Research to Correct the Problems of the Regulators of Client’s Risk

 

Kenneth Sullivan, Ph.D, Dean Kashiwagi, Ph.D, P.E.,  Blake Carroll,  Matthew Lee,  and Marie Kashiwagi 

Performance Based Studies Research Group (PBSRG)

Arizona State University

Tempe, AZ

 

The bonding and insurance surety industry has had difficulty regulating risk in the construction industry.  They have had a constant increase in payouts and premiums due to increased construction contractor nonperformance in the price-based construction environment.  This paper reviews the mechanics of the construction contractor funding model, the construction surety model, and the construction industry structure.  The risk of the surety industry is attributed to volume and price based practices.  It identifies that the surety industry is caught in the same predicament as the contractors: They are trying to regulate.  The paper proposes changes in the surety model, and a research proposal to test the hypothesis that sureties will be successful if they minimize the risk of nonperformance. 

 

Key Words:  Construction Industry Sureties, Price Based Practices, Construction Risk, Construction Performance

 

 

 

Introduction

 

The construction industry represents 8% of the U.S. gross domestic product according to the U.S. Census Bureau.  The construction industry employs over 6 million workers in over 1.9 million construction companies, with revenue of $916 billion (Engineering Technology 2004).  With the most competition seen than ever before in recent years and increased expectations by project owners, the construction industry is one of the most risky fields of business there is today (SIO 2004).  With this risk, there comes the need for insurance and bonding companies to underwrite and guarantee the completion of construction projects.  Over the past thirty years the construction industry has moved from a performance-based sector to a price-based sector.  This move has had an enormous impact on the construction industry.  When the focus of the industry was on performance, contractors were more attentive to the quality of work and reputation.  A contractor’s reputation was more important and based on past performance.  If a contractor did not perform, the chances of future work was slim.  The construction industry clients are concerned primarily with three performance areas: having the project completed on-time, within the proposed budget with minimized change orders and meeting the quality expectations of the owner.  When the construction industry moved into the very competitive price-based environment, contractor motivation shifted from quality to price, making performance an inconsistent attribute when selecting a contractor in today’s price based marketplace.

 

Figure 1 shows that high performance contractors are asked to not use their expertise and bid a construction project with the lowest possible price.  Because risk is the reciprocal of performance, the client’s directive to the contractors is to bid the lowest possible price and maximize the potential risk.  If the contractor is being asked to maximize risk, the client is giving the competitive advantage to those contractors who are:

 

1.        More likely to pass the risk to the client.

2.        Lower performers who cannot predict risk of construction projects.

3.        Volume based.

4.        Have a lower quality of work.

 

 

 

Price Based Environment in the Construction Industry

 

The construction industry can be simply explained by the Construction Industry Structure (CIS) model (Figure 2) which explains the industry based on performance and competition.  The three major segments of the industry are the negotiated bid (high performance, limited competition), the best value award (high performance and competition), and the price based sector (high competition, minimal performance).  The risk is highest in the price-based sector (risk is the opposite of performance).  Surety companies maximize their profit when the construction industry is in the high performance environments. 

 

 

The construction industry is not in the performance environment.  Rather it is in the price-based sector based on the following measurements and observations:

 

1. Construction performance is very inconsistent.
2. The craftsperson skill and construction coordination/supervision level is decreasing.
3. Contractor profits are relatively low for a high-risk industry (1-5%).
4. Contractor turnover is high, and not limited to new contractors.
5. Surety payouts are high.
6. Insurance companies participating in construction surety are consolidating and having a more difficult time surviving.
7. Construction bonding and insurance rates are increasing.
8. Both contractors and sureties are taking a volume-based approach instead of risk adverse position.
9. The contractor and the client are in an adversarial or “win-lose” relationship.  The client is requesting the contractor for the minimal performance for the lowest price.  The contractor is following the client’s instruction and maximizing instead of minimizing the client’s risk.  The client tries to minimize that risk by managing and inspecting the contractor and using performance bonding. 

