WHAT IS THE ROLE OF INSURANCE IN THE PROJECT FINANCE MATRIX? CAMILLE CHENGWING chengwing@yahoo.com ABSTRACT: The purpose of this paper is to examine the role of insurance in project finance. It achieves this by first looking at where insurance fits into the project financing structure and what the parties involved i.e. lenders, sponsors, government and contractors want from project insurances. Particular emphasis is placed on the degree to which insurance serves as a risk transfer mechanism during one of the most critical periods of the project financing the construction phase. The scope of coverage for specific risks such as property damage (Erection All Risks (EAR), delay in start up, force majeure, design risk and political risk are examined in detail. This is followed by a brief look at operational insurance. Finally, the role of insurance beyond the traditional risk transfer function to that of a source of finance and credit enhancement is explored. Camille has seventeen years work experience in the insurance industry with a concentration on energy/petrochemical accounts over the past 10 years. She joined Braemar Steege in January 2008 as an Energy Loss Adjuster and is responsible for handling a wide range of Property Damage and Buisness Interruption claims, both Offshore and Onshore. Her qualifications include : Associate of the Chartered Insurance Institute of London(A.C.I.I.), Dip. Business Administration, LLB (Hons), and LLM in Petroleum Taxation and Finance (Distinction) with the Centre for Energy, Petroleum and Mineral Law and Policy. 1
TABLE OF CONTENTS TABLE OF ABBREVIATIONS 3 1. INTRODUCTION 4 2. HOW DOES INSURANCE FIT INTO THE PROJECT FINANCE MATRIX? 5 3. WHAT DO THE PARTIES WANT FROM PROJECT INSURANCES 7 Lenders 7 Sponsors/Project Vehicle 8 EPC contractors 9 Host Government/Government Agency 10 4. WHAT ARE THE MAIN RISKS COVERED BY INSURANCE DURING THE CONSTRUCTION PHASE OF THE PROJECT FINANCING 11 Construction All Risks (CAR)/Erection All Risks (EAR) 12 Delay in Start up (DSU)/Advanced Loss of Profit (ALOP) 13 Force Majeure 15 Performance Failure/Design Risk 16 Political Risks 18 5. WHAT RISKS ARE THE MAIN RISKS COVERED BY INSURANCE DURING THE OPERATIONAL PHASE OF PROJECT FINANCING 19 6. INSURANCE AS A SOURCE OF FINANCE 20 7. CONCLUSION 22 2
TABLE OF ABBREVIATIONS ALOP BI CAR DIC DSU EAR ECA EPC FM GSA IA LD OCIP PFI PPA PPP Advanced Loss of Profit Business Interruption Construction all risks Difference in Conditions Delay in Start Up Erection all risks Export Credit Agency Engineering, Procurement and Construction Force Majeure Gas Sales Agreement Implementation Agreement Liquidated Damages Owner Controlled Insurance Programme Private Finance Initiative Power Purchase Agreement Public Private Partnership 3
1. INTRODUCTION This paper examines the role of insurance as a risk transfer mechanism within the project finance matrix and how it forms part of the financing package. It explores what the different parties (lender/sponsor/contractor/host government) want out of the project insurances with the aim of providing an understanding of how each party views the role of insurance in relation to their specific objectives. This is followed by an analysis of the main risks covered by insurance during both the construction and operational phase of the project. The reasoning behind separating the two is that they both present different risks to the insurance underwriters and signify different stages of the project financing i.e. for the project financing, once the completion test has been passed the sponsor s guarantee is released and lenders absorb all or part of the project risks and the project commences its limited recourse or non-recourse status; for the insurance underwriters risk exposure varies depending on on-site activities i.e. the EAR insurance period is divided into three phases, and once the completion test has been passed the operational insurances come into effect and this carries with it a new set of policy wordings/terms/conditions/premium/deductibles which have different implications on what cover is available for loss of revenue and hence debt repayment. In the process of identifying the main risks covered during the construction phase this paper will pay particular attention to construction all risks/erection all risks cover, delay in start-up, force majeure, performance failure/design risk and political risks; and for the operational phase, property all risks and business interruption. As the role of insurance in project finance is not limited to just risk transfer, the last section of this paper will examine its use as a source of finance and providing credit enhancement to the overall project profile. 4
