Surety Bonds are a new concept in India and recently IRDAI has released guidelines for it. Read here to know the pros, cons, and significance of them.
In Budget 2022-23, the government has allowed the use of surety insurance bonds as a substitute for bank guarantees in case of government procurement and also for gold imports.
Recently the Ministry for Road Transport & Highways (MORTH) has asked insurance regulator Insurance Regulatory and Development Authority (IRDAI) to develop a model product on Surety Bonds in consultation with general insurers.
What is a surety bond?
A surety bond is defined as a three-party agreement that legally binds together a principal who needs the bond, an obligee who requires the bond, and a surety company that sells the bond.
- The bond guarantees the principal will act by certain laws.
- If the principal fails to perform in this manner, the bond will cover the resulting damages or losses.
The obligee, usually a government entity, requires the principal, typically a business owner or contractor, to obtain a surety bond as a guarantee against future work performance.
A surety bond is provided by the insurance company on behalf of the contractor to the entity which is awarding the project.
- These bonds are mainly aimed at infrastructure development to reduce indirect costs for suppliers and contractors.
- This helps in the diversification of options hence acting as a substitute for a bank guarantee.
Types of surety bonds
- Bid bond: It provides financial protection to an obligee if a bidder is awarded a contract under the bid documents, but fails to sign the contract and provide any required performance and payment bonds.
- Performance bond: It assures that the obligee will be protected if the principal or contractor fails to perform the bonded contract. If the obligee declares the principal or contractor as being in default and terminates the contract, it can call on the Surety to meet the obligations under the bond.
- Payment bond: Bond assures that the contractor will pay certain subcontractors, laborers, and materials suppliers associated with the project.
Advantages of surety bonds
There are many benefits of contract surety bonds:
- As an impartial third party, the surety prequalifies the contractor to verify that the contractor is capable and qualified.
- The owner has the assurance of project completion, however, many things can cause contractors to default, and in that event, the surety bond offers protection against financial loss.
- If the contractor requests help, the surety may offer technical, managerial, or financial assistance. This can help the project move forward and significantly reduce the likelihood of default.
- These bonds protect the beneficiary against acts or events that impair the underlying obligations of the principal.
- They guarantee the performance from construction or service contracts to licensing and commercial undertakings.
- Surety bonds protect taxpayer dollars on public projects.
- When subcontractors and suppliers know they are protected by a payment bond, they may present lower quotes since they no longer have to absorb the risk of nonpayment.
For infrastructure projects:
The large liquidity and funding requirements of the infrastructure sector can be addressed with surety bonds.
The Surety bonds will assist in developing an alternative to bank guarantees for construction projects. This will enable the efficient use of working capital and reduce the requirement of collateral to be provided by construction companies.
Insurers will work together with financial institutions to share risk information which will assist in releasing liquidity in the infrastructure space without compromising on risk aspects.
- Bonded parties must pay for bonds and any valid claims
- A lapse in bond coverage can invalidate a license or contract
- Required bonds renewals can add ongoing costs and hassle
Surety bonds are a new concept in India hence are risky as insurance companies here are yet to achieve expertise in risk assessment in such business.
- There is no clarity on pricing, the recourse available against defaulting contractors, and reinsurance options.
- These are critical and may impede the creation of surety-related expertise and capacities and eventually deter insurers from writing this class of businesses.
IRDAI Guidelines on Surety Bonds
Insurance Regulatory and Development Authority of India (IRDAI) (Surety Insurance Contracts) Guidelines, 2022 came into force in April 2022.
- The premium charged for all surety insurance policies underwritten in a financial year, including all installments due in subsequent years for those policies, should not exceed 10% of the total gross written premium of that year, subject to a maximum of Rs 500 crore.
- Insurers can issue contract bonds, which assure the public entity, developers, subcontractors, and suppliers that the contractor will fulfill its contractual obligation when undertaking the project.
- Contract bonds may include Bid Bonds, Performance Bonds, Advance Payment Bonds, and Retention Money.
- The limit of the guarantee should not exceed 30% of the contract value.
- Surety Insurance contracts should be issued only to specific projects and not clubbed for multiple projects.
Most general insurers are still apprehensive and are seeking more clarity on the structure and pricing of these bonds before moving ahead.
There are also concerns about defaulting, reinsurance support, experience, and capacity to underwrite such bonds.
The major concern is that general insurers do not have the same understanding of customers as banks do. There also needs to have clarity on whether these bonds fall under the Insolvency and Bankruptcy Code.
Hence, more elaborate and clearer guidelines will encourage general insurers to adopt the surety bonds.