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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 ahead.

Surety Market Overview The U.S. 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 5.5% last year to $5.19 billion.

Year Premium Change % Loss Ratio 2009 $5.19 billion <5.5%> 19.5% 2008 $5.50 billion 1.2% 12.7% 2007 $5.43 billion 18.9%

The industry’s direct loss ratio was 19.5%, with total incurred losses slightly exceeding $1 billion. 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 $5.19 billion in surety premiums, $3.8 billion (75%) is attributable to contract bonds, with commercial surety bonds comprising the remaining $1.3 billion (25%). Losses on commercial surety bonds accounted for 52% of all losses, impacted disproportionately by the losses mentioned previously.

Surety History Premium / Loss Results

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Direct Written Premium Direct Losses Loss Ratio

In the first half of 2010, written premiums increased 5.9% from the first half of 2009. The overall loss ratio was reported at 17.4%, 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 U.S. 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.

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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. 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.

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 67.7%, down from 68.3% 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.

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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. 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. 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. 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. For example, in 2010, two sureties have discontinued writing Completion / Subdivision bonds and U.S. Customs bonds due to loss frequency issues. We expect to see sureties continue to target specific sectors and classes of bonds, based on loss frequency, and to modify their underwriting approaches to them accordingly.

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Construction Outlook In the words of Federal Reserve Chairman Ben Bernanke, we are currently experiencing an “unusually uncertain” economy. The daily economic indicators provide a muddled picture of the economy and its direction. The most recent data now points to a slow or “U” shaped recovery. In particular, the employment recovery is projected to be slower than originally forecast, with the unemployment rate dropping to 7% by the end of 2012. With 5% considered “full employment,” the high numbers of unemployed and under-employed individuals will continue to impact all facets of the economy, including the construction industry and housing market. Since 2008, approximately 2.2 million construction jobs have been lost, with many of these jobs unlikely to return in the foreseeable future. The current construction unemployment rate stands over 20%.

The projections for the full year 2010 for the U.S. construction continue to decline. Overall construction spending is predicted to decrease by 5% this year. Non-residential construction is predicted to decline by 16%; declines are expected to reach 6% for schools and office buildings, 5% for commercial structures, 12% for hotels and 18% for manufacturing buildings. Residential construction is expected to increase by 26%, but from a very depressed 2008 number. Public works projects will show a 10% increase, largely as a result of federal stimulus spending. With the stimulus funds dwindling, they will not have as strong an impact in the third and fourth quarters of this year.

Project funding continues to be the biggest obstacle for the construction industry. In the public sector, states, cities and quasi-public entities are wrestling with depressed tax receipts and are being forced to cancel or postpone many construction projects, often diverting dedicated construction dollars to other essential services. Many states are having a difficult time matching federal funds available on designated projects and having to delay or cancel these projects as well.

FMI reports that project delays continue to be four times the normal rate, while cancellations are five times the normal rate. Examples of the funding problems can be found in most states, particularly the more populated and financially stressed ones such as New York, California and Illinois.

In the private sector, construction lending continues to be problematic. Construction loans are the worst performing loan category across the banking system, with 17% currently non-current. This compares to a 5.5% non-current status for all bank loans, according to the FDIC. Many experts predict that this number is understated and will continue to climb. The Congressional Oversight Panel overseeing the federal bailout fund stated that, “construction loans are experiencing the biggest problems with vacancy or cash-flow issues, have the highest likelihood of default and have higher loss severity rates than other commercial real estate loans.” Even when demand for new projects return, we believe that banks will take a more cautious approach to funding them based on the current loss problems.

Merger and Acquisition activity has shown signs of rebounding. This is clearly visible with the large A/E transactions that have recently been announced. Likewise, we are also seeing M&A activity in the construction industry. Contractors seem to be in two camps – some view their weak backlogs and the current construction economy as a selling opportunity, while other contractors see it as a time to increase market share and/or to vertically integrate businesses that will let them maximize profit margins.

Source: U.S. Census Bureau

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Aon Surety Rolls Out Cost of Credit Analytics Database Initiative With a continued depressed economy, globalization of the U.S. construction marketplace, inconsistent market pricing and a changing owner delivery model, Aon Surety has worked to capitalize on its advisory knowledge, marketplace presence, and diverse portfolio of client engagements by creating a tool to respond to all of these challenges.

