INDUSTRY NEWS

• Near record low surety loss ratio in 2010 is misleading in certain respects due to several unusual factors. Mid and small market sureties have much higher loss ratios.

• Backlogs and utilization are declining significantly.

• A variety of non-surety insurance issues and factors at the corporate level are exerting pressure on surety underwriters.

• The outlook for growth in non-residential construction is exceedingly negative, perhaps all the way to 2014.

• Mismanaging overhead and straying away from core competencies are two of the biggest red flags for contractors.

• While corporate America has accumulated $2 trillion of cash, it is reluctant to spend that reserve.

Two separate, well respected sources recently shared with Pinnacle Surety their research, data, and projections about the current state and direction of the surety industry for the next several years.

Tim Sznewajs, Managing Director of FMI Corporation�s Investment Banking practice, tsznewajs@fminet.com published the company�s 15 page �FMI Special Report: 2011 Surety Providers Survey.� A second senior level surety executive at another public company also gave a luncheon presentation on the �State of the Surety Industry� recently at an industry function attended by Pinnacle representatives.

We share some of the highlights of these independently produced reports in an effort to provide our clients with insight and tools to navigate the treacherous economic environment we are experiencing.

FMI Corporation, www.fminet.com/news is a leading provider of Management Consulting and Investment Banking services to the construction industry. In conducting their survey, they received over 50 responses from surety providers, including responses from virtually every one of the top ten providers. These top ten exercise significant market power with contractors.

While the 2010 direct loss ratio was significantly improved from 2009 and stood near record lows, the raw percentage may be somewhat misleading due to other factors. A large percentage of the surety market is controlled by the top ten underwriters, whose strong underwriting standards may not be replicated by mid and small market underwriters. According to the public company executive�s presentation, there is usually an 18 � 24 month lag in claim activities which affects when losses are actually realized. The low direct loss ratio was impacted by the fact that both Liberty Mutual and Travelers showed negative loss ratios, which artificially improved the overall direct loss percentage. These negative loss ratios resulted from reversing previously booked accounting reserves that had been set aside as far back as 2001. It was estimated that without these negative loss ratios, the overall direct loss ratio would have been 21.2%.

Also troubling is the fact that backlogs as well as utilization have declined significantly. For small and middle market surety writers, ranked by volume from 11 to 35, the loss ratio was really 30%, and 6 of those underwriters had losses over 40%. The first six months of 2011, which normally would have been the best quarters of the year, were in fact the worst since 2001.

A separate trend was noted by both sources. Surety underwriting is but one aspect of the larger insurance industry. There has been significant pressure at the corporate level of large insurance companies on the surety segment due to a confluence of other external factors such as low investment returns, extreme weather, and natural disasters (floods, droughts, hurricanes, fires). The consequence of that corporate pressure has been a push for more written surety premiums, sometimes with additional collateral required from the contractor, or funds control in order to mitigate surety risk.

The outlook for growth in non-residential construction, as measured by the FMI survey, was exceedingly negative. Over 80% of the sureties surveyed don�t anticipate growth before the start of 2013, and more than � don�t expect any growth before the second half of 2013.

Of the major problems contractors have faced, the two mentioned most frequently were failure to manage overhead and straying from core competencies. The respondents predicted that contractors would have more difficulty in obtaining bonding next year and even harsher conditions within two years.

A major drag on non-residential construction has been the generally negative climate of fear and uncertainty existing in corporate America. While U.S. companies have accumulated $2 trillion in cash, which is equal to nearly 4 years of non-residential construction at current rates, they have not been spending that horde.

One additional dark cloud on the industry is the aging of construction company owners and the relative lack of effective succession planning.

Clearly, contractors continue to face difficult times. Prudent decision making and effective management are critical in this environment.

We at Pinnacle Surety feel that these tough times make it more important than ever to have a real bond specialist working for you. We are not only surviving but thriving in this difficult market because of our commitment to the surety business and our determination to find creative ways to provide bonds for our clients in a variety of situations and market conditions.

