New safety net a surety

Surety insurance bonds are adding a level of sophistication to India’s insurance sector while strengthening infrastructure development and the economy at large. Puneet Gupta and Akash Singh examine this insurance product and the steps needed to sustain it

The Noble Prize in Physics in 2022 was awarded to Alain Aspect, John Clauser and Anton Zeilinger “for experiments with entangled photons”. This is a state where two particles behave like a single unit, even when they are separated. What happens to one of the particles in an entangled pair determines what happens to the other, even if they are far apart.

Beyond quantum physics, we might apply the same state of existence to the insurance sector and the economy of a country. India is taking big strides and striving to become a USD5 trillion economy by 2025. The insurance sector is naturally responding.

For instance, private health insurance coverage could help the government save on healthcare expenditure; better crop insurance coverage can ensure compensation for crop damages and thereby reduce loan defaults; and surety insurance can help to increase liquidity for contractors and provide a boost for building and infrastructure projects. In short, the risk management offered by insurance will offer financial stability and peace of mind to individuals and businesses wanting to take the greater risks that will bolster the country’s economic development.

Insurance and economic growth are in an entangled state. That insurance will play an important role in economic growth was highlighted in the launch of the first surety bond insurance from Bajaj Allianz General Insurance Company in December 2022. This was followed by the launch of New India Assurance’s surety insurance in March 2023, offering more choices to the customers and opening the market for healthy competition.

The launch of new surety insurance products will aid in the execution of infrastructure projects at a faster rate. This will especially expand the road network, which will lead to greater prosperity, increased employment opportunities, better social connectivity, and overall economic and social growth of India. With the new leadership at the Insurance Regulatory and Development Authority of India (IRDAI) taking a proactive approach, the effects of insurance on business are starting to find applications.

There is now a large array of offerings touching on different aspects of business, namely: surety insurance; title insurance (or property insurance); and trade credit insurance. There are also changes in the insurance distribution ecosystem.

This article explores surety insurance, and in future articles the authors will look at title insurance, trade credit insurance and other developments.

Concept of surety bond

A surety bond is a tri-party agreement that legally binds a principal who demands the bond, an obligee who requires the bond because of an existing demand, and a surety company that issues the bond. Surety bonds provide a financial guarantee that an agreement will be fulfilled according to pre-defined and mutual terms. When a principal breaks a bond’s terms, the harmed party can make a claim on the bond to recover losses.

In large construction or infrastructure projects, the bank guarantee/surety bond is a contractual requirement or precondition to awarding an order to the contractor. In case the contract is not honoured, the bank/insurance company is called on to pay the bond or otherwise assure the finalisation of the contractual obligation. The performance bonds issued may cover up to 20%, or sometimes guarantee 100%, of a project’s value.

Need for surety insurance

Due to covid-19 and the consequent economic impact on liquidity and cash flow issues in the banking sector, it became opportune to examine the possibility of general insurance companies offering surety bonds. Accordingly, the Ministry of Road Transport and Highways requested the IRDAI to examine the feasibility of introducing surety bonds by general insurance companies for road contracts.

An IRDAI committee report in September 2020 recommended the move. It also recommended a solvency margin above a certain threshold, as the domestic market is yet to develop experience for surety insurance; the risk exposure under this business is quite significant compared to other lines of business that are reasonably mature in the Indian insurance market.

There is a statutory framework. Rule 59(i) of the Insurance Rules, 1939, refers to contract performance bonds or guarantees as a long-term category of insurance policy issued for more than one year. Section 64VB(1) and (5) of the act, read with rule 59(i), recognises contract performance bonds or guarantees (surety bonds) as insurance contracts.

Surety bonds are proven risk management mechanisms with a long history that help ensure public and private owners execute their construction projects in accordance with the plans and specifications, and ensure subcontractors and suppliers are paid. Surety bonds help provide construction projects owners with guarantees of success and enhanced reputations.

Taking the committee’s recommendations to its logical conclusion, the IRDAI issued the IRDAI (Surety Insurance Contracts) Guidelines, 2022.

The essential features of the guidelines are that they will be a contract of guarantee under section 126 of the Indian Contract Act, 1872. It is a contract to perform the promise, or discharge the liability of a third person in case of default. The person who gives the guarantee is called the “surety”; the person to whom the guarantee is given is called the “creditor”, and in the event of a default, the person for whom the guarantee is given is called the “principal debtor”.

