Introduction:
Surety insurance bonds (“Surety Bonds”) are a proven risk management mechanism, useful especially in the infrastructure, construction projects, and government procurement space. Surety Bonds can be an effective alternative financial solution to the principals/ contractors, who had to depend on bank guarantees earlier.
Internationally, the surety insurance business is well developed in jurisdictions such as Germany, Italy, the US, North and South America, besides Japan, South Korea, Australia and Philippines[1]. Such popularity is often attributed to supporting laws and faster turnaround time for enforcement through courts.
However, despite a formal legal and regulatory framework in place, surety insurance products are yet to reach their maximum potential in India. We discuss the regulatory landscape laid down by the IRDAI, and the development or the related issues concerning India’s surety insurance business.
Regulatory Framework around Surety Insurance in India:
The Insurance Regulatory and Development Authority of India (“IRDAI”) had issued the IRDAI (Surety Insurance Contracts) Guidelines, 2022, on January 03, 2022 (Surety Guidelines), which came into effect from April 01, 2022. It laid down the regulatory framework for Surety Bonds in India, to expand and develop the surety insurance business here. Prior to the Surety Guidelines, there was no formal legal framework for issuance of Surety Bonds in India.
Some of the key regulatory provisions under the Surety Guidelines are set out below:
- Available for only Indian Projects: Surety Bonds cannot be issued if the underlying asset/ commitment is outside India. Further, the payment for risk covered under the Surety Bonds shall be made in Indian rupees. Hence, Surety Bonds can be issued for domestic projects only, and not for Indian project contractors’ engaging in infrastructure projects outside India.
- Cap on premium: Premium on Surety Bonds – underwritten in a financial year by an insurance company, including all instalments due in subsequent year/s for those policies – shall not exceed 10% (ten percent) of the total gross written premium of that year, subject to a maximum of INR 500 crore (approximately $62 million). Therefore, only a small percentage of a general insurance companies’ portfolio can consist of issuance of Surety Bonds.
- Risk assessment: The insurance company is required to establish a risk assessment mechanism/ internal risk management guidelines to evaluate the technical/ financial strength of a contractor, who is involved in the project, before and after underwriting the surety insurance business. It is likely that insurance companies would have to conduct due diligence on project principals/ contractors to determine their standing before issuing Surety Bonds.Restriction on group companies: An insurance company shall not issue any Surety Bond on behalf of its promoters/ their subsidiaries, groups, associates and related parties.Financial guarantee: No Surety Bond shall cover financial guarantee in any form.Risk Management: The insurance company shall ensure that no single risk/ aggregate risk is disproportionate to the capital of the insurance company.
- Types of surety insurance bonds: Insurance companies are permitted to issue advance payment bonds, bid bonds, contract bonds, customs and court bonds, and performance bonds, as per the Surety Guidelines.
Following the Security Guidelines, the IRDAI issued circulars on January 12, 2023, and May 15, 2023, to provide further relaxations, as discussed below:
- The earlier 10% premium cap of the total gross written premium of that year, subject to a maximum of INR 500 crore charged on all surety insurance policies, is no longer applicable to monoline surety insurance companies, registered for doing surety insurance business on a standalone basis.
- Further, surety insurance, which was previously restricted to private/ government infrastructure projects, can now be issued for commercial contracts.
- The solvency margin applicable to insurers underwriting surety insurance is now prescribed to be at the control level of solvency specified by the IRDAI, from the earlier requirement of 1.25 times.
- Removal of 30% contract value restriction, being the exposure limit applicable on each contract underwritten by an insurer.
Development of surety insurance in India and related issues:
While the IRDAI had issued the Surety Guidelines in 2022, so far only four insurers viz. SBI General Insurance Company Limited, Bajaj Allianz General Insurance Company Limited, New India Assurance Company Ltd, and HDFC ERGO General Insurance Company Limited, have launched surety insurance products.[2]
It appears that the Government and the insurance regulator IRDAI’s plan to introduce Surety Bonds as an alternative to bank guarantees has faced various hindrances over the last three years due to technical and financial challenges.
Below are certain aspects of surety bonds that pose a challenge to its development in India:
Lack of strong recourse/ ineffectual legal environment
Under the Insolvency and Bankruptcy Code, 2015 (“IBC”), the rights of a surety insurer are not at par with a bank or a “financial creditor”. Under the IBC, as insurance companies are notified as “financial institution” in terms of Section 3(14), the claims of surety insurers against the contractor in respect of any counter security (to the extent such counter security is in the nature of any counter-indemnity or counter-guarantee by the contractor) will not be classified as “financial debt” and therefore, insurance companies will not be classified as a “financial creditor” of the contractor.
According to publicly available information, general insurance companies have sought amendments/ changes to be made to the IBC to make insurance companies at par with banks, with respect to legal recourse in relation to Surety Bonds[3].