2. HOW DOES INSURANCE FIT INTO THE PROJECT FINANCE MATRIX? In project finance there is a substantial degree of reliance placed on the performance of the project itself and as a result there is much emphasis on its feasibility and its sensitivity to various forms of risk. Unlike other forms of financing arrangement project finance is not primarily dependent on the credit support of the sponsors or the value of the physical assets 1 and its debt payment is secured on the cash flow of the project vehicle (on the basis of revenue contracts /off-take agreements (Power Purchase Agreements or Gas Sales Agreements PPA s/gsa s). When lenders agree to provide financing their main concern is to ensure that risks which can potentially affect the cash flow of a project are moved away from the project vehicle as far as possible. Insurance provides a means of shifting these risks from the project participants to a party not directly involved in the project. 2 This party is usually an insurance company (private or state-owned), a reinsurance company or a captive insurance company, depending on the particular project. Insurances are seen as a secondary structure in many aspects of project finance 3 and quite often it is a tail end concern in some project financings and regarded as the cinderella activity by many 4. This is furthest from the truth, as the ability to successfully place project insurances can be a determining factor in the lenders approval of a project financing package. This becomes even more important when the ability of the obligated parties to repay project debt on an accelerated basis is questionable. 5 1 Clifford Chance (firm), Project Finance, (London: IFR Publishing, 1991) p.3 2 Baker & Mc Kenzie, Project Finance The Guide to Financing Power Projects, (London : Euromoney Books 1996) p. 66 3 Tinsley R., Advanced Project Financing, (United Kingdom, Euromoney Books 2000) p.12 4 Foster Wyatt Training., Introduction to Project Finance, Handout 09, Risk Anaylsis and Allocation p.21 5 Finnerty J.D., Project Financing: Asset-Based Financial Engineering, (New York, John Wiley & Sons, 1996) p. 65 5
While expensive, insurance may be the only backstop available for many risks. For example a project finance deal may only be accepted if backed up by a substantial Delay in Start Up (DSU) package to backstop Liquidated Damages (LD) commitments 6. The following diagram (fig 1) illustrates the various parties involved in the commercial arrangements for a gas fired plant. Highlighted within this matrix are the insurances that will be discussed later in this paper. The purpose of the diagram is to give the reader a quick look as to what risks are transferred from within the matrix to the insurers. Property all risks/business interruption insurance Design Risks/ Performance DSU/ALOP Monoline Insurance CAR/EAR, DSU/ALOP, Force Majeure, Design Risks/Performance Risk and Political Risk Insurance Political risk insurance Political risk insurance Figure 1: Source: Project finance class notes and author 6 See supra note 3 at p.12 6
3. WHAT DO THE PARTIES WANT FROM PROJECT INSURANCE? Lenders It is the lenders who direct the need for insurance within the project finance arrangements and is therefore the party that will determine how much and what type of coverage is purchased. Lenders want to have a number of risks covered by insurance, like confiscation (including expropriation, nationalisation and denial of access); loss of profits/business interruption; contract frustration, repudiation and embargo; strikes, riots and civil commotion; kidnap and ransom; certain war risks; and such contingency risks as failure to honour financial guarantees in the event of default on loans or supply commitments, revocation of export licences or revocation of offshore currency repatriation arrangements. 7 Project finance lenders want their rights and interests in the insurances to be structured 8 so as to ensure that they receive first call on any claim proceeds and maintain subrogation rights throughout the policy period. This is achieved through: 1) Loss payee clauses which nominate the project finance lender as the recipient of any claims money 2) Assignment of policies, where the lenders are assigned the rights of the policy, as opposed to merely the proceeds (enhances credit support for the project 9 ) 3) Joint insureds, where the lenders become joint policy holders 4) Warranty waivers, which allow for payments of claims to the lenders in certain circumstances, despite the fact that the insurers could deny liability to the owners as policy holders because of a breach of condition on warranty in the policy 7 Donaldson T.H., Project Lending, ( London; Edinburgh : Butterworths, 1992) p.167 8 See supra note 3 at p.70 9 See supra note 7 at p.167 7