 

 

Volume Based Philosophy of the Price Based Environment

 

 

Figure 3, the Change Rate Chart and two way Kashiwagi Solution Models (KSM), shows that the difference between the low risk (high information party) Type A and the high risk (low information party) Type C.  The two way chart shows the relative difference of the two parties in relation to the amount of information that is being used.  For example in the first KSM, it shows that the Type A uses a maximum amount of information (longer line) before the event to minimize risk.  The Type C uses very little information (shorter line).  The Type A practices quality control.  The Type C practices very little quality control, and feels much more comfortable being managed and inspected.  The Type A does less work and maximizes profit.  The Type C maximizes the amount of work and minimizes their profit.  This is called commodity work, or price based work.  The risk is greater with the Type C work.  Figure 3 then defines the price-based work as:

 

1. Minimizing the use of performance information.
2. Minimizing quality control (that comes with expertise).
3. Maximizing management and inspection (which is required with inexperienced contractors).
4. Volume based work with lower profit margins.
5. Higher risk.   

 

Both the contractor investment/funding model and the surety model are both volume based (increased risk in a noncommodity industry).  There are two major participants in a construction contractor: the owner or investor, and the contractor personnel (construction managers and craftspeople).  Construction companies are usually created by the investor/owner’s investment funding.  The funding is used to purchase the required assets, personnel and services to start the construction company.  The contractor is then allowed to bid projects ten times the size of their financial worth.  In the vernacular of insurance companies, this is defined as risk.

 

The surety companies are in business to make a profit by underwriting contractors who can perform (finish on-time, on-budget, and meet the requirements of the client).  If the contractor cannot perform due to a lack of personnel who have the appropriate experience, financial stability, or have maximized their capability on other projects, it is in the best interest of the sureties to deny the contractor a performance bond.  In this manner, the sureties become the regulator of construction performance in the industry. 

 

When the contractor makes a 1% profit, the investors are actually making a 10% increase of their investment.  Therefore, the investors do not mind if the contractor makes a 1% profit of the project bid.  However, if a contractor does not make a profit, the investor’s loss is exponential.  It is therefore in the best interest of the investor for the contractor to do more work, minimizing the chances of not making a profit.  If the contractor is making only a 1% profit, the contractor’s personnel are put under extreme stress to ensure that the profit is maintained.  At a 1% profit, any mistakes in scheduling, bidding, unforeseen events, poor coordination, or construction errors can easily erase the profit.  To maintain the profit margin, the contractor will attempt to increase its volume and pass the risk to all other parties.  The high turnover rate of contractors, the poor performance record, and inability to increase the quality of work validates the concept that although investors are satisfied with a low profit margin, the low profit margin places the contractor personnel at extreme risk. 

 

It is the sureties’ function to regulate which contractors are not a risk (allowed to do ten times the amount of work as their assets).  It is common practice that the sellers of the performance bonds for the surety companies are independent sales personnel who are paid based on commission.  They are therefore volume oriented and not risk adverse.  They themselves have no risk.  After being paid their commission, they are no longer involved in the construction.  This coupled with the concept that the sureties do not make their profit on the underwriting but by investment of the fees in the stock market, also encouraged the sureties to be volume oriented.  These practices have brought risk to the sureties and insurance companies when the stock market significantly declined.  Also, as the volume oriented construction industry became riskier, payouts increased to almost 60% of premiums, putting sureties at risk and forcing indiscriminate higher insurance and bonding rates to the contractors.  The volume-based approach of both the contractors and sureties has done little to stem the nonperformance in the construction industry (Surety Bonds 2003).

 

As a result of the volume based approach, bonding and insurance companies are underwriting contractors based on project size rather than past performance and the ability of the contractor to minimize risk.  Underwriters still have brokers working to sell based on volume.  Brokers stand between companies that want to purchase insurance and the companies selling insurance, taking a commission for services rendered.  Not only are these brokers paid on commission, but they also occasionally receive kickbacks, which is paid only if the broker places a certain amount of business with a particular insurer.  (The Economist Newspaper 2004)

 

 

Bonding and Insurance Industry Losses

 

The problem on the contract side of the surety business started appearing in 2000 when there began to be a large number of failures by subcontractors that had taken on more work than they could handle.  This produced $600 million in losses for sureties, of which $400 million was pushed off to re-insurers.  After more than a dozen years of profitability, a recession began in the spring of 2001, which slowed down the construction industry and sent 255 public companies into bankruptcy, most of which were users of commercial surety bonds.  As contractor failures increased, sureties paid nearly $1.8 billion in claims in 2000 and 2001 according to The Surety Association of America (SAA).  Then the attacks on the World Trade Center hit insurers for roughly $40 billion (Krizan et al. 2002).

