Banks are no longer forthcoming for Performance guarantees & Payment Guarantees because of the risk management associated with these offerings. Banks have raised the costs of these performance securities, in some cases asking for 100 % margin money, making them expensive and time consuming. This ousted many SMEs from participating particularly in high value government projects.
FM gives Surety Bonds a go ahead
Finance minister, Nirmala Sitharaman, in her Union Budget 2022-23 allowed bidders to supply surety bonds instead of bank guarantees, thus, improving the viability of a contractors bid.
Insurers made ‘SECURED CREDITORS’ within IBC
Finally giving recovery rights to the surety bonds, the Insolvency and Bankruptcy Board of India(IBBI) made it clear that the insurance companies backing these surety bonds are `secured creditors’ within the frame work of Insolvency and Bankruptcy Code (IBC).
This means that the insurance companies can effectively recover their dues from defaulting parties of the surety bonds. This authority is at par with what Banks have with Bank Guarantees.
This decision would give confidence to other insurance companies to enter this new market of Surety bonds in India. It would make the ecosystem competitive, economical & responsive to the needs of Principals & Contractors.
Why insurance companies are better than banks?
Banks are, by definition, Financial Institutions & Insurance Companies are Risk Managers. Thus, Insurance Companies are better at managing risk. Further, Insurance Companies can group the homogenous low frequency, high severity risk of bond default & spread it, as to secure the market at minimum price.
The Freed up working capital with no to minimum collateral, low overall cost & high safety , security provided by insurers is going to take the construction and infrastructure market by storm and towards a better India. It will further propel many other cash strapped industries like EXIM, Real estate, Manufacturing etc.
Insurers get financial backing from reinsurers
Insurance companies on getting recovery rights at par with banks have got reinsurance support to cover over 97 per cent of the risks. It makes Surety Bond much safer & secure than Bank Guarantees as banks don’t have such option to spread risk to the international market.
Many Reinsurers have lined up for this including Munich Re, Swiss Re & French reinsurers SCOR, to name a few. This, when combined with the increase in FDI in the insurance sector will help effectively manage the risk through large PE firms outside India. This move, increases flow of FDI in India which further strengthens the financial institutions of India.
importance of RECOVERY RIGHTS for the unconditional bonds
A Surety Bond is unconditional as it allows the obligee ( party that asks for supply or service) to claim the money almost without any condition (except for some minor conditions such as the requirement of a written request being submitted within the valid term of the bond, etc.).
For instance, if work was not done satisfactorily by the Principal (party that provides service or supply) as per the contract, obligee can use the unconditional bond to claim the money from the insurance company immediately to compensate for any damages resulting from such breach. The Insurance company shall not make any detailed enquiry or ask the Obligee to prove the breach of contract.
The unconditionality of the surety bonds can thus be of great assistance to the Obligee. It allows the Obligee to immediately obtain money without having to file a lawsuit and go through time-consuming litigation proceedings. In other words, this transfers the burden of filing a lawsuit. But for this to work Surety Bonds were needed to have proper recovery rights , which now they have.
For videos explaining surety bonds click here.