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Surety Bonds – An Underwriter’s Perspective
Posted by Umeshpratap Singh on Dec 22, 2020 5:55:51 PM
Although well-established worldwide, Surety Bond is a relatively new concept in India. Essentially, a guarantee is issued by a Surety guarantor, whenever there is a need for assurance of a performance of obligations under a contract. In the event of a default by the Contractor, the obligee (the project owner) invokes the surety guarantee to recover its loss. After paying out, the surety attempts to recover its loss from the defaulting principal through the indemnity obtained from the Contractor.
As per the prevailing practice in India currently, an obligee takes partial performance Bank Guarantees to compensate against such a loss. However, Bank Guarantees as a tool for risk mitigation is a sub-optimal one for the reasons outlined below:-
1. Bank Guarantees are mostly issued based on overall Client/Contractor creditworthiness with an underlying assumption that all projects have the same project risk if they are executed by the same Contractor. As a result, the pricing and security of Bank Guarantees remain the same for all the projects undertaken by the Client.
2. Bank Guarantees are offered as a part of much wider product offerings (like Cash Credit, Term Loan, Letter of Credit Etc) by banks and hence the risks are not adequately priced /evaluated most of the time.
3. Banks try to cover their risk via collaterals/security and possess very limited expertise with respect to project underwriting and monitoring.
4. In case of default, the obligee/project owner can recover a maximum of 5 -10 % of the cost by way of invocation of the Bank Guarantee. The banks proceed for recovery against the Contractor and may approach IBC which impacts the Contractor’s performance across all other projects as well. As a result, in the entire process of invocation & recovery, the underlying projects are stalled and/or infinitely delayed which is counterproductive to the initial intent.
To sum it up, we can say that the Bank Guarantees, at best, provide some monetary compensation to the obligee but the whole process of invocation/recovery is detrimental to the timely completion of the project.
Surety bond providers try to overcome the above issues of plain vanilla Bank Guarantees by offering holistic customized guaranteeing solutions based on robust credit evaluation and project monitoring mechanisms.
Surety Underwriting: A two-pronged credit evaluation system:
The traditional credit risk assessment followed by the banks gives huge weightage to Contractor creditworthiness and specific project risks are either generalized and/or get a very limited evaluation. However, the ground reality is that many projects fail /are delayed or have a huge cost overrun due to project-specific risks like Right of Way (ROW), geo-political risk, change of scope, and/or technical difficulties of the project. It is not uncommon to find projects being delayed/surrendered by an otherwise good Contractor.
In order to offer comprehensive protection to the obligee/project owner, the Surety guarantor looks beyond the traditional approach of a balance sheet-based credit approval mechanism.
While evaluating the overall creditworthiness of a Contractor remains a key evaluation matrix, it is combined with in-depth project risk and monitoring to offer project-wise (not Contractor wise) risk solution.
Sureties usually imbibe this philosophy and grade every proposal on a two-scale matrix as depicted below :-
While underwriting any proposal, a Client/Contractor credit score/grade is arrived at by evaluating
• Promoter/Management Risk
• Business /operation risk of Contractor
• Financial risk
In addition to the above, each project is further evaluated minutely on the following parameters to assess the project risk
• Project Cash Flow Risk
• Complexity of project
• ROW/ External Risk
• Sponsor/Obligee Risk – payment frequencies, budget, and financial strength of Sponsor
Robust Project monitoring System :
Worldwide, Surety guarantor’s ability to monitor projects is one of the key differentiators for the Obligees to prefer Surety bonds over Bank Guarantees. A Surety guarantor keeps a tight vigil on project cost, project cash flow, and approval status on a monthly basis and helps them resolve in a timely manner by coordinating with the obligee and Contractor. The probability of completion of the project as per the schedule improves manifold if the project risks are addressed promptly and in an appropriate manner.
With a huge amount of investments lined up for the infrastructure sector in India, it is critical to find the right balance of awarding risk and rewards to each and every stakeholder (project owner, Contractor and lenders) of an infrastructure project. Surety guarantors are known to bring such balance by properly evaluating and pricing the risk in the system.
Topics: Surety Guarantees, Bank Guarantees
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