5) Lenders interest policy to circumvent a legitimate denial of a claim due to policy holder s breach of policy conditions (vitiation). In addition to the above comfort clauses in the insurance policies, lenders also want to see that there is comprehensive insurance cover/broad form policy structure based on international standards; an owner or principal-controlled insurance program; that deductibles are reasonable and realistic; full value insurance; if there is any coinsurance (self-insurance) that this is set at levels that cannot undermine cash flows needed for debt payment; there is minimum creditworthiness and stability of insurance underwriters (investment grade ratings that are higher than the project s ratings) with a proven record of claims payment and a claims process that provides timely coverage of cash shortages (agreed interim payments); and that there are appropriate controls over insurance cover through loan covenants. 10 Sponsors/Project Vehicle Although the terms may be used interchangeably the sponsor and the project vehicle are two distinct entities. The capitalization and revenue structure of the project vehicle (the borrower) is commercially segregated from that of the sponsor. 11 The sponsor (s) is the party responsible for the development of the project and it forms a special purpose (incorporated or unincorporated) vehicle for the purpose of implementing and operating the project. Sponsors will follow what the lenders tell them that they require out of an insurance program. This is mainly due to the fact that in project financing the extent of sponsor s liability is limited to the equity contributed to the project via the project vehicle. Lenders have limited or no lien on the sponsor s assets outside the project vehicle (limited/non-recourse finance), so as far as the sponsor is concerned the insurance program for the project has no impact on its own corporate insurances. This is important 10 Khan M.F.K., Para R.J., Financing Large Projects, (Singapore; Prentice Hall 2003) p.273 11 See supra note 10 at p.4 8
as any claims paid would not affect the loss ratios and hence the premium levels of the separate entities. Despite this however, the sponsor (through the project vehicle) will normally take the lead role in arranging project insurances as it has the ultimate responsibility for ensuring that it meets the requirements of the financing program. If this responsibility is passed onto the contractor problems arise as the contractor is not party to the financing agreement and therefore will not be in a position to properly assess the insurance needs of the project. In addition, it will be extremely difficult for the project vehicle to obtain stand alone DSU cover that does not follow a property program. To eliminate these issues the project vehicle will initiate an owner controlled insurance programme (OCIP) which will act as an umbrella over the entire project site. Basically the sponsors/project vehicle wants to satisfy the requirements of the lenders in order to obtain the required financing. There are limitations to this as some insurance premiums may be prohibitively expensive and can undermine the profitability of a project. Proper communication and understanding between the lenders and the sponsors is therefore essential when agreeing the terms of the insurance programme as there needs to be a balance between insurance costs and the amount of money being raised 12. The project company should, within agreed boundaries, be required to maintain insurance only to the extent that it is available on reasonable commercial terms. 13 EPC Contractors All the insurance requirements of the EPC contractor is driven by the works contracts which usually contains an insurance clause stipulating the terms of the cover provided by the principal (where there is an OCIP) and any additional cover that has to be obtained by the contractor (i.e. own equipment/offsite work). From the contractors point of view the 12 See supra note 3 at p.12 13 Davis H., Project Finance: Practical Case Studies Vol II Resources and Infrastructure, (London, Euromoney Books, 2003) p. 59 9
insurance programme supplements its own obligations under the LD provisions, but does not replace it (i.e. in event of an overlap in coverage the LD payment stands in front of any insurance payment). The contractor is not party to the loan agreement between the project vehicle and the lender, so it is not in a position to influence the terms of the financing agreement. Its main goal is to protect itself from any risks which will interfere with completing the project on time, without cost overruns and according to specifications. Contractors will normally carefully examine the insurance contracts provided by the principal and then make its own decisions as to whether it wants to obtain DIC (difference-in-conditions) cover or absorb the risk internally. Host Government/Government Agency Central and local government may be indirect sponsors and therefore have a vested interest in the project insurances. The