Surety offerings in insurance context
This article looks at how surety bonds are used in the insurance sector and how they are regulated in this context. Creditors and owners are becoming increasingly reliant upon these kinds of risk management mechanisms to ensure the performance and fulfilment of the other party's contractual obligations. These surety bonds and guarantees are, typically, offered by various global surety companies. The recent rise in demand for such instruments is particularly evident in the construction sector and in relation to other infrastructure and engineering projects, often as a pre-condition to the contracts being executed.
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 debtor will meet its contractual obligations or pay monetary compensation to the obligee if the principal fails to deliver on its promise.
In the absence of specific norms for the insurance sector, surety bonds are broadly governed by the principles contained in section 126 to section 147 of the Contract Act 1872, which expressly recognise contracts of guarantee, a term often used interchangeably with "surety".
Surety offerings in insurance context
While insurance companies in many countries commonly provide surety bonds as an alternative to bank guarantees, it has been unclear so far whether Indian insurance companies were ever permitted to issue such bonds, since no surety products are approved for distribution under the regulatory framework.
However, certain developments(1) over the past few years appear to have been instrumental in the Insurance Regulatory and Development Authority's (IRDAI) consideration of a regulatory framework to govern insurance companies' issuance of surety bonds. These developments include 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, and from the Ministry of Road Transport and Highways in 2020 to explore the possibility of general insurance companies offering surety to remedy pandemic-influenced cash flow issues in the banking sector.
On 1 July 2020, the IRDAI established a working group (WG) to study the suitability of non-life insurance companies 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 that 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".(2)
Following the recommendations made in the WG's report, the IRDAI issued the "Exposure Draft on IRDAI (Surety Insurance Contracts) Guidelines 2021" (the draft guidelines) on 8 September 2021 with the objective of promoting and regulating surety insurance business in India. A few key points proposed in the draft guidelines are:
- From the date that the final guidelines take effect, surety insurance business can be written only by a general insurance company registered with the IRDAI or a new category of specialised or monoline insurers that will have a limited registration to write surety 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:
- the principal debtor;
- the creditor or obligee; and
- 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. However, surety insurance contracts shall be issued only to specific projects and not combined for multiple projects.
- Registered insurance companies can offer surety insurance products 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 or aggregate risk can be written if it 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, a solvency margin, a total gross written premium and risk assessment mechanism for insurance companies undertaking surety insurance business.
The proposed framework appears to provide various market players with a much sought-after insurance product, particularly in the construction sector, which, until now, had to resort to either bank guarantees (which involved certain collateralisation and commissions) or surety insurance offered by overseas insurance companies following the receipt of regulatory approvals.
The draft guidelines are yet to be implemented and the IRDAI sought comments and suggestions from stakeholders by 28 September 2021.
For further information on this topic please contact Celia Jenkins or Anuj Bahukhandi at Tuli & Co by telephone (+91 11 2464 0906) or email ([email protected] or [email protected]). The Tuli & Co website can be accessed at www.tuli.biz.
(1) Paragraph 1(31) (page 16) of the WG report.