The past three union budgets have demonstrated a strong commitment to augmenting investments in the infrastructure sector. For instance, the capex of Rs 10 trillion in 2023-24 represents a 33 per cent increase from the budgeted expenditure of Rs 7.5 trillion in 2022-23 and a twofold increase over the actual expenditure of Rs 4.26 trillion in 2020-21. In addition to increased investments and a greater focus on green initiatives, inclusive development and improved connectivity, the government has ensured that India is well positioned to leverage emerging opportunities such as surety bonds.
The infrastructure sector has long expressed a need for an alternative to bank guarantees (BGs) such as surety bonds, which support India’s pro-business agenda. Further, this tripartite agreement between the principal (the one who demands the bond), the contractor (an obligee to the bond) and the insurance company (issuer of the bond) provides financial stability and a sense of security to individuals who are willing undertake higher risks.
The proactive adoption of these instruments could be a crucial reform for the Indian economy, as it may help India reach its goal of becoming a $5 trillion economy by 2025 and meet its infrastructure targets across sectors.
Mapping the evolution
In November 2022, the Federation of Indian Micro and Small and Medium Enterprises made a formal proposal for the introduction of surety bonds in order to enhance inclusivity in public procurement processes and facilitate the growth of micro, small and medium enterprises (MSMEs) by removing capital constraints. Furthermore, these instruments have the potential to enhance competition among MSMEs and put Indian businesses on par with advanced economies.
The credit gap for MSMEs has been a critical issue, with access to bank facilities being a persistent challenge. In addition, MSMEs are unable to take advantage of the 25 per cent purchase preference designated for them in central and state government purchases due to provisions such as the need for collateral and the required payment of 10-30 per cent margin money.
Surety bonds enhance liquidity within the infrastructure sector by freeing up the contractors’ working capital that is tied up in BGs. Banks typically aim to secure a cash margin of 30-50 per cent from smaller construction companies. The premiums associated with surety bonds are anticipated to be lower to make the product affordable. Besides greater liquidity, the industry stands to benefit from wider access to project opportunities and the release of collaterals. Project owners may also benefit from the participation of more proficient contractors, adherence to project execution protocols, and consequently, a decrease in contractor defaults. Most importantly, an improvement in the overall industry metrics may also start attracting additional private investments.
Since their launch, surety bonds seem to have been a non-starter due to technical and financial impediments. Despite the issuance of these bonds by SBI General Insurance Company Limited, New India Assurance Company Limited and Bajaj Allianz General Insurance Company Limited, the market has not progressed. Furthermore, there has been limited uptake in the infrastructure sector, the primary demand driver for these instruments.
The lack of interest in these products can be attributed to operational issues, delays in policy changes, and the absence of standardised processes (with various insurers employing various approaches), which can make navigating the market challenging for contractors.
In contrast to BGs, these products must be profitable for clients to encourage uptake and better initiatives. The currently available products, which are primarily based on performance, bids and maintenance, leave much room for improvement. They are often conditional, seek collateral, require hefty documentation, and entail more complicated claims processing compared to invoking a BG.
Despite being formally accepted as a substitute for BGs in government procurement, surety bonds offer minimal benefits in their current form. Furthermore, insurance companies have been demanding a large amount of information, including contractors’ experience, credit ratings and financial stability, especially in cases involving litigation, thereby increasing hindrances for customers.
Call for action
According to the Insurance Regulatory and Development Authority (IRDAI), India will need over Rs 100 trillion for infrastructure development over the National Infrastructure Pipeline timeline. This requires BGs amounting to around Rs 90 trillion in the next five years, a capacity that banks currently lack. Here, surety bonds can serve as a complementary solution to BGs.
In an effort of address the market stagnation, the Ministry for Road Transport and Highways has requested the insurance regulator, IRDAI, to collaborate with general insurers in developing a model with a few basic features. This would kick-start the launch, allowing insurers to further improve the product as per their capabilities and with reinsurance backing.
The IRDAI recently announced guidelines pertaining to surety bonds, aimed at creating a fair and transparent issuance process. The guidelines cover a diverse range of subjects, such as the eligibility for issuance of the bonds, the terms and conditions governing them, the criteria used for evaluating them and the pricing. Further, under these terms, it is imperative for the guarantor to be financially capable of meeting its obligation and for the surety bond premium to be reasonable in relation to associated risks.
Moreover, circulars dated January 2023 and May 2023 have included some revised guidelines, which have eliminated restrictions on businesses requiring underwriting by insurance companies, relaxed solvency margin prerequisites, allowed insurance coverage for commercial and contractual surety, and eliminated the guarantee cap, all with the objective of stimulating the surety insurance bond market.
The National Highways Authority of India (NHAI) has also been encouraging insurance companies and contractors to consider opting for insurance surety bonds as a complementary method for submitting bid security and performance security deposits for projects. These bonds will be cost-effective and provide significant security for NHAI road projects.
The way forward
India currently lacks the depth of a well-established surety bond market but exhibits strong potential for growth. Overcoming current market issues and creating a well-regulated and accessible surety bond market is critical to India’s economic development. In addition, the intermittent global recessionary patterns make it crucial for India to prioritise infrastructure creation by utilising risk management tools, enhancing expenditure and generating employment opportunities.
Going forward, the need for surety bonds is also likely to increase as India continues to focus on infrastructure development, especially through public-private partnerships. The IRDAI’s recent relaxations and the government’s decision to permit the issuance of surety bonds retrospectively, instead of specific infrastructure BGs, are expected to create new opportunities for insurers looking to issue these bonds. The current market participants are optimistic that alongside the implementation of policy modifications and the establishment of streamlined approaches, surety bond products will evolve over time, attracting new insurers into the market. Moreover, there is a considerable market segment that can be targeted, with an expected increase in demand from contractual projects and the ability to charge higher premiums in exchange for increased exposure.