Surety Bonds

Context:

In the Budget 2022-23, the government has allowed the use of surety insurance bonds as a substitute for bank guarantees in case of government procurement and also for gold imports.

What is Surety Bond?

• Surety Bond is a three-party agreement that legally binds together a principal who needs the bond, an obligee who requires the bond and a surety company that sells the bond.
• Surety bonds provide financial guarantee that contracts will be completed according to predefined and mutual terms.
• Surety bond is provided by the insurance company on behalf of the contractor to the entity which is awarding the project. When a principal breaks a bond’s terms, the harmed party can make a claim on the bond to recover losses.
• It can effectively replace the system of bank guarantee issued by banks for projects and help reduce risks due to cost overrun, project delays and poor contract performance
• Surety bonds are mainly aimed at infrastructure development, mainly to reduce indirect cost for suppliers and work-contractors thereby diversifying their options and acting as a substitute for bank guarantee.
• Currently, Surety Bond for contractors is not being offered by insurance companies in the market to guarantee satisfactory completion of a project by a contractor and provide performance security to various government agencies

How surety bonds will work?

• A surety bond is provided by the insurance company on behalf of the contractor to the entity, which is awarding the project.
• When a principal breaks a bond’s terms, the harmed party can make a claim on the bond to recover losses.
• It can effectively replace the system of bank guarantee, issued by banks for projects, and help reduce risks due to cost overrun, project delays and poor contract performance.

Types of surety bonds

There are two broad categories of surety bonds:

• Contract surety bonds; and
• Commercial (also called miscellaneous) surety bonds.

Contract surety bonds

• Contract surety bonds are those surety bonds that are written for construction projects.

How it works?

• A project owner (the obligee) seeks a contractor (the principal) to fulfil a contract.
• The contractor, through a surety bond producer, obtains a surety bond from a surety company.
• If the contractor defaults, the surety company is obligated to find another contractor to complete the contract or compensate the project owner for the financial loss incurred.

Types of Contract Surety bonds

There are four types of contract surety bonds

• Bid Bond: It provides financial protection to the owner if a bidder is awarded a contract but fails to sign the contract or provide the required performance and payment bonds.
• Performance Bond: It provides an owner with a guarantee that, in the event of a contractor’s default, the surety will complete or cause to be completed the contract.
• Payment Bond: It ensures that certain subcontractors and suppliers will be paid for labor and materials incorporated into a construction contract.
• Warranty Bond (also called a Maintenance Bond): It guarantees the owner that any workmanship and material defects found in the original construction will be repaired during the warranty period.

Why India Needs Surety Insurance Bond?

• India has unveiled a plan to spend Rs 5 lakh crore on building roads infra in the next three years.
• Yet, the sector is prone to delays and cost overruns. Bad loan fears dissuade banks from providing guarantees to private contractors that bid for projects.
• Surety bonds are prevalent in the developed markets. In the U.S., the law mandates surety for every public project.
• Canada, European nations, Australia and New Zealand also offer such guarantees.

What are the issues with the Decision taken in the Budget?

• Surety bonds, a new concept, are risky and insurance companies in India are yet to achieve expertise in risk assessment in such business.
• Also, there’s no clarity on pricing, the recourse available against defaulting contractors and reinsurance options.
  • These are critical and may impede the creation of surety-related expertise and capacities and eventually deter insurers from writing this class of business.

How can it boost the Infra Project?

• The move to frame rules for surety contracts will help address the large liquidity and funding requirements of the infrastructure sector.
• It will create a level-playing field for large, mid and small contractors.
• The Surety insurance business will assist in developing an alternative to bank guarantees for construction projects.
  • This shall enable the efficient use of working capital and reduce the requirement of collateral to be provided by construction companies.
• Insurers shall work together with financial institutions to share risk information.
  • Hence, this shall assist in releasing liquidity in infrastructure space without compromising on risk aspects.

What are the IRDAI Guidelines on Surety Bonds?

• According to new guidelines Insurance companies can launch the much-anticipated surety bonds now.
• The regulator has said the premium charged for all surety insurance policies underwritten in a financial year, including all installments due in subsequent years for those policies, should not exceed 10% of the total gross written premium of that year, subject to a maximum of Rs 500 crore.
• As per Insurance Regulatory and Development Authority of India (IRDAI), Insurers can issue contract bonds, which provide assurance to the public entity, developers, subcontractors and suppliers that the contractor will fulfil its contractual obligation when undertaking the project.
  • Contract bonds may include: Bid Bonds, Performance Bonds, Advance Payment Bonds and Retention Money.
    • Bid Bonds: It provides financial protection to an obligee if a bidder is awarded a contract pursuant to the bid documents, but fails to sign the contract and provide any required performance and payment bonds.
    • Performance Bond: It provides assurance that the obligee will be protected if the principal or contractor fails to perform the bonded contract. If the obligee declares the principal or contractor as being in default and terminates the contract, it can call on the Surety to meet the Surety’s obligations under the bond.
    • Advance Payment Bond: It is a promise by the Surety provider to pay the outstanding balance of the advance payment in case the contractor fails to complete the contract as per specifications or fails to adhere to the scope of the contract.
    • Retention Money: It is a part of the amount payable to the contractor, which is retained and payable at the end after successful completion of the contrac.
• The limit of guarantee should not exceed 30% of the contract value.
• Surety Insurance contracts should be issued only to specific projects and not clubbed for multiple projects.

Source: Indian Express

You can find many articles on ECONOMY (part of GS III) in our website. Go through these articles share with your friends and post your views in comment section.