Aon Surety is currently developing a dynamic analytical database that allows firms to benchmark and understand both their cost of credit for various scopes of work, as well as the overall terms and conditions of their current program compared to their peer competitors.

Our proprietary database will capture pertinent financial, operational, and surety specific information without compromising individual client data. We understand that surety cost and capacity are critical components to a firm’s operations. We are able to analyze a broad range of peer group data with similar scopes of operation, regional representation, bonded capacity and financial strength. This analysis has been performed for both national and international clients within our portfolio and has resulted in providing analysis surrounding the following topics:

• Analyzing broad market peer group to identify key cost and capacity drivers

• Evaluating capital structure and financial performance against key drivers

• Recommending actions to strengthen capital structure and improve performance

Aon Surety continues to evolve this platform and your local Aon contact looks forward to demonstrating the potential capabilities of the database to benefit your organization.

Sample Reports Available to Client Exhibit A: Carrier participation and impact on rates

Carrier participation and pricing

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Exhibit B: Carrier capacity and impact on rate

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Exhibit C: Comparing client’s cost of capital to peer group

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Weighted cost of capital  for large projects  is higher than of it’s peers

Small surety bond contracts are competitively priced 

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How Are Contractors Managing Growing Subcontractor Risk While Controlling Costs?

Contractor Default Insurance (CDI) CDI continues to develop as a valuable alternative to subcontract surety bonds. Earlier this year Arch Insurance Company launched a new CDI program. The introduction of competition to Zurich in the CDI marketplace validates the fact that the coverage is here to stay with new and exciting innovation to come.

Arch’s CDI product is designed for general contractors with less than $100,000,000 in annual subcontract volume. This lower volume feature, along with broad coverage, and an appetite for civil as well as commercial contractors makes the Arch program an attractive alternative.

The Arch program offers several innovative features:

• No minimum premiums

• No co-insurance provisions

• Indirect default cost recovery is based upon a percentage of the loss instead of a policy sub limit

• Programs are set up on projected subcontract volume over time as opposed to a calendar year

Managing subcontractor risk has far reaching impact to the success of a project. Aon is the leading broker in the application of CDI in the expanding P-3 marketplace in Canada. The experience we have gained in developing programs that actually drive the cost and structure of project finance opens great potential as public /private projects go forward in the U.S.

Textura Corporation Prequalification of subcontractors is critically important today with economic stress still growing in the construction sector. Textura Corporation has prequalification management (PQM) software to assist the visibility of subcontractor strength while minimizing cost and time. The PQM product targets general contractors and subcontractors facing the rigors of more detail and higher prequalification standards. The product

facilitates the electronic exchange of prequalification data efficiently, securely, and reduces costs.

Effective prequalification of subcontractors by general contractors reduces the potential of subcontractor default by 50%. Subcontractors with a good story to tell differentiate from the competition and demonstrate “tech capability” with the PQM system. For Aon colleagues, this is one more exciting opportunity to bring value to our clients and help them stay highly competitive.

AonBondLink Update Aon Surety continues to invest in surety technology to maintain an industry leading position in surety portfolio management. Over the past 18 months AonBondLink has added new functionality, with new features that include:

• Additional Joint Venture data tracking and reporting

• New data fields for e-mail contacts for bond requestors, underwriters and other client contacts

• On-line bond request page which now accepts contract attachments for specifications and bond forms

• Premium transaction page has additional invoice identifying data

Aon is already in the planning stage for the next update, which will include more robust international currency adjustments. The technology team plans to broaden the web platform to work with new and developing operating systems.

Aon is dedicated to bringing our clients the strongest surety technology platform in the industry minimizing frictional costs and providing meaningful real-time data to meet the speed of today’s business needs.

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Joellen Mendoza & Marisa Thielen Named “Power Brokers” Risk & Insurance magazine published the 2010 Power Broker winners that included two Aon Surety professionals, Joellen Mendoza and Marisa Thielen.

Joellen Mendoza, Director of Aon Surety, received the Power Broker Award in Construction, as well as a Power Broker award for the “40 under 40” category. One of Joellen’s notable accomplishments was her success in broadening surety participation by adding two new sureties and expanding a surety facility by $200 million for a large global manufacturer of escalators and elevators. Joellen is dedicated to bringing integrated and reliable surety solutions that provide relevant outcomes to respond to clients’ individual needs.

