Surety bonds: Slow take-off likely as pricing, reinsurance concerns remain

The insurance sector is yet to achieve expertise on risk assessment of suppliers and work contractors and there’s no clarity on pricing, the recourse available against defaulting contractors and reinsurance options, experts said.

While insurance regulator IRDAI has given the framework for issue of surety bonds by insurance companies, insurance experts said the guidelines are silent on the right of recourse available to a surety insurance company in the event of a default by the contractor. “These are critical and may impede the creation of surety-related expertise and capacities and eventually deter insurers from writing this class of business,” said an insurance sector official.

In the Budget speech, Finance Minister Nirmala Sitharaman said the use of surety bonds as a substitute for bank guarantee will be made acceptable in government procurements to reduce indirect cost for suppliers and work-contractors. Business such as gold imports may also find this useful, she said.

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Insurance experts said surety bonds, a new concept, are risky and insurance companies in India are yet to achieve expertise in risk assessment in such business. There’s no clarity whether surety bonds will get the required reinsurance support.

According to KK Srinivasan, former Member, IRDAI, these types of bonds are enormously risky and have the potential to sink reckless insurers. “And insurers are often blindly top line growth oriented. The risk to PSU insurers, whose ability to do cherry picking is relatively limited, is even more. To believe that reinsurers will provide cushion to this bad class of business is naive,” Srinivasan said.

“Banks which had expertise on credit risks were swamped by NPAs. Insurers here are light -years away from building expertise in assessing the type of risks that these bonds entail,” Srinivasan said.

As surety bonds is an entirely new line of business, insurance companies would need clarity on various aspects such as pricing, the recourse available against defaulting contractors, reinsurance options and global best practices.  “As an industry, we would urge the regulatory bodies to facilitate changes to laws such as the Indian Contract Act and the IBC and bring surety bonds on par with bank guarantees regarding recourse available to issuers. This will help the industry approach surety solutions with much more confidence, but it will be even more a viable proposition for all stakeholders,” said Bhargav Dasgupta, MD & CEO, ICICI Lombard General Insurance.

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. “With these surety bonds, I believe initial project cost will slightly reduce and the overall project viability will improve,” said Tapan Singhel, MD & CEO, Bajaj Allianz General Insurance.

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, experts say.

IRDAI said in the guidelines for surety bonds that the premium charged for all surety insurance policies underwritten in a financial year, including all instalments due in subsequent years for those policies, should not exceed 10 per cent of the total gross written premium of that year, subject to a maximum of Rs 500 crore.

The limit of guarantee should not exceed 30 per cent of the contract value. Surety Insurance contracts should be issued only to specific projects and not clubbed for multiple projects.

Covid-19 has impacted the surety market globally as construction companies were hit by the pandemic.