The worldwide surge in financial activities over the past decade or so has led to increased popularity of instruments such as surety bonds and other forms of guarantees as creditors/owners increasingly look to rely upon these kinds of risk management mechanisms for certainty in the performance and fulfilment of the other party's contractual obligations. These surety bonds/guarantees are, typically, offered by various global surety companies. The last few years have witnessed a rise in demand for such instruments particularly in the construction sector and in relation to other infrastructure and engineering projects, often as a pre-condition to the contract being executed.
In general terms, a surety bond is a contract, in which a surety provider or an Insurance Company provides a guarantee to an obligee or beneficiary that the principal or debtor will meet its contractual obligations or that a monetary compensation is paid to such obligee, if the principal fails to deliver on its promise. In the absence of specific sectoral norms, surety bonds are broadly governed by the principles contained in §126 - §147 of the Indian Contract Act 1872 ("ICA") which expressly recognise contracts of guarantee, a term often used interchangeably with "surety".
Surety Offerings in India
So far in India, provision of guarantees has predominantly been in the form of 'bank guarantees' issued by Indian banks, and other financial guarantees, in accordance with the norms prescribed by the Reserve Bank of India1.
While surety bonds are widely provided by Insurance Companies in many countries as an alternative to bank guarantees, it was so far unclear whether Indian Insurance Companies were permitted to issue such bonds, since there were no surety products approved for distribution under the regulatory framework.
However certain developments2 over the last few years, including communications to the IRDAI from the Department of Financial Services in 2016 to explore the possibility of introducing surety bonds in favour of Central Board of Indirect Taxes and Customs (CBIC), and from the Ministry of Road Transport and Highways (MORTH), Government of India in 2020 to examine possible offering of surety bonds by General Insurance Companies due to the cash flow issues in the Indian banking sector as a consequence of the COVID 19 pandemic, appear to have been instrumental in the IRDAI considering a regulatory framework to govern the issuance of surety bonds by Indian Insurance Companies.
The IRDAI had constituted a working group ("WG") on 1 July 2020 to study the suitability of Indian Insurance Companies (Non-life) offering surety bonds in India in order "to guarantee satisfactory completion of a project by a contractor and providing performance security to various government agencies". The WG report was issued on 30 September 2020, and in addition to providing certain recommendations, also clarified that the WG viewed surety bonds as an alternative to financial guarantees such as bank guarantees, and while a "Surety Bond refers to the performance or delivery obligations to complete the insured project, [a financial guarantee] refers to financial obligations to repay the debts or loans"3.
Following the recommendations made in the WG's report of 30 September 2020, the IRDAI has recently issued the "Exposure Draft on IRDAI (Surety Insurance Contracts) Guidelines 2021" of 8 September 2021 (Draft Guidelines) with the objective of promoting and regulating surety insurance business in India. A few key points from the Draft Guidelines, as proposed, are as follows:
- From the date that the final guidelines are notified, surety insurance business can be written in India only by a General Insurance Company registered with the IRDAI or a new category of specialised/monoline Insurer that will have a limited registration to write surety insurance and trade credit insurance. In terms of registering new Insurance Companies to write surety insurance in India, the Draft Guidelines underline the procedure to commence surety insurance business in India but clarify that preference will be given to applicants whose promoters are already carrying out surety insurance business in any jurisdiction.
- Surety insurance contracts will be tripartite contracts among: (i) the "principal debtor", (ii) the "creditor" or "obligee", and (iii) the "surety" or "Insurance company" which provides the performance guarantee.
- The Draft Guidelines allow surety insurance contracts to be offered to construction companies in India that cover road projects, housing/commercial buildings and other Government or Private infrastructure projects but surety insurance contracts shall be issued only to specific projects and not clubbed for multiple projects.
- Surety insurance products can be offered by registered Insurance Companies once they have been filed under the relevant Product Filing Guidelines specified by the IRDAI. However, surety insurance contracts cannot be issued for the credit enhancement of financial instruments, and alternate risk transfer mechanisms shall not be permitted. In addition, no single risk and/or aggregate risk can be written which is disproportionate to the capital of the Insurance Company.
- The Draft Guidelines recognise Advance Payment Bonds, Bid Bonds, Contract Bond, Customs and Court Bonds, Performance Bonds, Retention Money and Surety Insurance Contracts as types of surety contracts.
- The Draft Guidelines also prescribe specific operational requirements, including a Board approved underwriting philosophy, solvency margin, total gross written premium and risk assessment mechanism, for Insurance Companies undertaking surety insurance business.
The proposed framework appears to provide a much sought-after insurance product by various market players in India, particularly in the construction/projects sector, who, until now, had to resort to either bank guarantees (which involved certain collateralisation and commissions), or surety insurance offered by overseas insurance companies, post receipt of regulatory approvals.
The Draft Guidelines are yet to be implemented, and the IRDAI has sought comments and suggestions from stakeholders on the Draft Guidelines on or before 28 September 2021.
1. In this regard, guarantees issued by Indian banks are governed by the Foreign Exchange Management (Guarantees) Regulations 2000 and the RBI's Master Circular on "Guarantees and Co-acceptances" of 1 July 2015, which stipulates detailed guidelines on the manner of conducting guarantee business. As a general rule, the RBI guidance requires banks to "confine themselves to the provision of financial guarantees and exercise due caution with regard to performance guarantee business" (¶2.1.1 of the RBI Master Circular).
2. ¶1.31 (at p16) of the WG Report.
3. ¶1.8 (at p8) of the WG Report.
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