government can therefore simultaneously be part of the project and the regulatory body governing its activities. This may present potential conflicts of interest where the lenders require a particular form of insurance coverage i.e. political risk insurance, where reimbursement is towards the party that is the source of the claim in the first place. At the end of the day host governments want to ensure that the project insurances comply with local laws. For example, in some countries certain forms of insurance cover is compulsory i.e. workmen s compensation/employer s liability, automobile liability or pollution/ environmental liability. They also want to see that the local insurance industry benefits from the project. As a result the domestic law of certain host countries might require insurance to be taken out with local insurers and/or in local currency. In some developing countries insurance may only be purchased through a government monopoly or certain insurance (DSU/ 10
Business Interruption (BI) may have the status of non-admitted insurance. 14 The above has obvious implications on the project financing as the local coverage may be more limited than the international standard thereby exposing the project vehicle to a number of perils that may exceed its self-insurance capacity. 15 Further difficulties may arise as a result of limitations on the ability of local insurers to reinsure the risks on the international insurance and reinsurance markets. If the amounts that must be maintained for own account are large, relative to the financial solvency of the local insurer, the project vehicle and lenders will be assuming an undesirable payment risks. 16 To mitigate the above risks project lenders may negotiate with the host government through the Implementation Agreement 17 (IA) for permission for the insurance to be maintained offshore. 18 However, even though the IA may exempt the project vehicle from the above legal requirements, concerns will be raised inevitably by the lenders and/or their advisors as to the legality of such an exemption. 19 4. WHAT ARE THE MAIN RISKS COVERED BY INSURANCE DURING THE CONSTRUCTION PHASE OF THE PROJECT FINANCING The construction phase of a project marks the beginning of on site preparations and the mobilization of the contractors, engineers, workmen, machinery and equipment etc., to the project site and/or prefabrication yards and manufacturers workshops. This process involves careful planning as their must be co-ordination between all parties in order to maintain the agreed work schedule. 14 Insurance written by an insurer that is not licensed or registered to do business in the country where the insured exposure exists 15 See supra note 10 at p.273 16 See supra note 10 at p.273 17 A contract between the project vehicle and the host government which allocates risks of certain political and financial uncertainties. 18 See supra note 1 at p.82 19 See supra note 10 at p.273 11
During construction, funds are drawn down from the lenders based on a predetermined budget/schedule for spending with any major variations having to be formally approved by the lending committee. At this point the project is vulnerable to a whole range of risks such as completion and development risks, project planning and preparation risks, offtake or purchase agreement risks, technology risks etc. 20 For the purposes of this paper the following discussion will center around specific insurable project risk with an emphasis on construction/completion risk (property damage risks, delay in start-up, force majeure and design risk). Country and political risks will also be considered as this cover is highly sought by lenders in some projects. Construction All Risks (CAR)/Erection All Risks (EAR) CAR/EAR cover is for all risks of physical loss or damage to material, supplies, equipment, fixtures and temporary structures that are used in construction, fabrication, installation, erection or completion of the project. EAR is used in conjunction with engineering risks whilst CAR refers to general building risks. This insurance will normally be effected in the joint names of the project company, the project lenders, the construction contractor and subcontractors. 21 Although the term all risks is used the cover is restricted to accidental physical damage at the project site which is caused by an insured peril. In addition, the insurance contract does not reflect the scope of the EPC contract and will therefore not cover all the risks assumed by the EPC contract parties. 22 Since the risk exposure varies depending on on-site activities, the EAR insurance period is divided into 3 phases for underwriting purposes 23 20 See supra note 4 at p.5 for a full list of project risks 21 See supra note 2 at p.67 22 Bommeli M., Insurance aspects of gas turbomachines, Swiss Reinsurance Company: Technical publishing Engineering (2003)- p.25 23 See id., p.25 12
