Banking and insurance are different businesses

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The IRDA guidelines are silent on invoking the guarantee or how the amount will be settled by the insurance company

The Insurance Regulatory and Development Authority of India issued the IRDAI (Surety Insurance Contracts) Guidelines, 2022 on 3rd January 2022. The guidelines will come into effect from 1st April 2022. These guidelines apply to all insurance companies under the Registered Insurance Act. 1938. The guidelines define different types of security, namely Advance Payment Bond, Bid Bond, Contract Bond, Customs and Court Bond, Performance Bond, and Holdback. The guidelines contain various conditions to be eligible for the surety business, such as maintaining the solvency margin, the premium charged, the underwriting philosophy approved by the board of directors, the risk assessment mechanism and the compliance with specific conditions.

conditions.

Finance Minister Nirmala Sitharaman said the use of surety bonds issued by insurers as a substitute for bank guarantee would be made acceptable in public procurement.

It is unclear what prompted policy makers to allow guarantees to be issued by insurance companies. As things stand, there are a sufficient number of banks and bank branches to handle this business. Policy makers do not seem to have appreciated the nuances of bank guarantees.

Banks provide guarantees to their customers as part of the working capital facility. Although at the time of issuance of the guarantee there will be no outflow of funds, in the event of the guarantee being invoked there will be an outflow of funds from the bank. Therefore, what is initially treated as a non-fund based facility may become a fund based facility. Collateral invoked or collateral in default is similar to a loan book and ultimately this has

to recover from

customer.

Banks collect a margin amount, commission and also tangible collateral for issuing collateral. They obtain a “counter-guarantee” from the client to offset the amount of the guarantee in the event of an invocation. In most cases, as the customer benefits from different other facilities, the collateral guarantee provided will also be extended to warranties. Thus in the event of call of guarantee, the banks will be able to put the hand on the titles near them. Under no circumstances can this be done by an insurance company.

The guideline issued by the IRDA is silent on the invocation of the guarantee or how the amount will be settled by the insurance company and how will it recover this amount. Or will they pay the warranty invoked on their profit and loss account?

For all intents and purposes, the collateral portfolio should be treated solely as financial intermediation, as collateral can be called upon at any time and is squarely within the domain of banks. It is not a risk management mechanism and therefore not in the field of insurance. Why should insurance companies be allowed to enter this field?

Bank guarantees are well accepted by all as there are various RBI guidelines as to issuance and payment in clear terms. The RBI is adamant that wherever safeguards are invoked, payment should be made to the beneficiaries without delay or hesitation. It provides that an appropriate procedure to ensure this immediate fulfillment of safeguards must be established so that there is no delay on the pretext that legal advice or approval from higher authorities is in the process of being obtained.

Over the years, banks have come to understand that delays on the part of banks in honoring collateral when called upon tend to erode the value of bank guarantees, the sanctity of the collateral regime, and the image of banks. It also offers the possibility for the parties to go to court and obtain injunctive orders.

It is only where there is an element of fraud in the issuance or invocation of guarantees that payment of the guarantee is withheld. Such occasions are very rare. The courts have repeatedly made it clear that the payment of guarantees cannot be stopped by the banks.

Sometimes fake bank guarantees are used by customers. As no payment is involved when issuing a guarantee, it is possible that certain guarantees purporting to be from banks could be prepared and the beneficiary company could be defrauded. In such cases, it is only if safeguards are invoked that the fraud will be revealed. To avoid such a situation, banks provide a system to verify and obtain confirmation of guarantees issued by higher authorities of the bank. The IRDA does not include such a provision in its guidelines.

Finally, when banks are not allowed to enter the insurance business (they only act as distributors for insurance companies), why should insurance companies enter the territory of banks? That too where there is a huge risk.

(The author is a retired banker. Opinions expressed are personal.)

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