Private infrastructure investment, accounting for approximately one-fourth of the total infrastructure expenditure, is another significant factor driving growth.
With such large-scale projects, it is vital to ensure that qualified contractors are selected, project specifications are met, timelines are adhered to, and maintenance is planned. These factors demand significant time and resources, and project owners must be assured that contractors can fulfil their obligations.
To safeguard against unforeseen issues, legal protections are essential for ensuring project success and protecting investments. In 2022, IRDAI introduced surety bonds to strengthen infrastructure development in India by harnessing insurance companies’ financial capacity and resilience.
This initiative aims to provide crucial support for large-scale infrastructure projects, offering security and reducing risks for project owners while ensuring timely project completion.
Now, let’s understand more about it.
A surety insurance bond is a contract between the contractor (the principal debtor) and the surety (the insurance company), offering the project owner (the obligee) legal and financial assurance in case of any default by the contractor.
The insurance company, leveraging its underwriting expertise, assesses the contractor’s financial stability, technical competence, performance on past projects, paid-up capital, current liabilities, future cash flows, and numerous other factors before issuing a surety bond. This process essentially serves as a capacity analysis, ensuring that the contractor is equipped to complete the assigned project effectively.
Unlike a bank guarantee, a surety bond requires minimal collateral and instead involves the insurance company charging a fee (premium) for issuing the bond.
If the contractor defaults, the surety company compensates the project owner and then seeks reimbursement from the contractor through subrogation rights. This streamlined process saves the project owner valuable time and resources.
The types of surety bonds that provide guarantees in various phases of the Project:
1. Bid Bond: Ensures the contractor will begin the project if awarded the bid. If the contractor withdraws, the surety covers the owner’s losses.
2. Performance Bond: Guarantees the contractor completes the project as per contract terms. If they fail, the owner can claim compensation.
3. Advance Payment Bond: Protects the owner’s advance payments to the contractor. If the contractor defaults, the surety reimburses the advance.
4. Maintenance Bond: Ensures the contractor provides required maintenance after project completion. If they don’t, the owner can claim compensation.
Let’s see the Benefit of a surety bond for the parties involved:
1. The Principal (Owner): – a) Awarding a project to a contractor typically involves bidding. Contractors can bid at more competitive prices with surety bonds requiring minimal collateral and lower cash margins. This increases competition in the bidding process, helping reduce costs for the project owner.
b) Surety bonds are issued based on a thorough risk analysis of the contractor’s likelihood of default, providing the project owner with valuable assurance of the contractor’s capability to complete the project.
c) As an alternative to bank guarantees, surety bonds give the project owner more options for securing the contract. This flexibility allows the project owner to select a contractor offering the best value in terms of pricing and reliability.
2. Contractor: – a) Surety bonds help free up collateral that would otherwise be tied up in a bank guarantee, allowing the contractor to maintain greater liquidity for working capital. This, in turn, helps reduce the contractor’s debt burden.
b) By offering an alternative to bank guarantees, surety bonds empower contractors to secure projects without pledging collateral. This flexibility allows contractors to bid on more projects and expand their business operations, thereby increasing potential revenue and reducing the burden of debt.
Initiatives to foster surety bond for the insurance and infrastructure sector:
There are some initiatives to be implemented to support surety bonds as an essential risk management tool in infrastructure development.
1) Amendments to the legal framework are essential to granting insurance companies the same legal recourse as banks under the Insolvency and Bankruptcy Code. The right to indemnity for insurance companies is crucial for faster recovery. Currently, if an insurer needs to recover losses from a contractor in the event of a default, the insurer must sue the contractor, a process that can be time-consuming.
2) The development of a Bank-Surety syndicate is an innovative approach to supporting infrastructure development. This collaborative effort creates a robust project risk management tool, where both financial institutions (insurance companies and banks) combine their expertise. This collaboration allows both institutions to contribute their strengths, ensuring enhanced resilience and effective risk mitigation for infrastructure projects.
3) Effective data sharing among banks, the government, and insurance companies regarding the contractor’s past performance, completed projects, and the history of the project owner is crucial for understanding the nature of the parties involved. This collaborative approach will enhance underwriting processes when issuing surety bonds, ensuring more informed risk assessments and better decision-making.
In conclusion, Surety Bonds are transforming the infrastructure and construction sectors by offering a flexible and efficient alternative to traditional bank guarantees.
They provide financial protection to project owners while freeing up contractors’ resources, enabling them to focus on project execution and pursue new opportunities without liquidity constraints.
By diversifying the financial support landscape, we open the door to even more ambitious projects, fuelling a new era of infrastructure development.
This shift toward innovative financial solutions will unlock greater potential for ambitious projects, powering the growth of our economy and paving the way for a sustainable future.
(The author is MD and CEO, Bajaj Allianz General Insurance)
(: Recommendations, suggestions, views, and opinions given by experts are their own. These do not represent the views of the Economic Times)
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