1) Construction /erection 2) Testing /commissioning phase 3) Manufacturer s risk within the EAR cover (defects liability/maintenance) The significance of this difference to the project financing and to the lenders is that each phase carries different premium rates and deductibles thereby influencing not just the cost of the insurance but the claim settlement amount. The EAR policy forms the basis for the DSU cover (discussed later) so it is very important that the parties have full knowledge of the perils covered and the applicable exclusions as this will influence whether a claim for loss of revenue will be paid or not. Another point to note is that the EAR policy will only provide all risks cover for on-site activities and excludes off-site work i.e. at manufacturer s site. It is therefore important from a project financing standpoint, to ensure that the necessary insurance or contractual guarantees from suppliers/manufacturers are in place to make sure that there is financial compensation in the event that major items of equipment/material are not delivered. Delay in Start up (DSU)/Advanced Loss of Profit (ALOP) One of the main features of project financing is the collateralization of loans with project assets and their repayment purely on the basis of project earnings. The revenue generating capability of a project is thus a critical financing factor and stringent conditions regarding delays in scheduled project completion have been added to contracts between financiers and principals, and particularly to those between principals and (EPC) contractors 24. The works contract between the principal and the EPC contractor stipulates that as a rule, the contractor is accountable vis-à-vis the principal for any project start-up delay arising 24 Bommeli M., Delay in Start-up Insurance, Swiss Reinsurance Company: Technical publishing Engineering (2003) p.5 13
through any fault on the part of himself or his subcontractors 25. This obligation is however relieved where certain risks are expressly undertaken by the sponsor i.e. force majeure events. DSU cover is designed to secure the portion of revenue which the principal requires to service debt and realise anticipated profit. It provides fairly broad protection against delays arising from physical damage caused by any type of peril included in the relevant material damage cover. However, it does not cover delays caused by other events which are cited in an exclusion and consequently do not qualify as accidental physical damage 26 For example, terrorism cover is usually expressly excluded from the EAR cover (as this has to be purchased separately), therefore if damage to property arises out of an event that is deemed to be terrorism, any delay in the project and resultant loss of revenue will not be covered. In addition, if the physical loss, even if caused by an insured peril, is not on the critical path, DSU cover will not be triggered as it does not result in a project delay. DSU cover is often a prerequisite for a loan, and with the shift from governmental funding programmes to private financing schemes (i.e. UK PFI/PPP) there has been a notable increase in demand for the coverage as both principals and contractors are faced with increased financial exposure. As a result of this increased demand there have been a number of recent cases where the size of the insurance requirements for DSU cover has been sufficiently large in relation to market capacity that concerns over availability and the likely terms have had a bearing on the structure of the financing 27 (this is because the coverage also acts as a form of credit enhancement). This highlights the necessity of addressing the issues of DSU coverage at the prefinancing stage so that any changes can be made then, rather than trying to adjust previously agreed terms. 25 See id., p.7 26 See id., p.8 27 See supra note 4 at p.21 14
For example, in a power project the DSU underwriter must have comprehensive knowledge of the loan agreement and the Power Purchase Agreement (PPA) 28 and the Fuel Supply agreement (FSA) to verify the expected revenue flow and assess the viability of the DSU sum insured. 