 

In reaction to severe losses, many sureties exited the business, some increased rates, and all took a more disciplined approach with underwriting and capacity. A few surety companies consolidated or left the market altogether. Sureties became more cautious about bonding large-scale, long-term contracts. It was no longer a buyer’s market. The more conservative surety companies continued to do business as always but with an eye on underwriting and claims (Surety Bonds 2003).  Today, the commercial and contract surety markets are having trouble with capacity restrictions due to reinsurance.  In the past seven years, insurance and bonding rates have increased.  In those seven years, the losses incurred jumped from 25.6% to 69.8%, a total increase of 52.1% (see Table 1).

 

 

 

More than 80,000 contractors failed during 1990-1997, leaving private and public construction projects with liabilities exceeding $21.8 billion (Construction Chart Book 2002).  Surety was a $3.2 billion industry in 2001 and there were nearly $2.2 billion in gross losses (State Of The Surety Market 2002).  With these dramatic increases in surety losses, the construction industry’s stability and sustainability is questionable if it remains in the price-based sector.  Underwriting standards declined consistently from 1992 to 2000 with new carriers fighting for market share and becoming more aggressive, resulting in poor loss ratios for the industry (State Of The Surety Market 2002).  Bonding and insurance companies looking for profitability and sustainability must re-evaluate their operations.   

 

 

Impact on Construction Industry Sustainability/Profitability

 

Some insurers have reviewed the losses on their construction book of business and have decided to stop underwriting construction risks.  Not only do other insurers not want to write new construction accounts, but they are issuing cancellation notices to contractors in the primary construction class codes, the majority of them being General Contractors and Artisan Contractors in trades such as excavation, concrete, carpentry, drywall, and roofing.  Some contractors are looking away from insurance companies as well.  Contractors as well as other companies are buying less coverage.  Policy limits for insurance in all industries declined 9.4% in 2003 and 14.5% over the past three years, according to a survey by broker Marsh and McLennan Cos., New York City.  Construction insurance costs are near the top for all industries.  For $1 million of coverage it costs on average $20,620 (SIO 2004).  Many contractors’ premiums have climbed substantially, more than doubling in some cases.  Even though contractors are paying more than double for their policies, their umbrella coverage in most cases is half what it used to be.  This is forcing many smaller construction company owners to downsize by cutting managers pay and making unwanted layoffs.

 

Ten years ago the top ten sureties had 20% of the business and today they have 40% (Krizan et al. 2002) As the loss ratios have increased bonding and insurance companies have had to merge or leave the surety business completely.  Bonding and insurance agencies have had to limit the coverage with numerous exclusions with hopes to spread the risk (SIO 2004).  Contractors now must find numerous insurance policies to cover a project, which in the past was covered by a single insurance company.  Therefore, construction companies are paying higher premiums for many insurance policies with less overall coverage. 

 

Contractors on mega projects ($200 million and up) will experience the greatest change in their bond programs (Surety Bonds 2003).  Not only are the large projects affected, small contractors who perform well and produce quality products will also be affected. 

 

 

Hypothesis

 

The authors are proposing that sureties cannot increase their profitability in the price- based sector.  The structure of the environment is increased risk, a higher cost of overhead in an attempt to manage and inspect the risk.  This includes increased bonding and insurance costs.  Sureties are not profitable in underwriting contractors with high risk.  The paper proposes that sureties can be more profitable in the best value, high performance environments. 

 

 

Methodology

 

The methodology would be to identify contractors who either take the approach of a high performance contractor who minimizes their workload or is working for a best value client who is providing an efficient, “win-win” environment for the contractor.  The methodology would include minimizing any high risk or volume based practice previously used.  This includes giving lower rates on volume-based work or using independent brokers paid on commission. 

 

 

Proposed Research

 

One of the co-authors is being asked to present to the National Sureties Meeting for the second year in a row.  The first presentation explaining the risk of the price based construction sector surprised the majority of attendees (independent sales personnel, sureties, insurance company personnel).  Their reaction confirmed that sureties/independent sales personnel don’t understand the mechanics or risk of the construction delivery process.  The objective of this year’s presentation is to propose a research project with a surety/insurance company.  The research effort will be to design the mechanism for the following:

 

1. Identify high performance/low risk contractors who can be regulated with performance information.
2. Identify contractors who are high performing and working for best value clients who have use a risk minimization delivery process.
3. Identify how the sureties can minimize their risk on an ongoing basis by motivating the contractors to continuously improve.
4. Identify the mechanism that will replace the independent broker who works on commission.

