By Nitin Zamre

While presenting the Union Budget 2022, the finance minister introduced surety bonds (SB) as an insurance product that could potentially replace bank guarantees (BG) in India. The Insurance Regulatory & Development Authority of India (IRDAI) permitted general insurers to issue Surety Insurance Bonds from April 2022. In December 2022, the first SB product was introduced by insurer Bajaj Allianz. In March 2023, New India Assurance, the largest non-life insurer, entered the surety bonds business. These developments are not just welcome but are critical for India’s $1.5-trillion National Infrastructure Pipeline (NIP).

What is a security bond? It is a legally binding contract entered into by the principal (contractor), the obligee (eg the National Highways Authority of India, or NHAI), and the surety (insurer) that underwrites the contractor’s performance by providing monetary compensation to the obligee in case of contractor’s failure to perform. However, there is a fundamental difference between SB and BG. While BG needs collateral, SB is like insurance and needs a premium. SB, therefore, does not lock in funds. However, unlike the usual insurance products, SB has the right to recover the claim from the principal.

BGs are needed throughout the project cycle—from bidding till completion of the defect liability period. Providing a BG is dependent on many things, such as the principal’s overall borrowing limits and creditworthiness, the bank’s risk limits, project cost, and risks, et al. The last 15 years’ growth in India’s Engineering, Procurement, and Construction (EPC) space necessitated contractors to borrow more and provide more BGs. Banks also ran up stressed assets, limiting their risk appetite, and seeking higher margin money. This effectively squeezed the contractors’ growth. The most affected were the medium-sized contractors.

India plans to spend `115 trillion on infrastructure through the NIP over the next five years. A recent research paper published by The Infravision Foundation estimates that such an investment would need BGs that could go as high as ’95 trillion. The banking system is unlikely to be able to provide BGs of this value, making an alternate instrument like SB to fill in the gap critical.

Globally, SBs are a $20-billion market, growing at about 6% CAGR, dominated by North America and Europe, with 75% share. They are extensively used to support infrastructure-building with laws that mandate their use. The US even has an SB Guarantee program to help small, emerging contractors who lack the experience and financial strength to obtain commercial BGs. In India, SBs were introduced over a year ago but have not been taken off due to the daunting challenges related to adoption and scaling up, pricing, and recovery of claims.

The first challenge is the lack of awareness. While the NHAI has shown willingness to accept SB, many other agencies, including state governments, have not.

The second challenge is the lack of data. An insurance product needs actuarial pricing models, using historic customer data. In the case of the Indian SB market, insurance companies don’t have enough data.

Lastly, there are major concerns over recovery in the case of claim. Insurance companies are not part of the Insolvency & Bankruptcy Code (IBC), and therefore may not get recourse to the project assets in the case of default.

Development of the SB market is extremely important as the system’s ability to provide BGs can choke infrastructure development. The Infravision Foundation research presents a set of recommendations in this regard.

Awareness campaigns: awareness needs to be created among all the authorities by bringing them on the same page regarding the acceptance of SBs. The unique nature of SBs needs to be understood and factored into structuring, pricing, and capital guidelines.

Solvency ratios: Unlike standard insurance products, SB issuers enjoy access to project assets and cashflows in the event of a claim. The insolvency regulations for SB issuers need to take these into account.

Credit rating of surety bonds: Actuarial pricing models won’t work in India due to a lack of data. Regulators could permit insurance companies to use the external credit rating of principals to assess the underwriting risk and the probability of default under the counter indemnity. These can be used to price the SB.

Indemnity agreement: SB issuers need indemnity agreements to recover money in case of a claim. Standard indemnity agreements should be made mandatory as part of the Sbs, wherein the principal unconditionally indemnifies the losses of the SB issuer. The government may also think of providing partial counter indemnity for MSMEs not having acceptable credit rating to back the indemnity. Alternatively, the SB issuers can be recognized as financial creditors under the IBC, removing the need for providing an explicit indemnity.

Right of subrogation and IBC: Effective implementation of SBs can be increased by providing the right of subrogation/substitution. That would allow the issuer to “step into the shoes of” the principal and use the contractual rights to recover the cost of making payment or performing on the principal’s behalf.

Three things can be implemented immediately: awareness campaigns, indemnity agreements in standard SB, and permitting insurance companies to rely on external credit ratings for pricing.

The remaining action points will require broader engagement with multiple stakeholders. However, a roadmap for implementing these should be drawn up to ensure the SB market develops to its fullest extent.

With technical inputs from Supratim Sarkar and Manoj Mohan (SPJIMR)

(Nitin Zamre, Chief Operating Officer, The Infravision Foundation)

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