29 Failure to provide appropriate information would lead to either the DSU coverage being severely restricted or problems with claim settlement calculations when a claim is actually presented. Force Majeure Project financed transactions are distinguishable from corporate finance or structured finance assets because of their potential vulnerability to force majeure risks 30. This vulnerability arises out of the dependence on the project as a single source of income and not having the comfort of a diversified asset portfolio to cushion the effects of a loss. Lenders typically require that insurance be taken out to protect against certain risks of force majeure, 31 i.e. acts of nature hurricane/earthquake/flood. Failure to allocate the risks of force majeure events away from the project vehicle tends to limit most projects to the BBB category or below. This is however more likely to occur on site concentrated projects (i.e. processing plants) rather than infrastructure project (i.e pipelines and road projects) as the latter can more readily be returned to operations following a force majeure event. If a project can mitigate force majeure risk with business interruption and property casualty insurance, some rating elevation may be possible. Unfortunately many insurance 28 In deregulated markets where PPA s do not necessarily apply it is difficult to predict anticipated revenues and gross profit. This is remedied by specifying a maximum indemnifiable amount (hourly/monthly/weekly or monthly basis) during the delay period or max per kwh 29 See supra note 23 at p.30 30 Penrose J., Rigby P., Project Finance Debt Rating Criteria :Part I, 10, International Energy Law and Taxation Review, (2001)- p.2 31 See supra note 5 at p.65 15
policies will either exclude many of the force majeure events that would affect the project rating or are prohibitively expensive. 32 Where the uninsurable risk covers part of the project which can be replaced, the answer may be to build up other protections to a higher level. i.e. a particular part of the process may be prone to fire or explosion as to be uninsurable. However proper loss control measures might ensure that the fire could not spread to the rest of the project and the part destroyed might be replaceable at a manageable cost. The project lenders might then accept these precautions against the fire spreading together with an injection of extra equity by the sponsor to cover replacement cost. 33 Performance Failure/Design Risk It is critical that when purchasing design coverage that the parties are aware that various wordings exist within the industry and that each carries a different set of consequences that impact on what is actually paid when a claim is made. When a loss event arises from defective design, materials, or workmanship, the design clause determines what is covered and what is not. There are two main standard industry wordings that are currently being used the London Market Defect Exclusion (DE) and Munich Re (LEG) wordings. 34 These standard wordings tend to be confusing and misleading as they come in various forms and their differences are subtle but important. For example, if a faulty seal causes damage to a compressor and the entire unit has to be replaced DE 3 35 coverage would not pay for replacement of the compressor but will pay for any resultant damage to any other property which is not part of the defective unit (i.e. damage to surrounding property), 32 See supra note 31 at p.3 33 See supra note 7 at p.17 34 http://www.converium.ch/234.asp 35 DE 3: Limited Defective Condition Exclusion. Excludes damages to property that is in a defective condition, in whole or in part; covers consequential damage to any other property free of defective conditions 16
whereas DE 4 36 coverage would pay for everything except the defective seal (faulty part). The trick is in identifying what is the faulty part (which is sometimes almost impossible) and what is deemed to be other property distinct and separate from the defective part. Proper identification of risks and appropriate covers are therefore critical in writing contracts for such eventualities: If a million-dollar gas turbine is at risk from a defective two-dollar rivet, DE3 could have catastrophic results for the insured, while DE4 might result in extensive payments from the insurer. 37 Where there is no physical damage i.e. where the processing plant will simply not run to designed specification, conventional insurance will not apply. 38 Where negligence can be proved against a designer or contractor, the owner and the lender may be able to pursue damages and may ultimately benefit from the negligent party s professional indemnity insurance ( this is however an indirect route to insurers and the first claim rests on the courts 39 ). The following flow chart (fig 2) highlights where insurance cover will and will not apply in design error which results in either physical damage and/or consequential loss: 36 DE 4: Defective Part Exclusion. Excludes damages to only that constituent part of the property that is deemed defective (the "faulty part"); covers consequential damage to any other property free of defective condition 37 http://www.converium.ch/234.asp 38 Tinsley C.R., Emerson M.E., Eppler W.D., Finance for the Minerals Industry, Society of Mining Engineers, ( Maryland, Port City Press, 1985) p.474 39 See id., p.474 17
