critical issue for contractors, contributing to a significant rise in loss severity across the surety industry. The result? An increasing loss ratio for surety providers, a trend that has been steadily growing over the past year.

This escalation is driven by economic challenges that have persisted over the last several years. Even though some factors—like inflationary pressures and supply chain disruptions—have started to subside, the underlying financial health of contractors remains under stress. While job completion prices may have normalized relative to contract balances, these positive developments have not been enough to offset other financial difficulties plaguing the industry.

The Snowball Effect

Many surety bond claims may seem minor at first—like a small payment bond claim due to past-due payables. However, as surety providers dig deeper during their claims investigations, they often discover far more significant financial problems.

Much like a snowball rolling downhill, what starts as a minor issue can quickly grow into a severe financial crisis. For contractors, this means what may initially appear to be a small payment bond claim can rapidly evolve into a much larger performance bond loss, as financial strains make it impossible for the contractor to fund operations or pay subcontractors and suppliers.

The Cash Flow Crunch

Contractors across the board—regardless of type or geographic location—are facing serious cash flow problems. These cash issues are widespread and are a common denominator in many surety claims.

In several cases, contractors have approached surety providers for financial assistance to maintain performance on bonded projects. This assistance typically comes in two forms:

• Direct financing: Contractors request sureties to pay for payroll and operational costs.
• Indirect financing: Contractors ask sureties to resolve payment bond claims or pay their outstanding bills.

While surety providers employ all available methods to mitigate losses, they remain hesitant to provide direct financing. Indirect financing, however, is far more common. Complicating matters further, many contractors are maxing out their borrowing capacity with traditional lenders. Some have even turned to factoring receivables as a means of securing working capital. This complicates the resolution process when claims and losses arise. Additionally, sureties are increasingly relying on tools like joint check arrangements and funds administration to manage contractors’ cash flow challenges.

Good News and Bad News

There’s both good news and bad news for the surety industry:

• Good News: Many key performance indicators (KPIs) in the industry are showing positive trends. New business growth is expected to continue, particularly with the rising demand for surety bonds linked to public infrastructure projects. Over the last year, construction surety premiums have consistently increased, and claims frequency has remained relatively low.

• Bad News: Despite fewer claims, it’s the severity of the losses that are driving the negative trend. Contractors are facing more severe financial hardships, which is escalating the magnitude of losses when claims do occur.

Key Takeaway: Stay Mindful of Industry Trends

For contractors, the lesson is clear: Stay mindful of these industry trends when assessing your own financial health, as well as that of your subcontractors and suppliers.

Partnering with a proactive surety provider that applies common sense underwriting can make all the difference. A surety that works closely with contractors to prevent claims—or to minimize the severity of claims when they arise—will provide long-term value to the relationship.

Conclusion: By staying informed and choosing the right surety partner, contractors can better manage these challenges and mitigate the risk of severe losses.

How do I get a Surety Bond?

Surety bonds are issued by Merchants Bonding Company (Mutual) through insurance agents. Contact your local insurance agent or use our Find an Agent tool. They will guide you through the process, informing you of what documents and information are needed by the surety (Merchants Bonding Company (Mutual)) to underwrite your bond.

What is a Surety Bond?

A surety bond is a three-party agreement that ensures the fulfillment of a commitment or contract. For instance, the surety (Merchants Bonding Company (Mutual)) may provide a surety bond to a construction company (the principal) which is required by the state (the obligee), ensuring the construction company will perform the duties as outlined in the contract. In bonding the construction company, Merchants assumes the risk should the company default or not fulfill their contract. A surety bond is different from traditional insurance in that the principal is obligated to pay back the surety company on any claims paid out.

All information provided is subject to change.