Why infra projects need surety bonds

For a few years now, one of the key stress points in the construction and infrastructure sector has been bank guarantees (BGs). With the known deterioration of the balance sheets of contractors and associated service providers, such as consulting engineers, or operation and maintenance providers, coaxing banks to issue a BG to the project owner assuring that the service provider concerned will meet all obligations has become a serious bottleneck.

This has often led to service providers struggling with BG limit availability and liquidity requirements for margins. For the uninitiated, a Rs 100 BG will typically require a Rs 10 cash-down, often as a fixed deposit parked with the issuing bank. Sometimes, the stress on this account has led to contractors abandoning the pursuit of new projects altogether; which is hardly what India needs right now.

Project owners such as the National Highways Authority of India, and similar Central and state entities, impose strict conditions on bidders for projects, requiring them to provide BGs as security for their bids as well as performance over the longer term. Currently, projects worth around Rs 6 trillion are being executed in the highways sector alone, and BG requirements can be as high as 20 per cent of this amount. Banks are the mainstay of such BG issuance. There is growing concern over the commissions and costs of such financing, the extent of cash margins being asked for, and other conditions being imposed by banks for sanctioning BGs. In many cases, existing BG limits have been fully utilised and banks are refusing to increase them, even if business growth demands it. Sometimes, banks even ask for 100 per cent margin money before providing a guarantee. Relief could be on the way from the insurance industry through an instrument known as surety bonds.

A working group of the insurance regulator, the Insurance Regulatory and Development Authority of India (IRDAI), has recently circulated a working paper broadly aligning with the idea of surety bonds being issued by insurance companies, which could act as a replacement for BGs. Surety bonds are a tripartite agreement signed between an insurer, a contractor and a project owner, which guarantees the performance of the contractor.

How are surety bonds different from BGs?

One, they are more unsecured than BGs and are provided largely on the basis of the contractor’s track record and financial health, whereas BGs typically require a modicum of tangible security. Two, surety bonds tend to be in force for the life of the project, while BGs have to be renewed periodically. Three, and most importantly, BGs are unconditional and payable on demand, whereas surety bonds are like an insurance policy — when a claim is made, the insurer examines the claim and pays out if the claim is valid. This point addresses the increasing caseload of encashment of BGs for unsubstantiated, and unprofessional reasons. Finally, an advantage of surety bonds over BGs is that the credit limits with banks remain untouched; thus, enlarging the extent of financing available for other needs.

Globally, surety bonds are a big business. According to a report by Aon, the financial services firm, the global contract surety market was worth $6.5 billion in terms of premiums in 2018. In the United States, for example, an Act called the Miller Act, a federal law, makes it mandatory to obtain a payment and performance bond while bidding for public works projects above a certain amount. As a result of this Act, surety bonds have edged out BGs in the US to the extent that the latter are not used as a tool to provide performance guarantees in public works projects. In other markets, such as Brazil and Mexico, both types of products are available.

The working group report of IRDAI acknowledges that even if surety bonds are introduced in India, they will take time to take off. Much work still needs to be done. The legal framework for surety bonds in the country is undeveloped and needs to be expeditiously worked upon.

The issue of surety bonds may seem a narrow, technical one, but it should lead to a broader understanding of the kind of entities that provide infrastructure financing in this country. Global pension funds and private equity funds, with an eye to longer-term and more stable returns have made an entry in the Indian market, but they comprise a small part of the business. The bulk of the funding still has to be domestic — and with banks turning their backs on the sector, the only entities with long-term financial heft and expertise are insurance companies.

The biggest benefit of the proposed surety bonds may have less to do with substituting BGs than ensuring that insurance companies play a much bigger role in infra financing in India.

The writer is the chairman of Feedback Infra