There has been a lot of buzz going around about Surety Bonds in India. Affirmative headlines are making their ways in the top sections of the finance sector. The insurance companies and construction businesses are eagerly waiting for the launch of this insurance product since its usage was allowed by the government in place of bank guarantees in the budget 2022-23.
Government is also working cohesively with the respective stakeholders in order to make surety bonds in India a reality.
So what are Surety Bonds? And why is there so much hype around it? Let’s get deep into it.
First of all let’s understand, What are Surety Bonds?
A surety bond is basically a legal contract that encircles three parties and is entered into by these 3 parties, which are,
- Insurer or Surety
- And the Obligee
Here, the Principal is the rightful owner of the project.
The Insurer or Surety is, as you can guess, the insurance company or the Surety Company. They will issue the Surety Bond.
And the Obligee here is the government. They mandate the principal (the project owner) to secure the terms of contract by purchasing a surety bond which further guarantees the obligation (here government) against future work performance.
Surety Bonds are majorly used in the construction/infrastructure projects and as Custom Bonds for Import of Goods by the Customs Department. The reason is simple. The possibility of deteriorating performance during the course of construction of the project is highest in this industry.
Surety Bonds are issued by an insurance company on behalf of Principal (winner of the project) to obligee (awarder of the project).
To explain in simple words. Surety Bonds basically protect the obligee/beneficiary against acts or events that hinder the underlying responsibilities of the project that are mentioned in the contract.
Why Surety Bonds now? How did it work between these three parties before?
Till now, the surety bonds were only a concept in India. Until most recently, Bank Guarantees were being used to support construction projects.
In a nutshell, a Bank Guarantee basically gives a guarantee to the beneficiary, that if things go sideways, the bank will cover their losses on behalf of the debtor. To do this a bank would usually ask the debtor (on behalf of whom it covers losses) for collateral.
In our case, both the beneficiary and the debtor are obligee and principal, respectively.
So what is the problem with Bank Guarantees?
The major problem with bank Guarantees is that banks require collateral in order to issue a guarantee. To do this they usually lock up the 20%-50% of entire working capital funds of the construction project. Whereas a surety bond does not require a collateral whatsoever. Bank Guarantee uses the Bank Credit which is a valuable resource.
This is why the “No Collateral” option seems affordable and feasible to Principals.
On top of the collateral, banks also charge a hefty commission whereas the fee of surety bonds (issued by an insurance company) is comparatively lower.
So surety bonds basically become a no-brainer for businesses.
But that’s not the only reason why Surety Bonds must come to India
Here are few other advantages of Surety Bonds
- Bank Guarantees freeze 20%-50% of entire working capital funds.
Now with Surety Bonds almost coming up, it will free up around ₹8 lakh crore of private funds which erstwhile were tied up as collateral for Bank Guarantees.
- Improved liquidity in the construction sector
- Increase in Construction Opportunities
- Increase efficiency in execution of projects
- Less defaults between suppliers/contractors and project owners
- An incline in private investments
- Risks will now be more diversified since insurers will now take place of banks
- A new stream of revenue for insurance companies. Which means more jobs.
- Chances of an increase in FDI in the insurance sector
The major issue with Surety Bonds in India (That will be soon solved)
Surety bonds are a new concept in India. And insurance companies here are yet to achieve that level of risk handling required in this business.
There has been no clarity, as such, on the pricing of Surety Bonds. And the major concern of the insurance industry is that they want Surety Bonds to be at Par with Bank Guarantee in terms of recourse when a default happens. This means that the insurance companies want the Surety Underwriter to be the Financial Creditor under the Indian Bankruptcy and Solvency Code.
This happens to be a genuine concern for the industry and IRDAI is backing it. The government has also taken this positively.
And to solve this problem the government has asked for development of a model product.
Read IRDAI (Surety Insurance Contracts) Guidelines, 2022 here.