Further, India’s contract enforcement score is 163 out of 190 countries[4], hence the rights and recourses that should be made available to surety insurer from an enforcement point of view becomes even more crucial.
Accordingly, it may be noted that while banks that issue guarantees can file an application under the IBC to initiate an insolvency resolution process against a contractor as a financial creditor, similar mechanism is not available to a surety insurer. Therefore, insurers currently do not have any recourse under the law in case of a default. On the other hand, enforcement through courts is a relatively slow process here, compared to other developed jurisdictions, and can hinder the growth of India’s surety insurance market.
Presently, effective and faster dispute resolution is more likely via alternate routes such as arbitration.
Also, to further expand the scope of Surety Bonds, the central Government in its notification for amendment to General Financial Rules, 2017, dated February 02, 2022 (“Financial Rules”), had prescribed that for “bid security and performance security”, “Insurance Surety Bonds” may be accepted, along with other instruments like fixed deposit, demand draft, bank guarantee, etc. However, the Financial Rules do not mention any details on such “insurance surety bonds”. The Financial Rules also do not specify whether such insurance surety bonds shall be conditional or unconditional.
Product clarity and reluctance in the market
It is anticipated that there will be a significant demand-supply mismatch for bank guarantees in the future, creating substantial potential for Surety Bonds. Historically, the Indian markets are used to conventional products such a bank guarantee and other financial instruments (such as demand draft, cash deposit, fixed deposit, etc).
Surety Bonds and bank guarantees serve as financial assurances, but the crucial difference is that Surety Bonds may have project specific terms and conditions and may not necessarily be unconditional, unlike bank guarantees. Our article, available here, gives a detailed analysis on replacement of bank guarantees with Surety Bonds.
When a claim is made on a Surety Bond, the insurer conducts an investigation into the circumstances to assess whether remediation efforts were undertaken. Though there can be unconditional Surety Bonds, such Surety Bonds are typically costlier than the conditional ones. On the other hand, instruments such as bank guarantee provide unconditional payment assurance. In case of a payment request on such instruments by the beneficiary, there will be guaranteed payment by the bank or financial institution. Contractors might be hesitant to embrace premium rates exceeding those of bank guarantee or even minimum collaterals required in case of Surety Bonds.
Accordingly, the Indian markets are still adapting to the idea of Surety Bonds, particularly the conditional ones, in contrast to the traditional forms of financial instruments like bank guarantees. Indian markets are required to understand why Surety Bond rates are higher than bank guarantee rates due to various reasons. One such reason being that banks have multiple options of recovery, against a bank guarantee.
Limited Underwriting and Reinsurance Expertise of Insurers
Introduction of new insurance products often lacks local underwriting and claims experience, leading insurers to rely on foreign counterparts for technical support in terms of underwriting and pricing. However, the international underwriting experience cannot be seamlessly applied to India.
Further, insurers, unlike banks, lack access to financial information of clients (including information pertaining to blacklisted contractors or contractors whose bank guarantees have been invoked in the past), which is the basis for risk assessment and pricing the risk.
Therefore, it is important for this product to gain traction, to develop local underwriting expertise and data tools, which can be handy for underwriters.
As of now, most insurers issuing Surety Bond are working without adequate reinsurance support, thus curtailing their capacity to issue Surety Bonds of relatively small monetary values. Leading reinsurers involved in designing Surety Bonds in India, also feel that buyers are not willing to pay adequate premiums and provide sufficient collaterals for the policy, which are crucial for selling Surety Bonds in India[5].
Challenges for customers
Insurers have been asking for enormous amounts of data, including a contractors’ previous experience, credit rating, financial stability and other information, especially in cases involving litigation, thus increasing the challenges for customers.
Conclusion:
Development of the Surety Bonds’ market in India points to a promising, but intricate landscape. However, challenges persist (above mentioned). Hopefully, these will be resolved in due course and insurers will explore mechanisms to address them, such as monitoring project performance, collaborations with banks, data repository maintenance, arbitration for dispute resolution, etc.
[1] Report of the Working Group on suitability of offering of Surety Bond by Indian Insurance Industry, 30th September, 2020.
[2] Link to information: New India Assurance becomes second company to offer surety bonds – The Economic Times (indiatimes.com), surety-insurance-policy—performance-bond-wording-for-mmrda.pdf (hdfcergo.com), Surety Bond Bima | SBI General Insurance.
[3] Link to article: https://www.business-standard.com/article/companies/irdai-wants-insurers-at-par-with-banks-on-legal-recourse-for-surety-bonds-122022400581_1.html
[4] Link to information: EODB | Department of Justice (doj.gov.in)
[5] Link to information: India’s surety bond market fails to gain traction | Insurance Business Asia (insurancebusinessmag.com)