Indian tribes in several states have developed many casinos and other resort facilities over the last few decades. Construction companies, investors, and other financing entities involved with these large projects often need surety bonds. But both the recent economic downturn and the unique legal status of �sovereign� tribes present real dangers if your surety agent is not completely knowledgeable with the myriad of legal ramifications bonding with tribal entities require. Ignoring or not fully understanding these subtle risks have too often been disastrous for the uninformed.

Mark Richardson, a principal of Pinnacle Surety, recently attended an intensive seminar conducted by NASBP, the National Association of Surety Bond Producers. The speaker was attorney Edward Rubacha of Jennings, Haug & Cunningham LLP http://www.jhc-law.com/. Mr. Rubacha�s areas of practice are in construction law & litigation, surety, Indian law, and commercial litigation. As such, he is especially qualified to explain the nuances of dealing with tribal entities.

DISCLAIMER: Neither Mark Richardson nor Pinnacle Surety are attorneys at law and as such offer this information only as generic guidelines. Readers should engage and consult their own legal representation for any and all matters relating to the content presented herein. Pinnacle Surety and its employees shall be held harmless from any action taken by readers of this document.

Mark�s attendance at this conference provided him with valuable insight that can assist clients in preventing costly mistakes when dealing with tribal entities. Here are just a few of the salient points to consider.

• Tribes enjoy sovereign immunity from law suits in both state and Federal court and absent tribal law to the contrary, cannot even be sued in their own tribal courts.

• There are a variety of business entities that might be set up under the auspices of a tribe each with its own legal consequences. Knowing the exact nature of the entity you are contracting with is critical in protecting yourself.

• It is often difficult to determine who in fact has the authority within a tribe or tribal entity to sign a contract involving a tribal entity.

• The procedures to �waive sovereign immunity� are complicated and must be painstakingly precise to effect a valid waiver.

• Disputes involving reservation land generally cannot be heard in state courts. Contracting on tribal lands or with tribal entities can subject the party to tribal court jurisdiction. Tribal law might be written or oral and can be based on a variety of historical, religious and cultural values.

• Presenting a package to a surety should carefully address what exact entity is involved, how that entity is related to the tribe, the details and decision about a possible waiver, how and where disputes will be resolved, what law will be applied, and how funding will be handled. If an express waiver of sovereign immunity is sought, it must be unequivocal and ideally waive recourse to tribal courts in favor of state court jurisdiction and applicable law. However, there are alternative mechanisms should no such waiver be obtainable.

Summary: Tribes and tribal entities continue to be involved in numerous and widespread projects across the U.S. Yet the risks and complications of such projects are significant. If surety bonding is necessary, it makes sense to deal with a firm that has studied and researched the key factors that are involved. Pinnacle Surety is licensed in 18 states and has the necessary expertise and network of professionals to help protect your interests. Contact Mark Richardson for more information.

This past month the principals of Pinnacle Surety had the opportunity to attend a presentation from Hugh L. Rice, Chairman of FMI Corporation, the nation�s largest specialized management services firm serving the construction industry. For almost 90 minutes, Rice provided charts, graphs, analysis, and projections on both where markets are and what the future might hold. Much of what he said came from an 18 page FMI 2nd Quarter 2011 Construction Outlook Report that can be downloaded from the FMI website, www.fminet.com/news.

For our clients, however, we offer the following bullet points presented by Mr. Rice. While they are obviously condensed and simplified, they nonetheless provide valuable insights as to the future of construction in the U. S. Here are some of the highlights we think deserve your attention:

Macro Trends

The economy is recovering, but very slowly.

The stock market may be bullish, but Main Street is still struggling.

In 2011, total construction should increase about 2% after a 9% decline in 2010.

Most construction growth will occur in infrastructure related projects such as sewage & waste disposal, power generation & energy, and environmental related conservation projects.

Construction spending growth is more cyclical than nominal GDP growth and will continue to capture a lower percentage of total GDP than it did in the 2000 � 2010 decade for at least five more years.