Yes Was there physical damage to plant caused by design errors? Were design errors negligent? Yes Yes No Are there consequential losses as well as physical losses? Are there consequential losses as well as physical losses? Losses are consequential only Yes No No Yes Loss covered by conventional insurance Consequential losses not usually covered (but can be) Loss not necessarily covered by conventional insurance Loss not necessarily covered by conventional insurance No Were design errors negligent? Not covered by conventional project insurance Losses are consequential only Not covered by conventional insurance No Figure 2 - Source: Tinsley C.R., Emerson M.E., Eppler W.D., Finance for the Minerals Industry, Society of Mining Engineers, ( Maryland, Port City Press, 1985) pg 473 Political Risks Political risk insurance is provided by private insurers as well as multilateral 40 and bilateral agencies. 41 Private political risk insurance is now increasingly available for emerging markets 42 as an alternative to the coverage commonly provided by ECA s and other agencies 43 or acts as a supplement to existing coverage. 40 See Nevitt P.K., Fabozzi F.J., Project Financing: 7 th Edition, (London : Euromoney Books 2000) pg 28 for list of government agencies providing political risk insurance. 41 Insurance and guarantees from bilateral agencies normally cover 85 95% of losses caused by political events. Coverage is either global or specific - Rasavi H., Financing Energy Projects in Emerging Economies, (Tulsa, Okla: Penwell 1996) pg 72 42 CBK Power Plant, Philippines 43 Davis H., Project Finance: Practical Case Studies Vol I Power and Water, (London, Euromoney Books, 2003)- pg 140. 18
Rates for private political risk insurance are generally higher but are justified by greater speed, flexibility and capacity. 44 Risk covered by political risk insurance are as follows: Asset-Based Risks Confiscation, expropriation, nationalization, deprivation (CEND) Forced divesture Forced abandonment Arbitration award default Trade-Related Risks Currency inconvertibility Exchange transfer risk Contract frustration Unfair calling of guarantee/wrongful calling of guarantee Import/export licence cancellation, embargo War and political violence Figure 3 - Source: Galvao, Daniel, Political Risk Insurance: Project Finance Perspectives and New Developments, Journal of Project Finance, Summer 2001, p.35 Political risk insurance would cover the company s failure and its future contract obligations if the failure was caused by one of the policy s defined political risk events as shown in the above table (fig 3) 45. The cover may overlap partially with the commitments provided to a project vehicle by the host government under the IA.. 46 In the event that this occurs any government guarantees would stand in front of the insurance cover. 5. What Risks Are The Main Risks Covered By Insurance During The Operational Phase Of Project Financing At this stage of the project financing construction has been completed, the contractors have been de-mobilized and the operators have been left to take over the running of the power plant/process facility etc. In addition, all design and performance specifications have been met (completion test passed), the ownership of the facility is handed over to the project vehicle (from EPC contractor) and the project is now in a position to earn revenue. It is important to note that having passed the completion test two things happen that affect the structure of the insurance program: 1) The sponsor s completion guarantee falls away leaving lender to absorb all or part 44 See id., p.141 45 See supra note 13 at p.186-187 46 See supra note 10 at p.274 19
of the project risks and the project commence its limited recourse or non-recourse status. 2) The construction insurances terminate and operational insurances commence. The significance of the first point is that the lender no longer has recourse to the sponsor in the event that there are any further performance or maintenance issues with the project and therefore has to rely solely on manufacturer s warranties or insurance coverage should any event occur that prevents the project from earning revenue. Insurance coverage during the operational phase will usually be in the form of property all risks insurance (including machinery breakdown/marine cargo/third party liability etc.) and business interruption. Under both policies the same protection of lenders interest will apply as in the construction insurances (see pgs 10& 11). The property program will cover the physical assets of the completed project whilst the BI policy will reimburse it for loss of profits arising from physical damage due to an insured peril. 