In recent years, the financial activities in India have grown exponentially. As a result, the reliance on financial instruments such as bonds and guarantees have increased. The companies undertaking such financial instruments subject themselves to higher risks of non-payment by other party or insolvency and bankruptcy. To mitigate such risks, specialised insurance products have been curated and introduced in the Indian market recently by the Insurance Regulatory and Development Authority of India (“IRDAI”).
Recently, IRDAI released two guidelines introducing such products which help in mitigating risks involved in financial activities namely IRDAI (Surety Insurance Contracts) Guidelines, 2022 (“Surety Insurance Guidelines”) (as detailed in our earlier article IRDAI (Surety Insurance Contracts) Guidelines, 2022 – Lexology) and IRDAI (Trade Credit Insurance) Guidelines, 2021 (“Trade Credit Insurance Guidelines”).
The Surety Insurance Guidelines governs insurance contracts that deals with a contract to perform the promise or discharge the liability of a third person in case of any default. It is required to be a contract of guarantee under Section 126 of the Indian Contract Act, 1872. It is a tripartite agreement between a creditor, debtor and insurance company intended to protect the creditor from any default by the debtor.
Under the Trade Credit Insurance Guidelines, the risk of non-payment for goods and services by buyers is covered. It is intended to ensure that any invoice sent out to the other party will be paid, even if the other party defaults on the payment, or enters insolvency or bankruptcy.
The Surety Insurance Guidelines allows general insurance companies registered under the Insurance Act to issue surety bonds. Such policies/ contracts are largely found in construction contracts in India involved in road projects, housing or commercial buildings and other infrastructure projects of the government or the private sector. Further, the surety insurers are permitted to work alongside banks and other financial institutions to share risk-related information and technical expertise to monitor projects, cash flow amongst other aspects.
The scope of the Trade Credit Guidelines are the credit risk that has a direct link with an underlying trade transaction and the delivery of goods or services. If no such direct link exists, the outstanding amount is not insurable under a trade credit insurance policy. The two distinct types of risks which this cover deals with are commercial risks and political risks. Trade credit insurance cover enables general insurance companies to offer covers to suppliers as well as licensed banks and other financial institutions to help businesses manage country risk, and to manage non-payment risk associated with trade financing portfolio.
A noteworthy observation of the Surety Insurance Guidelines is that every insurer undertaking surety insurance business is required to incorporate prudent underwriting practices, sound risk management and internal controls. Further, insurers are required to assess their own ability to retain surety risks on their balance sheets based on their financial strength. While conducting due diligence of the contractors or debtors, insurance companies must review the contractor’s financials, cash flow, tax return, liquidity and debts, assuming that the underlying obligation created will eventually be fulfilled. However, insurance companies undertaking such surety insurance business need to be satisfied of a recourse in the event of a default or insolvency by the debtor or the contracting party.
In an event of insolvency by a debtor, surety insurance companies would step into the shoes of the creditor after the they have fulfilled the debtor’s obligation of paying the creditor. After such subrogation, the insurance companies are entitled to receive the remedy that the creditor had against the debtor. Further, as the insurance companies would possess the rights of a surety, they
are entitled to initiate corporate insolvency proceedings against the debtors. Under the Insolvency and Bankruptcy Code (“IBC”), a waterfall mechanism has been prescribed to categorize the flow of net proceeds of the debtor’s assets post liquidation. Whether the insurance company would be a financial or an operational creditor will need to be ascertained to determine their order in the distribution of proceeds. Reports suggest that stakeholders are pushing to bring surety bonds at par with bank guarantees when it comes to recourse available to them in case of a default. An additional right of the surety insurers to have another recourse other than ordinary dispute resolution mechanisms gives an added advantage to Surety Insurance Contracts.
In our view, underwriting surety insurance is not limited to assessing the financial capabilities of contractors. Instead, it opens new avenues for insurers to evaluate technical expertise, past record and capability of the contractors supported with information and data. Insurers could look at surety insurance as a prospective opportunity as it comes with a risk mitigation framework for the insurer in the form of recourse under IBC. On the other hand, surety insurance could be a favourable option for various industries as it intends to take away the hassle of a bank guarantee i.e., collateral and commissions. Additionally Trade Credit Insurance enables companies to expand their business without fear of loss. It also facilitates liberal credit facilities from banks/ financing companies. As the industry is gearing towards more hybrid risk mitigation methods, combining traditional and non-traditional products, solutions such as surety insurance and trade credit insurance can be explored more widely. It is yet to be seen how the industry will respond to these new guidelines, and what risk transfer solutions would emerge.