Inflation and uncertainty. How does this impact the global surety bond market?

Authored by Sarah Haylock, Senior Underwriter - Financial Risks Reinsurance - Political Risks, Credit and Surety, Liberty Mutual Reinsurance

As the impact of rising inflation becomes more apparent, those of us working in the surety market are closely monitoring the effect of inflation on costs, labour, capacity, supply chains and ultimately, potential losses.  As we did during the pandemic, all stakeholders should consider how best to support their clients and help them to navigate successfully through this uncertain period.

Rising input costs

While inflation affects prices across many sectors, the construction sector in particular has been acutely impacted by global inflationary pressures. When contractors have included material cost estimates in their project bids, they may not quite reasonably have considered that inflation would rise so much or so rapidly.  A direct impact on their profit margins looks likely to affect surety writers on two fronts: probability of default and loss given default basis.  As I write this, inflation in the US has jumped to 9.1 per cent a record 40-year high.

Price escalation clauses, which enables them and owners to negotiate coverage for future price impacts  can offer contractors protection from global market volatility.  However, not all contracts include such provisions, particularly those which are relatively small or unsophisticated.  This means SMEs are likely to feel the biggest impact from post-bid material cost escalations.

As the price of materials and labour costs increases, so does project size.  This puts additional pressure on direct writers in the US, where 100% bond penalty limits mean their capacity requirements correlate precisely with overall project costs.  This pressure is less severe elsewhere, depending on the country or jurisdiction, and overall market capacity is sufficient.  However, that could change if the market’s loss ratio were to rise significantly.

The pricing cycle

Surety cycles typically last 10-12 years.  This long-observed trend is linked to periods of economic instability, such as recessions, when tightened liquidity drives up insolvency rates.  However, despite losses during the 2000s, the surety market has experienced neither a subsequent, significant change in available capacity, nor a hardening of rates.  Many were waiting for the pandemic to push us into a more cautious landscape, but the surety market once again proved resilient, particularly because governments globally considered construction to be essential, and prevented widespread defaults.

During periods of uncertainty, still the fundamentals of surety underwriting become more pronounced when assessing the viability of a contractor, often referred to as the five C’s – capital, capacity, character, communication and cash management. These pillars help determine the contractor’s ability to deliver on their obligations, and to identify which surety products are most suited to the risks they present.

Many of these principles also correlate directly to Treaty Underwriters. Our team is therefore working closely across the global market in order to understand the effects on their portfolios.  Our focus is, and will remain, on sureties having proactive portfolio management and robust claims controls for loss mitigation.  Meanwhile we are leading discussions about market-wide approaches that will help to ensure clients and their customers are able to navigate successfully through the current, inflation-fuelled period of uncertainty.