The different types of bonds recognised under the guidelines are: advance payment bonds (a promise to pay the outstanding balance of the advance payment); bid bonds (a bidder promising that it will furnish the prescribed performance guarantee and enter a contract agreement within a specified period of time); contract bonds (an assurance to the public entity, developers, subcontractors and suppliers that the contractor will fulfil its contractual obligation when undertaking the project); customs and court bonds (guaranteeing the payment of a public receivable incurred from opening a court case, clearing goods from customs, or losses due to incorrect customs procedures); performance bond (the obligee will be protected if the principal or contractor fails to perform the bonded contract); and retention money (a part of the amount payable to the contractor, which is retained and payable at the end after the successful completion of the contract).

A surety from insurance companies/banks provides the financial guarantee to the obligee (government) that the principal (contractor) will fulfil its obligations as per the agreed terms. Surety bonds will aid in developing an alternative to bank guarantees for the construction of infrastructure projects. However, these are different from bank guarantees as, among other things, a considerable amount of the contractor’s project funds do not get frozen in giving surety.

The IRDAI has rightly taken a cautious approach to put certain limitations on surety insurance. The premium charged for all surety insurance policies underwritten in a financial year, including all instalments due in subsequent years for those policies, shall not exceed 10% of the total gross written premium of that year, subject to a maximum of INR5 billion (USD60 million).

The insurer should have a board-approved underwriting philosophy on surety insurance business, adequate underwriting competence and skills, risk management, and required infrastructure for underwriting the surety insurance.

Furthermore, the limit of guarantee should not exceed 30% of the contract value and the insurer shall ensure that no single or aggregate risk is disproportionate to the capital of the insurer. The insurer also cannot issue any surety insurance contracts on behalf of its promoters, subsidiaries, groups, associates and related parties.

The contracts should not be issued where the commitment or underlying assets are outside the country. The surety insurance contracts will be issued only to specific projects and not clubbed for multiple projects. No surety insurance contract will cover financial guarantee in any form.

Issues and concerns

It is laudable that the IRDAI has allowed surety insurance contracts to be offered to infrastructure projects of government and private sectors in all modes. On one hand, surety insurance opens new doors of opportunity but, on the other hand, it brings a host of new risks for Indian insurers.

Being a relatively new concept to the Indian market and insurers, this will test their capabilities, especially with underwriting and risk management. For want of underwriting expertise in surety insurance, insurers may be too risk-averse or too risk-tolerant, neither of which is a desirable state.

Similarly, for want of claim experience, the pricing can also go awry. The due diligence of the insured and the project is another area of concern, given that very limited information pertaining to contractors and their past performance would be available in the public domain.

In addition, some contractors are becoming asset-light and moving more towards the outsourcing model, and hence they have less on-book assets. There is, therefore, not enough market data available to assess the associated risks both on the quality aspect and the timelines perspective.

The other major possible risk could be a lapse in bond coverage, which would invalidate a licence or contract. In addition, required bond renewals could add to ongoing costs and hassle. There is no clarity on the recourse available against defaulting contractors and reinsurance options.

Further, in case of a claim due to the insolvency/insured event getting triggered and the insurer paying the amount, the existing subrogation laws need to be strengthened to facilitate the insurer receiving an easy and timely recovery from the insured.

Way forward

The stated safeguards built by the IRDAI rely on a prudent approach of “innovation with caution”. The guidelines will ensure orderly development of the surety insurance business and surety bonds market.

With more players, the insurers, insured and the IRDAI can gain experience from the working of the guidelines. This will allow the market to see the transition from “innovation with caution” to “maturity with profits”, and will lead to sharper underwriting norms.

Surety insurance will certainly provide the necessary impetus and ensure the much-needed liquidity, efficient use of working capital, and reduction of collateral required that construction companies need to provide.

Insurers will work in tandem with financial institutions to share risk information, which will in turn be helpful in multiple check points of due diligence, structured approaches towards risk management and checking delays in projects. The intertwined nature of the insurance sector, infrastructure projects and the economy will have a domino effect to aid in development and growth.

PUNEET GUPTA is the assistant vice president, legal, and AKASH SINGH is a senior manager, legal, at Max Life Insurance.