Surety bonds are now accepted in India for government procurement. Despite this, it has been slow to take off. While surety offers insurers a major new revenue stream, the issue of surety bonds to replace bank guarantees has thrown up both legal and technical challenges.
Today, we look at the need for surety bonds in India, the opportunity they provide for economic growth, and the answers insurers need.
The Growth Agenda
In a determined effort to speed up growth, the Indian Government plans to spend US$1.4 trillion on infrastructure over five years covering the power, railways, urban irrigation, mobility, education and health sectors. As a nation of 1.38 billion people, India urgently needs to develop infrastructure to keep up with its growing economy and population.
With the Government awarding 50% of infrastructure contracts to new players, the resulting benefit is more competitive bids and faster construction. However, this poses a problem for new players who find it difficult to get bank guarantees.
Also, in recent times Indian banks have exercised tighter controls in issuing collateral free/waivers for bank guarantees due to corporate failures resulting in non-performing assets. In many cases, margin money and commissions have increased, making it expensive for contractors. Many large contractors also find it difficult to avail finance due to restrictions placed by banks on group exposures.
In her 2022-23 budget speech the Indian Minister for Finance announced the acceptance of surety for government procurement. With micro, small and medium enterprises (MSMEs) making up a large portion of suppliers, surety bonds mean they can avoid having to provide mandatory bank guarantees and release valuable working capital.
It is hoped that this will create more of a level playing field where rather than relying only on the financial capacity of the contractor, developers can now consider their capability, technical expertise, and track record.
Issues for Insurers
For insurers in India, surety bonds have the potential to be a major new stream of business. especially if the private sector adopts a similar model. The Surety Insurance Contracts Guidelines came into effect on the first of April, and while the expectation was put on insurers to come out with products quickly, they have been largely apprehensive, so rollout is at a standstill.
Insurers have raised the need for the following to be addressed
- Legal tools for indemnification of the surety by the principal from any liabilities and principal cooperating with the surety in the investigation of the claim.
- A stronger legal recourse mechanism with irrevocable subrogation rights to avoid elongated civil recourses under the Indian Contract Act.
- The use of loss mitigation tools like payment to contractors to complete the project Inclusion under the Insolvency and Bankruptcy Code. 2016 to ensure effective and speedy resolution of defaults, and enforcement of indemnity by surety providers.
- Solvency margin of 1.25x would require a minimum solvency margin of 1.875x which could be a struggle for insurers.
- Accounting norms for insurers
The development of a reliable surety bond market is essential to meet the twin objectives of the Indian economy for development to go hand in hand with protection. To achieve this, government support is important for setting up a legal framework for a centralised databank between banks, insurers, and credit rating companies to avoid bad risk, similar to the credit information bureaus licensed by the Reserve Bank of India for the banking business.
Unless the Government provides some back-end support, insurers may prefer to cater only to the high premium clients, and MSMEs may not benefit.
In an effort to make progress, the Indian Minister for Road Transport recently met with key insurers to understand their concerns, which have been communicated back to the regulator.
Making changes to the Insolvency and Bankruptcy Code will not be a simple exercise, but there is hope for some simple tweaks to the Guidelines. For insurers, it is now a case of wait-and-see. Without a viable operating framework, surety in India is on a road to nowhere. If appropriate change is made, it has the potential to drive rapid growth and prosperity.