By Aditya Sharma, Head – Chief Distribution Officer – Retail Sales, Bajaj Allianz General Insurance
India, with its growing economy and expanding population, is poised to become the world’s third-largest construction and Infrastructure market. This surge in infrastructure development is expected to necessitate a staggering US $1.5 trillion in investments over the next decade. Surety insurance is a financial instrument that
ensures the work starts on time for these projects and protects all stakeholders involved.
In recognition of this, the IRDAI took the initiative to open the country's surety bond insurance market for the first time. This move is expected to significantly address the enormous amount of infrastructure cover needed in the coming years. The construction industry alone offered Bank Guarantees (BGs) of Rs. 1.70 Lakh Crores in 2019, and this figure is projected to grow to Rs. 3 Lakh Crores by 2030. Surety insurance has a huge role to play in India’s infrastructural development.
So, what exactly are Surety Bonds?
Surety Bond Insurance acts as a risk transfer mechanism and is an alternative arrangement to Bank Guarantee, protecting the project owner from potential losses if the contractor fails to fulfil their contractual obligations.
Surety Insurance acts as a financial safety net in three-party transactions. It involves –
- a principal (often a project owner),
- a contractor (responsible for completing the project), and
- a surety provider (typically an insurance company / Banks).
In simpler terms, the surety company steps in and assumes financial responsibility if the contractor defaults on the project.
Consider an example: Imagine a city planning to build a new bridge over a river to improve traffic flow and connectivity. The city council hires a construction company, XYZ Builders, to undertake this major infrastructure project. To ensure the project is completed as per the agreed terms and quality standards, the city requires XYZ
Builders to obtain a surety bond before commencing work.
This bond guarantees that if the contractor fails to fulfil their obligations, such as completing the project on time or up to the agreed standards, the surety company will step in to compensate you for any financial losses incurred as a result. In this way, the surety bond provides you with assurance and financial protection throughout the project development process.
The surety company assesses the contractor's qualifications and sets a bond amount. If the contractor fails to uphold the agreement, for instance, by doing poor-quality work or not finishing the job, you (the obligee) can file a claim with the surety company. They will then investigate and, if valid, compensate you for the financial loss up to the bond amount. This could involve finding another contractor to complete the project or reimbursing you for repairs.
Surety Bond Insurance serves a dual purpose: ensuring legal compliance and guaranteeing contract fulfilment. Upon paying a valid claim, the insurance company has the right to seek reimbursement (subrogation) from the contractor for the covered losses.
Moreover, Surety bonds are recognised as one of the most cost-effective ways for contractors to secure contract
obligations. This translates to several advantages for contractors:
- Alternative to bank guarantees: Surety bonds serve as a viable alternative to bank guarantees, offering similar financial security for project owners while ensuring timely execution, reduced procedural time, cost-effectiveness, and minimal formalities.
- Access to working capital: Contractors can retain their own funds by utilising surety bonds. This allows them to bid on more tenders and contracts, enhancing their business prospects.
- Preserved credit lines: Surety bonds don't tie up a contractor's bank credit limits, freeing up those lines for essential purposes such as working capital or financing expansion plans.
Having grasped the importance of surety bond insurance, it's time to delve into the various types of surety bonds. Knowing the different options available will enable you to choose the one that aligns with your particular requirements.
- Bid Bonds – Purpose: Assure the project owner that the bidder will honour their bid and will execute the contract at the bid price if awarded.
Example: Scenario: A construction company bids on a government project to build a new school.
Function: The bid bond guarantees that if the company wins the bid, they will enter into the contract and provide the required performance and payment bonds. If the company fails to do so, the project owner can claim against the bid bond to cover the cost difference of awarding the contract to the next lowest bidder.
2. Performance Bonds – Purpose: Guarantee that the contractor will perform the work according to the terms of the contract.
Example: Scenario: A contractor is hired to build a bridge.
Function: The performance bond ensures that the contractor completes the project as specified in the contract. If the contractor defaults or performs poorly, the project owner can claim against the bond to hire another contractor to complete the work or to cover the costs of correcting any deficiencies.
3. Payment Bonds – Purpose: Ensure that the contractor will pay subcontractors, labourers, and suppliers as per the agreement.
Example: Scenario: A general contractor is overseeing a large commercial building project.
Function: The payment bond guarantees that all subcontractors and suppliers will be paid for their work and materials. If the general contractor fails to make these payments, the subcontractors and suppliers can make a claim against the bond to receive their due payments.
4. Maintenance Bond – Purpose: Provide coverage for a specified period after project completion to address any defects or issues that arise.
Example: Scenario: After completing a highway project, the contractor provides a maintenance bond.
Function: The maintenance bond guarantees that any defects in workmanship or materials discovered within the specified maintenance period (e.g., one year after completion) will be repaired at no additional cost to the project owner. If the contractor fails to address these issues, the project owner can claim against the bond to cover the costs of necessary repairs.
Now that we are well-versed in the various types of Surety Bond Insurance, we understand how the Premium calculation is done.
How is the Premium Calculated?
The premium for a surety bond is typically a small percentage of the total bond amount. It is influenced by several factors, including:
- Contractor’s financial health: Strong financial statements and credit history can lower the premium.
- Project complexity and risk: Higher-risk projects or those with complex requirements may attract higher premiums.
- Bond amount: Larger bond amounts usually have lower rates due to the scale but higher absolute premiums, with tenors typically ranging from 12 to 36 months in the context of surety bonds.
- Experience and track record: Contractors with a proven history of successful project completions may receive lower premiums.
Let us now understand the tenure of Surety Bond Insurance –
The tenure of a surety bond varies based on the project duration and specific contractual requirements. Typically, the bond is effective for the duration of the project plus an additional period to cover potential claims, which might be a year or more post-completion. This ensures that any latent defects or performance issues arising shortly after project completion are also covered. Maximum bond tenure is 60 months (including contract, maintenance period and extensions) or based on the contract bond, whichever is lower.
Having reviewed the specifics of surety bond insurance, remember that it is an unconditional bond that ensures the contractor cannot dispute or reject any terms and conditions outlined in the agreement. This type of bond provides security and assurance to project owners, ensuring that the contractor adheres to the agreed-upon standards and deadlines.
Conclusion
Surety insurance is still a relatively new concept in India, and its full potential is yet to be discovered. As the market matures and regulations evolve, we can expect to see a broader range of surety products catering to diverse project needs. Increased awareness and education among stakeholders will further drive adoption. Surety
insurance holds immense promise for fostering a more secure and efficient infrastructure development in India. It can bring a brighter infrastructural future by mitigating risks and ensuring financial accountability.
