The Union Budget 2022-23 announced various incentives for the insurance industry as well as small businesses and MSME contractors. Finance Minister Sitharaman announced in her speech on February 1 that surety bonds will be used in government procurements in place of bank guarantees and a framework for these has been released by IRDAI (Insurance Regulatory and Development Authority of India).
This is welcome news not just for insurance companies but also for a large section of MSME units including small suppliers and work contractors who can reduce their indirect costs and save precious working capital.
Bank guarantees, which need a security deposit, collateral and working money, block a huge amount of working capital of the contractors and businesses. This makes them unable to take on multiple projects. On the other hand, surety bonds do not need any collateral and thus are relatively cheaper for MSMEs.
Let us first take a look at what do surety bonds mean, what are the advantages of surety bonds and a quick comparison between bank guarantees and surety bonds.
What are Surety Bonds?
Most people do not have any idea what a surety bond is until they are asked to furnish surety bonds for a contract or a government project.
A surety bond is essentially a contract between 3 parties - the surety, the principal and the obligee. It is a written agreement between these three parties in which the surety financially guarantees to the obligee that the principal will perform the obligations of the bond.
Surety (or guarantor) - Entity that gives guarantee in case of default of bond terms (insurance companies/banks)
Principal - Entity that purchases the bond and promises to perform an obligation (businessperson, supplier or contractor)
Obligee - Entity requiring the bond, usually the government
In simple words, the surety guarantees to the obligee that the principal will perform according to the terms of the bond, in return for payment of premium by the principal.
How do Surety Bonds work?
- The principal (such as businesses or contractors) purchases the bond from surety to guarantee that they will perform certain tasks.
- The government organizations or the obligee require these bonds in case of any financial loss.
- The government needs assurity that the principal will be able to fulfill their obligations.
- The company acting as surety agrees to bear the financial risk and provides payment in case of default.
Surety Bonds vs Bank Guarantees
How are Surety Bonds different from Bank Guarantees? Let’s take a look at the features of both Surety Bonds and Bank Guarantees.
Advantages of Surety Bonds
What are the advantages of Surety Bonds over Bank Guarantees? Here are some of the key benefits of surety bonds -
- Bank Guarantees lock up nearly 20 percent of working capital funds.
- With Surety bonds acting as a substitute for the bank guarantee, it will free up about ₹8 lakh crore of private sector funds
- Improved liquidity and release of collateral
- Access to increased project opportunities
- Better execution of projects
- Reduced defaults in contracts between suppliers/contractors and project owners
- Increase in private investments
- Improved overall performance of projects
- Diversified risks as insurance bodies act as an alternative to banks
- A new stream of revenue and capital to insurance companies
- May attract FDI in the insurance sector
According to Sitharaman, businesses such as gold imports may also find surety bonds useful.
In the last few years, corporations in the infrastructure sector were facing issues in getting bank guarantees and had to pay high premiums for the same.
The insurance regulatory body IRDAI had come up with guidelines on these surety contracts which laid down the norms for this business. IRDAI has put a cap on the quantum of surety insurance contracts at 10% gross premium for an insurer subject to a maximum of ₹500 crores per year. Moreover, the limit of guarantee cannot exceed 30 percent of the contract value.
The insurers have been allowed to issue the following bonds - advance payment bond, bid bond, contract bond, customs and court bond, performance bond and retention money.
These rules are expected to be implemented from April 1, 2022.