6. INSURANCE AS A SOURCE OF FINANCE The role of insurance in project finance is not limited to risk transfer as the insurance market also provides a source of finance directly and indirectly. Project debt can be sold to life insurance companies through private placements 47. The market for these placements tend to be concentrated within a few large companies, and from a borrowers perspective this is positive as it may reduce the cost and time required to arrange project financing. 48 Life insurance companies are however very sensitive to the creditworthiness of project debt securities 49 therefore bringing some exclusivity to its availability as a source of finance. As a result, security arrangements and restrictive covenants are important issues in private placement negotiations and project loan 47 Privately placed securities are not registered with Securitie sand Exchange Commission (SEC) 48 See supra note 5 at p.173 49 Life insurance companies have exhibited a strong preference for debt that is rated minimally as investment grade (NAIC-2) = Standard & Poors rating of BBB, Moody s rating of Baa 20
agreements typically include limitations on indebtedness, on liens, and on cash distributions, and they impose liquidity/working capital tests. 50 A project s attractiveness to potential lenders can also be enhanced through the use of monoline wraps. The policy guarantees the timely payment of interest and principal payments in the event the issuer of the debt securities is unable to make these payments due to financial difficulties. 51 This form of credit enhancement can be useful in two ways: 52 (1) The cost of bonds rated AAA plus the cost of credit insurance is sometimes less than the cost of uninsured bonds (which is of great benefit to the borrower in securing the loan) (2) Bonds cannot be sold to investors unless they were insured (thus allowing the project to raise funds). This form of credit enhancement is especially important where there are concerns about emerging market credits and where institutional investors have no room in their portfolio for non-sovereign paper (i.e. from Latin America). By wrapping in insurance products it is then possible to expand the structured finance options for a project financing (especially securitisation and new varieties of capital market or quasi-equity funding). 53 Credit insurance thereby becomes a method of ensuring that the deal gets done 54. 50 See supra note 5 at p.171 51 http://info.insure.com/ratings/fitch/index.cfm?task=marketsector_define 52 Davis H., Project Finance in Latin America: Practical Case Studies, (London, Euromoney Books, 2000) pg 82 53 See supra note 3 at p.70 54 See supra note 54 at p.82 21
7. CONCLUSION The role of insurance in project finance is not as straightforward as one might think. Project risks are dynamic and there are no set of rules dictating how these risks should be managed. The insurance industry itself is vulnerable to sudden changes in its attitude towards certain risks and therefore it cannot be taken for granted that the insurance coverage will always be available. In addition, not all operating risks are insurable and the proceeds of insurance may not be sufficient to cover lost revenues or increased expenses (i.e. certain types of equipment may not be readily replaceable, given their large and project specific character). 55 It is therefore important to differentiate between risks for which an insurance solution exists and risks for which there is limited or no insurance solution. Conventional insurance, geared to physical damage is well suited to asset-based lending, but falls short of the mark when applied to project lending 56. In asset-based lending the lender s main concern is that the asset is available if and when needed, whereas in project lending it is not so much the physical asset that is important but that the project produces a revenue stream sufficient to service its debt. This revenue stream can be halted by whole range of factors other than the physical asset i.e. availability of reserves, availability of a market, price, interest rates etc. Insurance therefore tends to be almost one dimensional in its approach to risk transfer as it focuses only on physical damages and any consequential loss (financial loss) must follow actual physical loss. This limitation should however not be seen as a setback as insurance provides one out of many alternatives to managing project risk. There is a tendency for the parties to believe that once insurance cover is in place that they could sit back and relax and any losses will be taken care of by the insurance company. As experience would show, this is hardly the 55 See supra note 13 at p.272 56 See supra note 39 at p.474 22
case as there is a time gap between making a claim and receiving settlement, which a project can ill afford. Nothing therefore replaces sound risk management practices in identifying, evaluating and minimising the impact of project risks and it is clear that insurance would always have a role within this process. 23