Marisa Thielen, Director of Aon Surety, received Power Broker award for “40 under 40” category and was named a finalist in Aviation. Marisa was nominated as part of her efforts in the Defense & Aerospace Industry and the Chemical Industry. One of her achievements in 2010 included building a multi-million dollar surety credit facility that was used to replace existing letter of credits with surety bonds. This resulted in savings of approximately $720,000 for her client.

The Power Broker award recognizes the passion, effort and successful solutions both Joellen and Marisa have brought to their surety clients. Congratulations to Joellen and Marisa for this outstanding accomplishment!

Joellen Mendoza Marisa Thielen

Director, Aon Surety Director, Aon Surety

State & Local Taxes The Florida Hurricane Catastrophe Fund will increase the mandatory 1% assessment to 1.3% on all applicable policies, including surety bonds, effective January 1, 2011.

Aon continues to see additional premium surcharges applied at the state and local level by other governmental bodies. To date, we have not noticed a significant increase in these costs, but this is an item that we will continue to monitor as governmental budgets continue to face greater challenges.

Aon’s Surety Experts We continue to believe that the corporate credit constraints, government leverage and budgetary issues will result in turbulence in the surety market over the next 24 months. Having expert surety representation that can provide timely, customized and innovative solutions will be most valuable. A surety team that goes beyond placing bonds and offers introductions to potential consortium partners or Public-Private-Partnerships (P3s) capital resources can be the difference in profit margin.

Aon Surety’s dedication to providing Reliable & Relevant surety consultation and service is more critical now in this rapidly changing economic environment.

We look forward to working with both existing clients and prospects to provide solutions to meet their surety needs going forward.

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Aon Chicago Construction Services Group Volunteers at Special Olympics On July 28, Aon Chicago’s CSG team volunteered its day to run a Special Olympics golf event at the historic South Shore Cultural Center. Throughout the steamy Chicago summer day, forty-four CSG members performed various duties, including caddying, score-keeping and serving food. A few volunteers even hacked their way around the course with the athletes. Following the round of golf, a lunch and awards ceremony was held. The annual CSG volunteer day was another success and an enjoyable and fulfilling time for all involved.

Aon Chicago CSG team at the Special Olympics

Contact Information Aon Surety www.aonsuretyhub.com

Geoffrey Heekin | National Practice Leader +1.312.381.4594 geoffrey.heekin@aon.com

Michael Cusack | Boston +1.617.457.7719 mike.cusack@aon.com

Michael Herrod | Houston +1.832.476.5834 michael.herrod@aon.com

John Hyland | New York +1.973.463.6006 john.hyland@aon.com

Michael Marino | Miami +1.516.396.4290 michael.marino@aon.com

Robert McDonough | New York +1.212.441.2628 robert.mcdonough@aon.com

Richard Moore | Chicago +1.312.381.4591 rich.moore@aon.com

Michael Parizino | Irvine +1.949.608.6381 michael.parizino@aon.com

Paul Rodriguez | San Francisco +1.415.486.7221 paul.rodriguez@aon.com

Douglas Wheeler | Philadelphia +1.215.255.1705 doug.wheeler@aon.com

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About Aon Aon Corporation (NYSE: AON) is the leading global provider of risk management services, insurance and reinsurance brokerage, and human capital consulting. Through its more than 36,000 colleagues worldwide, Aon delivers distinctive client value via innovative and effective risk management and workforce productivity solutions. Aon’s industry-leading global resources and technical expertise are delivered locally through more than 500 offices in more than 120 countries. Named the world’s best broker by Euromoney magazine’s 2008, 2009 and 2010 Insurance Survey, Aon also ranked highest on Business Insurance’s listing of the world’s largest insurance brokers based on commercial retail, wholesale, reinsurance and personal lines brokerage revenues in 2008 and 2009. A.M. Best deemed Aon the number one insurance broker based on brokerage revenues in 2007, 2008 and 2009 and Aon was voted best insurance intermediary, best reinsurance intermediary and best employee benefits consulting firm in 2007, 2008 and 2009 by the readers of Business Insurance.

For more information on Aon, log onto aon.com.

Copyright 2010 Aon Inc.

This publication is distributed with the understanding that all reasonable care has been taken in preparing this publication.

Aon accepts no responsibility for any errors it may contain, whether caused inadvertently or otherwise, or for any losses allegedly attributable to it.

Nothing contained in this publication should be construed as establishing or recommending any specific guidelines or standards of the Surety market. Nothing contained in this publication should be construed as establishing or recommending any specific guidelines or standards.

Reproduction permitted with written authorization.