 

The proposed research methodology includes:

 

1. Identification of a high performing contractor or best value based client.  Identification will include a collection and analysis of past performance information, ability to effectively assess risks on contracts, and project performance in ongoing operations.  The same would hold true for the selection of best value based clients – the best value system used by the selected clients would have to show consistent results of procurement through high performing contractors.  Delivered work would have to be consistently on-time, on-budget, no GC generated cost change orders, and high customer satisfaction. 
2. Surety Results from Best Value Pool – once the high performing contractors and best value clients have been identified the research would move to tracking the results of the sureties profit from these research pools.  The research pool would consist of profit based contractors that do not operate under volume-based returns.  If the profit results from the high performing research pools showed gains over normal operations the research would move into the phase of implementing change.
3. Adjustment and Testing of Surety Practices – once a statistically significant difference in surety performance has been established between the research pool and normal operations adjustments and testing of those adjustments to normal operation would commence.  Adjustment could include, though are still in development, considerations for volume based work, broker payment, tracking of performance information, etc.  The developed mechanism will assist or replace the broker-on-commission practice.
4. Final Analysis of Surety Adjustments – after a decided duration (2-3 years) the results will be analyzed to determine if the surety improved and to ensure that the improvement was caused primarily by the adjustments made and not outside market factors.

 

 

Conclusion

 

The regulatory function of the surety/insurance groups is dysfunctional.  The observations and measurements of the surety company and construction industry show high risk and low performance.  The authors are proposing that increasing rates in the price-based sector will not stabilize construction industry performance.  The price based delivery process that uses minimum standards, management, control, and inspection by client’s representatives, which sets an adversarial relationship and maximizes the opportunity for less experienced contractors, puts the sureties at risk.  It is proposed that the sureties move their business to the best value environment and use the practice of performance information and risk minimization to maximize their profit.  This proposal will be further discussed with potential surety research partners. 

 

 

References

 

Ames, W. (2002) Secrets of a Surety.  The Associated General Contractors (AGC) of America.

 

Bonding and Insurance Trouble.  (2004, February 26) Engineering News Record (ENR). URL http://enr.construction.com/opinions/editorials/archives/040126.asp

 

Construction Chart Book. (2002) The Construction Chart Book (3^rd ed). The U.S. Construction Industry and Its Workers.

 

Engineering Technology Curricula & Courses (2004, September 1) Construction Management. Western Carolina University: Engineering Technology.  Accessed on October 1, 2004, at http://et.wcu.edu/ET-CC_CM-gen-info.htm.

 

Grenier, D.  (2001) Construction Insurance in 2001 and Beyond: A Wake-Up Call! C-Risk Inc. Consultants in Risk Management. URL www.c-risk.com/Articles/dlg_ins_wake-up_01.htm

 

Kashiwagi, D. (2002) Best Value Procurement (2^nd ed).  Performance-Based Studies Research Group

 

Korman, R. (2004, January 26) Rising Prices, Shrinking Policies Generate Waves of Uncertainty.  Engineering News Record (ENR), 252 (4), 22-27.

 

Korman, R. and Illia T. (2003, August 4) Insurance: Policies for Defects Axing Key Elements.  Engineering News Record (ENR), 251 (5), 12-13.

 

Krizan W., Korman R., Tulacz G., and Ichniowski T. (2002, February 11) Bonding Businesses Going For Broke? Engineering News Record (ENR). URL http://enr.construction.com

 

Schubert L.  (2001, July) Surety Industry Addresses Increases in Surety Losses. URL http://www.irmi.com/Expert/Articles/2001/Schubert07.aspx

 

SIO (2004, November 15)  Surety Bonds At Work. Surety Information Office (SIO).  URL www.sio.org/html/sbw

 

SIO (2003)  “Why Do Contractors Fail? Surety Bonds Provide Prevention & Protection.” SIO Surety Information Office.

 

Surety Bonding: The Importance of Surety Bonds in Construction.  (2003, October 15) MORGAN Insurance. URL http://www.sio.org/html/importance.html

 

The Economist Newspaper. (2004, October 21) Just How Rotten?. URL http://www.economist.com

 

State Of The Surety Market (2002, December) Accessed on October 31, 2004, from http://www.cybersure.com/documents/surety/surety%20market%20-%202002.pdf.

 

Surety Bonds 2003 (2003) Accessed on October 31, 2004, from http://enr.construction.com/resources/special/archives/surety_2003.asp