Surety Bonds [UPSC Notes]

In order to ensure fairness and transparency in the issuance of surety bonds, the Insurance Regulatory and Development Authority of India (IRDAI) issued guidelines for surety bonds. In this context, understand what are surety bonds and how are they significant. This topic is important for the IAS exam GS paper III, Indian Economy segment.

What are Surety Bonds?

Surety bonds can be considered as risk management tools that will ensure economic growth. They are governed under the Indian Contract Act of 1872.

• Surety bonds are generally issued for construction and infrastructure projects and guarantee that the principal will meet the commitments indicated in a contract.
• In the event of the principal failing to meet obligations, the obligee (one who is protected by a surety bond) is compensated by surety which will reduce financial risk.
• A surety bond is a legally binding agreement between three parties namely the obligee (the entity requiring the bond), the principal (the party required to fulfil a certain task or duty), and the surety (the party ensuring that the principal can perform the assignment).
• The main objective of obtaining a surety bond is to protect the project owner from financial risk such as in case a contractor fails to complete a project or achieve the contract’s quality standards.
• For example, in a construction project, the project owner (Obligee) can demand a contractor (Principal) to get a performance bond from a surety company which will protect the project owner from the various risks mentioned above.
• The different types of surety bonds such as bid bonds, performance bonds, advance payment bonds, and retention money bonds are issued for a variety of purposes.
• An important fact that needs to be noted is that the guarantor must be financially capable of meeting the obligations under the bond. The surety bond premium is based on the risk involved and must be reasonable.

IRDAI Guidelines on Surety Bonds

The objective of the IRDAI guidelines is to promote and control the sustainable growth of  India’s surety insurance sector.

• The guidelines cover a wide range of topics, including the types of surety bonds that can be issued, terms and conditions, underwriting criteria, and pricing.
• These guidelines form the framework for the issuance of surety bonds.

Challenges:

• The lack of a deep and well-established surety bond market in India is leading to difficulty in obtaining bonds by contractors, particularly in small and medium-sized organisations (SMEs).
• Lack of uniform standards due to varying standards and procedures by different surety providers which make the system challenging to understand for contractors.
• The lengthy, time-consuming and complex process involved in surety bond enforcement since it also involves legal conflict.

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