India’s insurance regulator has released draft rules for surety contracts as the nation looks to support infrastructure, a sector that is vulnerable to delays, defaults and litigation.
The proposed IRDAI (Surety Insurance Contracts) Guidelines, 2021, will make it possible to offer surety insurance or bonds. These are essentially guarantees without a collateral.
Surety insurance protects the awarding authority, like the government, against poor service, failure to complete a project or a default by a contractor. And for the construction contractors, they work like guarantees for working capital.
One of the key conditions under the draft rules is that the guarantee should not exceed 30% of the project value.
Why India Needs Surety Insurance
India has unveiled a plan to spend Rs 5 lakh crore on building roads to laying in the next three years. Yet, the sector is prone to delays and cost overruns. Bad loan fears dissuade banks from providing guarantees to private contractors that bid for projects.
Surety bonds are prevalent in the developed markets. In the U.S., the law mandates surety for every public project, according to Vikash Khandelwal, chief executive officer at Eqaro Guarantees. Canada, European nations, Australia and New Zealand also offer such guarantees, and the concept is catching up in Africa and Southeast Asia, he said.
How Surety Insurance Works
Surety insurance, also called an insurance bond or a surety guarantee, does not require a collateral, unlike bank guarantees.
It’s a tripartite agreement between the contractor (principal debtor), the awarding authority like government departments (obligee) and an insurance company (surety) issuing the instrument.
Such contracts are of multiple types:
Contract bond: Offers assurance to the public entity, developers, subcontractors, suppliers that the contractor will fulfil its contractual obligation. These include bid bonds, performance bonds, advance payment bonds and retention money.
Advance payment bond: It's a promise by the insurance company to pay any outstanding balance of the advance payment in case the contractor fails to complete the contract as specified or doesn't adhere to the terms.
Bid bond: Provides financial protection to the awarding authority if a successful bidder fails to sign the contract within a specified period of time.
Customs and court bond: A public office such as tax office, customs administration or the court is guaranteed payment by the surety if the contractor fails to pay. Such an obligation could arise from a court case or while clearing goods from customs or losses due to incorrect customs procedures.
Performance bond: Allows an obligee to call on the surety to meet obligations if the contractor defaults.
Retention money: Money withheld by the beneficiary that is released to the contractor as working capital.
Who Can Issue Surety Bonds…
General insurance companies registered under the Insurance Act will be allowed to issue surety bonds to construction companies in India involved in road projects, housing or commercial buildings and other infrastructure projects of the government or the private sector, according to the draft.
New companies will be required to register under the Insurance Act.
Since sureties do not require collateral, they are an asset-light business, Khandelwal said.
According to the proposed guidelines, key parameters for a company issuing such bonds are:
A solvency margin of 1.25 times or higher.
Underwritten premium from the surety business not exceeding 10% of the total gross written premium in a fiscal, up to a maximum of Rs 500 crore.
Risk assessment mechanism/internal guidelines to evaluate technical and financial strength of the client before and after underwriting.
A limit of 30% of the project value for the guarantee or surety.
The contracts should be issued only to specific projects, and not clubbed for multiple projects.
How Will They Help
The move to frame rules for surety contracts will help address the large liquidity and funding requirements of the infrastructure sector, Khandelwal said.
Surety bonds will create a level-playing field for large, mid and small contractors, he said. “Capability, technical expertise, the past track record will be the parameters to judge a developer rather than just its financial capabilities.”
According to Abhaya Agarwal, partner, infrastructure practice at EY, surety insurance business will assist in developing an alternative to bank guarantees for construction projects. "This shall enable the efficient use of working capital and reduce the requirement of collateral to be provided by construction companies."
"Insurers shall work together with financial institutions to share risk information," he said. "Hence, this shall assist in releasing liquidity in infrastructure space without compromising on risk aspects."
(Corrects an earlier version that misstated the designation of Vikash Khandelwal.)
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