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Latam Briefing: Brazil’s new surety bond market rules

Construction men working in the morning light.

New rules for infrastructure tenders and a regulatory update that gives insurers more freedom to develop policy wording should give a boost to the surety bond market in Brazil, according to experts.

As well as the new rules, it is also hoped that the improved legal framework, which puts the Brazilian market closer to more advanced jurisdictions such as the US, will help the country to reduce the number of infrastructure investments that remain unfinished, a chronic problem in the country.

A report by TCU, the body that is in charge of auditing the accounts of the Brazilian federal government, estimated that, by 2022, almost 31,000 infrastructure projects had been halted before conclusion, out of a total of 88,097 that were under way at the time.

To tackle this failure, back in 2021 the Brazilian government approved new legislation for public infrastructure tenders that, among other things, increase the role played by surety bond insurers in the structuring and management of projects.

Starting in April, when a transition period comes to an end, insurers can provide completion bonds to the equivalent of 30% of the total value of a project. Until now, limits were restricted to 5% or, in exceptional cases, 10%.

The new limit can be demanded by public entities in the case of projects that require investments of more than BRL 200m ($38.3m). It will apply to projects sponsored by the federal government, but market observers expect public entities at the regional level to follow a similar road. State-owned companies may also apply the new legislation to their infrastructure investments.

Another important novelty introduced by the law is that, in the case of a claim, insurance companies will be allowed to step in and take over a project until its conclusion, alternatively to paying the value of the loss to the government.

The changes are inspired mostly by the experience of the surety market in the US, where federal projects are insured with completion bonds of 100% of their value. Even though the Brazilian limit is significantly lower, it should provide enough of an incentive to significantly change the practices of the surety bond market in Brazil.

“The 5% ratio was seen as insufficient to guarantee the conclusion of the projects,” says Cristina Tseimatzidis, the executive director of Financial Solutions at WTW in São Paulo. “The big question now in the market is whether 30% will be sufficient, and how insurers will work from the point of view of the risk analysis of projects.”

In Tseimatzidis’ opinion, the market will become much more rigorous when assessing the ability of clients to fulfil the commitments expressed on their project bids. Surety insurers will have to increasingly look at the financial strength of the policyholder, but also the capacity to deliver the project. They will have to take into account the experience of the bidding company, the characteristics of funding and equity providers, and the project finance expertise of all participants. Insurers may also have to create teams specialised in engineering, and some may focus on specific kinds of infrastructure projects.

“The new rule means that insurers will be more rigorous. They will no longer accept every single thing that comes their way,” says Leandro Freitas, the head of Financial Lines at MDS Brasil in São Paulo.

Tseimatzidis expects that some surety insurers will have a higher degree of specialization, and will rely on reinsurance markets to provide capacities required for the higher limits.

“Reinsurance will play an essential role in this market,” she says.

Another important effect should be the forging of closer relationships between surety insurers and construction companies. These will have to integrate the insurance aspect of their projects in earlier stages of the bid structuring process, different from current practices, where the insurance elements of bids are usually left to the latter stages.

“We are already seeing a narrowing of relationships, which is something that is a feature in the US market,” says Carolina Jardim, the head of Credit Specialties at Marsh in São Paulo. “In the US, insurers and construction companies are partners. Contractors share their financial numbers and their business strategies with surety underwriters.”

The closer relationship brings benefits for both parts, she says. On the one hand, contractors will have to share a higher volume of sensitive information with their underwriters, and will not want to do that with multiple insurers at every bidding process. But surety insurers will need to know their clients well in order to feel confident that they can take over infrastructure projects in the case of a claim and outsource its conclusion to a trusted contractor.

Jardim notices that, as of today, surety insurers are chosen mostly on the basis of the prices they charge for the bonds. That is set to change for two reasons. By increasing the values insured by the bonds, public entities will show a willingness to accept less advantageous bids in order to increase the odds that the projects will actually be concluded. Furthermore, new regulation introduced by Susep, Brazil’s insurance supervisor, to adapt surety insurance to the new infrastructure tender rules have paved the way for underwriters to offer wordings that are more adapted to the needs of particular projects.

“The new rules give the parties more room to agree on the terms and conditions that they want, and, if there is enough reinsurance capacity available, it will be possible to create tailor made covers for a client or a market niche,” Tseimatzidis says. “We are already preparing studies with the market to introduce new products and bring covers that are available abroad.”

Taking advantage of the new wording leeway provided by Susep, market entities such as Fenseg, an association of P&C insurers, are discussing with official infrastructure agencies the introduction of new surety bonds that match the needs of every sector.

“Each agency is likely to develop its own surety bond wordings,” Freitas says. “Aneel, the energy agency, will make its own requirements, and so will ANP, in the transportation sector, and ANATEL for telecommunication projects.”

Some agencies are already experiencing with demanding different levels of cover depending on how aggressive the bids presented by tender participants are, Jardim points out. This has happened in some energy concessions, where completion bonds of up to 10% of the value of the project have been asked from participants that made proposals that charged rates below a specific threshold. The usual limit for concessions is 5%.

Concessions like public private partnerships are not included in the new public tender law, but are also the target of regulatory updates currently being discussed and that could bring some innovations in this area as well.

In any case, Jardim believes that public works should take a boost in the near future as they are the kind of investment favoured by Luis Inacio Lula da Silva, a left-wing politician who started his third mandate as president in January.

“With the new government and the new law, and also with the discussions about a new framework for infrastructure concessions, we believe that public projects will gain relevance once again,” Jardim says.

More importantly, though, it may help to avoid further swelling the already huge backlog of unfinished building works that Brazil has to deal with at the moment.

“An unfinished projects has a much higher cost,” Jardim says. “It is much harder for a company to take over a project whose contract was rescinded and was on hold for a while.”

The infrastructure market could also gain new players as companies from other countries, especially other Latin American economies and the US, have expressed an interest on Brazil’s infrastructure market since many of the local players were cut down to size during a corruption scandal in the mid-2010s.