Surety Bonds

In News

• Recently, the Ministry for Road Transport & Highways (MORTH) has asked insurance regulator IRDAI to develop a model product on Surety Bonds in consultation with general insurers.

Key Points

• Several challenging issues which made Surety Bond a complete non-starter with the insurers were discussed and it was proposed to IRDAI that it should design a model product.
• The insurers can further improvise the product according to their capacity and on the basis of reinsurance support.
• The issue of changes in Indian Contract Act and Insolvency and Bankruptcy Code (IBC) as wanted by the general insurers are also being looked into.
  • It is being done so that Surety Bonds can be at par with bank guarantees when it comes to recourse available to them in the case of a default.
• Aimed at supporting the implementation of large-scale project finance, particularly in the area of road projects of National Highway Authority of India (NHAI)
• It was mentioned in Union Budget 2022-23 that bidders for government projects could supply Surety Bonds instead of bank guarantees, which are much more expensive, thus improving the viability of their bid.
• Norms by IRDAI: The IRDAI had come out with the detailed norms on the issuance of Surety Bonds by the general insurers. 

Surety Bond

• About: 
  • A surety bond is provided by the insurance company on behalf of the contractor to the entity, which is awarding the project. 
  • When a principal breaks a bond’s terms, the harmed party can make a claim on the bond to recover losses.
• Definition: It is a written agreement to guarantee compliance, payment, or performance of an act. Surety is a unique type of insurance because it involves a three-party agreement. The three parties in a surety agreement are:
  • Principal: The party that purchases the bond and undertakes an obligation to perform an act as promised.
  • Surety: The insurance company or surety company that guarantees the obligation will be performed. If the principal fails to perform the act as promised, the surety is contractually liable for losses sustained.
  • Obligee: The party who requires, and often receives the benefit of— the surety bond. For most surety bonds, the obligee is a local, state or federal government organisation.

Image Courtesy: SB 

IRDAI Guidelines

• A general insurer can commence a surety insurance business if it has 1.25 times the solvency margin it is required to keep. 
  • Also, if at any point in time the solvency of the insurer goes below the required level, the insurer has to stop underwriting the new surety insurance business until its solvency margin is restored to above the threshold limit.
• The underwritten premium in a financial year for any general insurers from the surety insurance business shall not exceed 10 percent of the total gross written premium subject to a maximum of Rs 500 crore.
• The insurers need to have a board-approved underwriting philosophy on the surety insurance business, incorporating all aspects for managing this business. 
• The insurers can work together with banks or other financial institutions such as NBFCs to share risk information, technical expertise to monitor projects, cash flow amongst other aspects. 
  • They can also work with contract awarding authorities in order to evaluate the risk with more information and data.
• The surety insurance contracts can be offered to infrastructure projects of government/private in all modes. 
  • The contract bonds may also include bid bonds, performance bonds, advance payment bonds and retention money. 
  • Apart from contract bonds, the insurers may underwrite Customs or tax bonds and court bonds.
• The limit of guarantee shall not exceed 30 percent of the contract value. Also, surety insurance contracts should not be issued only to specific projects and not clubbed for multiple projects.

Significance 

• Different from Insurance but better: Unlike most insurance policies, surety bonds do not protect (or provide coverage to) the owner of the policy (the bond). 
  • A surety bond is typically written to protect, indemnify, or provide a financial guarantee to third parties such as customers, suppliers or state taxpayers. 
  • The surety company has agreed to undertake the risk in exchange for a premium paid by the principal.
• Overcoming the challenge of Insurers: The big challenge for new players is that often they find it difficult to get bank guarantees and that’s where the role of Surety Bonds comes in. 
• Government support: The government has planned investment worth Rs 7 trillion for infrastructure projects to be spent over the next 2-3 years.
• Allowing the surety insurers to work alongside banks and other financial institutions to share risk-related information and technical expertise will help foster a robust ecosystem and prevent contagion.

Issues

• Completely New: Given the Surety Bond is an entirely new line of business, insurance companies would need clarity on various aspects such as pricing, the recourse available against defaulting contractors, reinsurance options and global best practices
• Not at par with Bank guaranteed: As an industry, we would urge the regulatory bodies to facilitate changes to laws such as the Indian Contract Act and the IBC and bring surety bonds on par with bank guarantees regarding recourse available to issuers. 
  • This will help the industry approach surety solutions with much more confidence, but it will be even more a viable proposition for all stakeholders.

Way Ahead

• A huge market is available for Surety Bonds in the country and now, the onus is on the insurance fraternity to come out with products quickly.

Source: IE