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Draft surety guidelines: Ushering in new era in Indian construction risk underwriting

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IRDA, the Indian insurance regulator issued the draft surety insurance contracts guidelines on September 8. IRDA had earlier set up a working group last year to explore the feasibility of Indian insurance companies offering surety products.

Draft surety guidelines: Ushering in new era in Indian construction risk underwriting
IRDA, the Indian insurance regulator issued the draft surety insurance contracts guidelines on September 8. IRDA had earlier set up a working group last year to explore the feasibility of Indian insurance companies offering surety products. The recommendations of the working group now form the basis of the draft guidelines issued by the IRDA.
As an introduction to the concept, a surety bond is a risk transfer mechanism where the surety company assures the project owner that the contractor will perform a contract in accordance with the contract documents. Through a surety bond, the surety agrees to uphold, for the benefit of the obligee—the contractual obligations made by the principal. In the event of a default and the subsequent invocation of the guarantee, the surety will pay and then turn to the principal for reimbursement of the amount paid on the default plus any legal fees incurred. Surety bonds are a prevalent concept in many parts of the world and are also mandated by law on public works projects
The introduction of surety bonds in India has been a long-standing demand from the construction and the infrastructure industry. The issuance of the draft guidelines and invitation of suggestions from the stakeholders is a welcome giant step towards formalising the availability of surety bonds for infrastructure projects. Surety Bonds help impart efficiency to the management of working capital and collaterals and the guidelines once approved will help address the woes of the construction & infrastructure companies with respect to bank guarantees.
The draft guidelines are well thought out and address most of the aspects of surety underwriting in India. The draft also lays down the guiding principle of surety underwriting principle with respect to the accumulation of risks, retention on the surety’s balance sheet, aggregation risks, group-level exposures etc. By barring the issuance of guarantees on behalf of the surety co’s promoters, their subsidiaries, groups, associates and related parties, the regulator has ensured prudent practices and an arm’s length distance between entities belonging to the same group. The guidelines provide for preference being given to applicants whose promoters are already engaged in carrying out surety insurance business in any jurisdiction. This should encourage global entities to set up/invest in surety insurance companies in India thus bringing in much-valued surety expertise into the country.
As a strong proponent of the concept of sureties in India, we would like to extend our heartiest congratulations to the members of the working group and to the authors of the draft guidelines for having drafted such a comprehensive document. It is never easy introducing a new concept in a country as large and diverse as ours specially without the availability of surety related expertise within the country.
Having said the above, we do have a wish list that we would ideally like to see as part of the guidelines when they are eventually approved by the regulators
  • The draft guidelines stipulates that any entity intending to commence the surety insurance business should be an Indian insurance company registered with the IRDA. It also provides for registration of an insurer as a specialized monoline insurance company for surety insurance and credit insurance business. The regulations require an initial paid-up capital requirement of Rs 100 crore which is equivalent to that of a full-fledged General Insurance Company undertaking multiple lines of business. This may act as a deterrent for new registrations since a larger capital requirement will bring in additional cost associated with such capital. Since the specialized/monoline Surety Insurance Companies will be restricted to surety and credit insurance only, the capital requirement for setting up a Surety Insurance company should be reduced from Rs 100 crore to Rs 50 crore.
  • The basis of surety underwriting is the notion of zero-loss underwriting - “This essentially means that the underwriting decision for a bond is based on the conviction that the underlying obligation will certainly be fulfilled. If, however should the principal default and the surety is required to pay upon the invocation of the guarantee, the surety has to be assured of a full recourse against the principal. As such, the guidelines should ideally spell out with clarity the recourse available to the surety. How will the surety be treated under the other regulations such as the IBC & SARFAESI? Will a surety be considered as an operational or a financial creditor? Will it have the right to file for insolvency against a defaulting contractor? Clarity on these issues will help spur investments in creating capacities for surety insurance underwriting.
  • The guidelines also do not provide for the rating of the reinsurance partner. The report of the working group had suggested the minimum required rating for reinsurers as S&P A. This is one notch higher than the commonly accepted international practice for reinsurance rating requirement of S&P A- or A3 by Moody’s. This is while the Indian reinsurer GIC RE has a credit rating of B++ by AM Best. The role of reinsurance capacity has to be explicitly laid out as well. While the report of the working group had a mention of relief in providing for capital to the extent reinsured, the draft guidelines is silent on this aspect. This is important since the amount of cession and the rating of the reinsurer will play a large role in the amount of the capital to be provided for. Else, we may risk the same situation as EU-sureties have with EU-judicial bonds. The Directorate-General concerned failed to mention the role of reinsurance capacity when deciding of the size of bond lines as accepted by the EU. As a result, reinsurance is not considered and bonds are hardly being issued to EU authorities for this risk category.
  • Sureties today are being introduced to ease the bank guarantee woes of the contracting community. Bank guarantees are unconditional on call documents. Surety bonds can be worded in a manner that can make it either conditional or an on-call instrument. India has traditionally been an unconditional guarantee market. While project owners would prefer an on-call instrument, the contractors for obvious reasons would like a conditional guarantee. Additional clarity will be extremely welcome.
  • The draft guidelines provide for sureties to work along with other financial institutions to share risk, technical expertise while underwriting large projects. A new concept such as sureties will need such support from the existing ecosystem. This will also help mitigate any systemic risk to businesses. However, this might also give rise to a situation with a potential conflict of interest and will probably work very well only as long as the financial state of the contractor/obligor is in good standing. Once the financial condition of the contractor starts deteriorating, the bank may have interests that are divergent from that of the surety. In order to ensure adequate protection of the rights of the surety, the surety company’s rights should rank parri- passu with that of the bankers. Something on the lines of the rights of a member of a lending consortium
  • India has the potential of being one of the largest surety markets globally. Many global surety giants have often evinced interest in participating in Indian construction risks.  We believe that clarity on the above will help increase participation from a larger number of players, create an appropriate mechanism for contract enforcement while at the same time fostering an enabling environment for the surety insurance industry.
    The author, Vikash Khandelwal, is CEO at Eqaro Guarantees. The views expressed are personal
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