Segment Trends

Multifamily construction will grow more rapidly than condo or single family residential construction.

Healthcare related construction should rebound strongly by 2012.

Office and lodging construction will recover slowly except for renovation and retrofitting projects.

Power related construction, wind & solar energy, water supply, sewage & waste disposal projects will all see steady consistent growth.

Manufacturing construction recovery will be slow.

State and local budget constraints will hamper education, public safety, and street construction.

Population and Employment Trends

Construction employment is still very weak and little if any improvement appears imminent in either employment or unemployment.

Construction industry faces a looming worker shortage as well as an aging workforce. The average age of construction workers is almost 50 years old.

Hispanics make up about 44% of all construction industry workers.

Women on average have higher educational achievements than men, make up � of the workforce, but account for only 6% of construction related employment.

Unlike the U. S., western Europe working age population will decline over the next 40 years.

China annually produces five times more engineers than the U. S.

Florida, California, and Texas will account for almost � total U. S. population growth over the next 20 years.

The over 65 aged population in the U. S. will grow by almost 80% over the next 20 years.

Survival Tips

Adjust your strategies to reflect the changing conditions of customers & markets, competitors, overall business & governmental climate, and your own company�s profile.

Be in the right markets.

Execute consistently. Do the �right things, right.�

Carefully monitor your pricing and risk management. Accurately assess your costs to bid appropriately, and know the financial strength of the owners you work for.

Preserve your capital.

Pinnacle Surety is dedicated to �going the extra mile for you.� We look forward to helping our clients thrive in the midst of our challenging and volatile economic environment.

Vertex is a large multinational company that performs a wide variety of services including construction, environmental, and air quality. The company has 14 locations spread out over 12 states, and another 46 offices worldwide covering Canada, Latin America, Europe, and Asia. Every year they publish a detailed, comprehensive report on the State of the Construction and Surety Industry. A link to the 32 page, 2010 report completed in October 2010 is attached below. http://www.vertexeng.com

Here are a few highlights of the most recent report, that we find quite valuable and relevant for our industry. Our additional comments are added in parenthesis and italics where appropriate

Overall US Economy

- This is deepest recession since World War II.
- It officially ended in June 2009, but recovery is very slow and a double dip recession is possible. (Recent turmoil in the Middle East and resulting gasoline price spikes have increased that chance.) - Corporate Profit growth has been largely a result of reduced overhead rather than revenue growth.
- Far West GDP growth still lags below national average.

Construction Industry

- Overall condition of the industry is not good. Slow growth at best is all that can be expected for at least the next two years.
- Construction unemployment rates continue to be well above the overall U.S. Rate.
- General Contractor Finances: Big increase in Accounts Payable and Liabilities compared with Net Worth.
- Heavy Contractor Finances: Revenue and Profit figures better than General Contractors, but Balance Sheets are still very weak due to extensive Capital Equipment needs.
- Specialty Contractor Finances: Somewhat better than both General Contractors and Heavy Contractors.
- Overall, the level of contractor failures has dramatically increased during this recession.
- Market Sector Construction Analysis: Lodging, Office, and Commercial sectors are extremely bad. Tenant Improvement sector is improving somewhat due to in place remodeling by tenants. Highways and Street sector has held up fairly well. (Severe State and Federal budgetary problems will likely hurt this sector in 2011 and beyond.) Residential sector improving from its steep decline.

Surety Industry

- Surety premiums trend with the level of public construction spending.
- Surety losses trend with the overall U.S. economy with about a 2 year lag.
- Surety losses are likely to peak in 2012-2013 and could go as high as 50%.
- The weak economy leads to more aggressive bidding, thereby lowering profit margins, which along with tighter credit standards can cause higher Surety losses.
- Contractors should restructure and refinance debt early and aggressively in the economic cycle to protect their balance sheets.
- Contractor overhead is difficult to cut, but must be done nonetheless in difficult times.
- Surety merger and acquisition activity will likely increase in the short term

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