The Role of Surety Bonds in India's Infrastructure Growth
Exploring the impact of surety bonds on India's infrastructure development and their potential to replace traditional bank guarantees.
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This week on Eximius Echo, we talk about the global rise of surety bonds and how India is beginning to embrace this trend, particularly in the infrastructure sector. Let's learn more about what surety bonds are, their historical significance, and their potential to reshape the future of infrastructure and real estate development in India.
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The global uptake of surety bonds has been impressive, and India is now beginning to embrace this trend, particularly within the infrastructure sector. Historically, liquidity requirements have posed significant challenges to infrastructure growth in India, stalling many ambitious projects. However, the introduction and increasing adoption of surety bonds are set to revolutionize this landscape.
But before that, let’s look at what they are
Surety bonds are a type of financial guarantee that involves three parties: the principal (the entity required to perform a contractual obligation), the obligee (the entity requiring the guarantee), and the surety (the party providing the financial guarantee). Essentially, surety bonds ensure that the principal will fulfil their obligations to the obligee, or the surety will step in to cover the costs and ensure the project is completed. These are a type of hybrid insurance plus loan bonds that are crucial in industries where performance and reliability are paramount, such as construction, real estate, and infrastructure development.
History of Surety Bonds Outside India
The concept of surety bonds dates back thousands of years, with some of the earliest examples found in ancient Mesopotamia and Rome, where parties used primitive forms of suretyship to guarantee contractual performance. In more modern times, surety bonds became formalised in the 19th century, particularly in the United States and Europe. The Miller Act of 1935 in the U.S. mandated the use of surety bonds for all federal construction projects, marking a significant milestone in the widespread adoption of these bonds. This legal framework ensured that contractors performing public work projects were bonded, thus protecting the public interest and maintaining project integrity.
In Europe, surety bonds have also been widely used, especially in the construction and real estate sectors. Countries like the UK and Germany have well-established markets for surety bonds, often utilised in large infrastructure projects to mitigate risks and enhance the credibility of contractors. The global surety market is to grow at 5.7% CAGR from $19 billion in 2024 to $26 billion in 2032.
Successful Case Studies Emerging In the USA
Jetty and Rhino in the USA are disrupting the rental market by offering alternatives to traditional security deposits through the innovative use of surety bonds and other financial products.
Jetty has raised $63.5 million and offers a range of products including deposit alternatives, flexible rent payments, renter's insurance, and credit-building tools. Utilising a tripartite surety bond arrangement, Jetty does not run credit checks, targeting the subprime market. They have agreements with property management companies managing 2.2 million units.
Rhino, with $177 million in funding, provides deposit products, digital cash deposits, renter's insurance, and lease guarantees, also through a tripartite surety bond model. Rhino conducts credit checks on tenants and has a strong presence in urban centres like New York. They cater to student and young professional housing, with their products available in 2 million homes and generating $102 million in annual gross written premiums as of August 2022.
Comparatively, all two companies use surety bonds to varying extents to provide deposit alternatives, with Jetty focusing on a broader product suite without credit checks, and Rhino emphasising digital solutions and credit checks.
Adoption in India Across Sectors
India's infrastructure and real estate sectors are gradually adopting surety bonds, moving away from traditional bank guarantees. This shift is driven by regulatory support and the recognition of the benefits offered by surety bonds.
Infrastructure: The infrastructure sector, characterised by large government projects, is increasingly using surety bonds. These bonds provide an alternative to bank guarantees, freeing up capital for contractors and enhancing liquidity. Government initiatives like the National Infrastructure Pipeline (NIP) are accelerating this adoption, reducing financial burdens on contractors and ensuring timely project completion.
Real Estate: In real estate, surety bonds help de-risk projects by guaranteeing timely completion and regulatory compliance, protecting buyers' investments. This is particularly important in a market plagued by delays and defaults. By adopting surety bonds, developers can improve their credibility and attract more investments, thereby gaining a competitive edge.
The Insurance Regulatory and Development Authority of India issued the IRDAI (Surety Insurance Contracts) Guidelines, 2022 (Surety Guidelines), which laid down the foundation for the development of the surety insurance business in India. The Surety Guidelines came into effect on April 1, 2022, and the entry of insurance companies in the government procurement space will offer an alternative financial backstop to the Contractors who had earlier been dependent on banks for procuring a bank guarantee. Insurance companies in India have issued about 700 insurance surety bonds valued at about ₹3,000 crore after the Centre made the instrument on par with bank guarantees for all government procurements.
Our Opinion: Will Surety Bonds and Insurance Models Work in India?
Surety bonds and insurance models for replacing security deposits have shown mixed results globally. In the U.S., Rhino generated $18.6M in premiums in 2021 but faced a 134% loss ratio on $11.1M in earned premiums. Jetty and Rhino’s pursuit of tenant collections negatively impacts tenant experience. Hence, the model, while very powerful, requires a re-look at how it is structured and underwritten.
In India, the efficient implementation of Surety Bonds requires several key steps.
Authorities need awareness campaigns to understand their similarity to bank guarantees.
Policymakers must recognize the unique nature of Surety Bonds compared to other insurance products.
Incorporating indemnity agreements is crucial, either through legislative changes or standardised agreements.
Credit ratings should be used to assess Surety Bond risk until more data is available.
Ensuring the right of subrogation is essential for seamless contract work.
Lastly, solvency ratios should consider the assurance of reimbursement from the principal and underwriting can be more robust.
These models could address affordability and liquidity in sectors like infrastructure and real estate. However, India must consider issues like false claims, high loss ratios, and complex claims processing. A robust credit-check system and effective collection strategies are crucial for success, which will include connecting to the Account Aggregator (AA), as they include housing data and other credit check data to underwrite. While challenging, the potential exists if these models adapt to India's unique market conditions and heavy technical development.
To conclude, Surety bonds, historically rooted and increasingly adopted globally, offer promising alternatives to traditional security deposits, fostering liquidity and credibility, notably in infrastructure and real estate sectors. While their implementation in India faces challenges, including regulatory adaptation and operational complexities, their potential impact on affordability and project completion warrants strategic consideration and further development tailored to India's unique market dynamics.
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