Risk management: The vital ingredient for project finance

07 June 2002

Insurance was seldom a deal-breaker in project finance before the events of 11 September 2001. However, since then it has become a key issue for Middle East project sponsors, and for states called upon to step in as 'insurers of last resort'.

The inability of the international insurance markets to provide the quality and quantity of coverage has forced sponsors or project lenders to bear more risk than they are accustomed to. Otherwise new projects will flounder and existing loans risk technical default.

Several major liquefied natural gas (LNG) and offshore platform/pipeline projects are looming in the region, and many must be concerned whether adequate insurance can be found to provide sufficient comfort not only for sponsors to proceed but also for lenders to finance the deal.

The World Trade Center disaster is not the only reason for the crisis. Hefty underwriting losses have been building up for years, and were already unsustainable before 11 September. Lloyd's losses for the years of account 1999-2001 average £1,750 million ($2,500 million) annually. That represents 17 per cent of underwriting capacity but nearer 31 per cent of actual net premium written - and the Lloyd's figures are better than many reinsurers during that period.

Prior to 11 September, insurers were reluctant to seek increases of more than 20-30 per cent on record low rates for fear of losing market share. After that, rises of 300-1,000 per cent coupled with substantial increases in deductibles and more restrictive coverage were not uncommon for insureds coming out of long-term deals.

The rates now being charged are not unprecedented. What has shocked the industry is the speed of change without warning and also that the quality of coverage is significantly less and deductibles many multiples higher than previously applied.

Few projects can comply with the insurance covenants drafted when the market was soft. Terrorism cover is available only with low limits from specialist markets. Business interruption cover has become prohibitively expensive, and extensions for both customers and suppliers have been curtailed. Faulty design and machinery breakdown prove problematic particularly for power projects. Offshore construction placements are rarely completed at any price without sponsor support and onshore placements face the imposition of loss limits below the contract value. Fortunately, such loss limits still exceed the likely estimated maximum loss but the safety margin has gone. In the absence of competitive pressures in the market, Lenders face little choice but to grant waivers on existing projects.

For new projects, lenders are at least forewarned. They can require more concrete guarantees from sponsors and ensure that financial models reflect current levels of premium and uninsured risk. Projects are still proceeding despite the uncertainty over the quality and quantity of insurance, but this reflects the calibre of sponsors and competitive pressures within the banking fraternity. Lenders' clauses protecting their rights unfortunately have been severely curtailed.

Rate increases are particularly galling for the Middle East because its losses have rarely contributed to the crisis. The region has few natural perils and does not suffer from liability problems. Even when the increases tail off, projects will be left with insurance constituting a major budget item. Yet considerable risk is still being left on the balance sheet. Long-term agreements are no longer possible, leaving insureds with an annual ordeal at renewal and lenders faced with regular requests for waivers. The seamless link offered by some insurers from construction to the first few years of operational cover has long gone. Insurance has become a short-term partial solution to a long-term problem.

What are the alternatives? Additional capacity has entered the reinsurance market but it is unlikely to make much difference in the short term because it will not generate competitive pressures amongst the front-end insurers. Other methods of risk management must be used in order to mitigate the crisis.

The Middle East has traditionally retained little fortuitous risk. Broad coverage with low deductible options reinsured into the international markets has been the norm. Without doubt, the region has the resources and now the portfolio spread to retain significantly more risk than is now the case. This can entail accepting significantly higher deductibles at the project level or involve local insurers having sufficient capital and enhanced portfolios.

To make risk retention more comfortable, greater emphasis must be placed on risk management. This would include risk engineering to reduce the frequency and severity of loss. It is technical failures or human error rather than natural perils that produce the losses. These can be reduced by physical engineering and training with the cost saved many times over not just in lower premiums as loss records improve but also by the reduced impact of uninsured losses on a balance sheet.

Risks that are insured out require a great deal more planning than previously. Risk transfer is much more fragmented than a year ago. Instead of one placement covering several classes of insurance, packages are unbundled and consequently negotiations with many more markets are necessary. The quality of underwriting information required is much more detailed and, overall, the process of placing insurance considerably elongated. The shock of renewal terms often prompts insureds to leave renewal orders to the last minute hoping for a dramatic reprieve and it is all too common to see placements incomplete at expiry date. This is unsatisfactory for both insureds and lenders because it exposes balance sheets to excessive and unnecessary risk.

Insurance is no longer an automatic 'tick in the box'. Projects both present and future will gain little comfort from traditional insurance markets. It is an opportune time to step back to look at the whole management of risk and decide what can be retained and what ideally transferred at an economic price. From this fundamental reappraisal of risk, organisations should seek to reduce exposure by risk engineering and seek to retain more risk internally.

A good example of where a reappraisal is required is consequential loss insurance in the form of delay in start-up cover pre-completion and business interruption during the operational phase of a project.

The requirement for delay in start-up insurance may disappear if there are completion guarantees or the engineering, procurement and construction (EPC) contract shifts risk to the contractor via liquidated damages. Business interruption cover is rarely waived. In the soft market it was cheap to buy and even though the risk may have been slight, it was accepted as a cost of borrowing. Now, its necessity should be reappraised. It is vital to assess the risks of delay scientifically and see what practical means can be taken to mitigate them. Business interruption coverage should be evaluated to see whether the waiting period negates protection for most incidents, the project can service the interest payments should some production still be possible after the worst envisaged loss and whether the premium cost would be better left in the project to finance a risk reduction programme.

There should never be an automatic assumption that insurance is required. The risks should be analysed and if a risk cannot be retained comfortably, it should be transferred by contract or avoided. Insurance should be seen as a means of transfer by contract and not the automatic response to risk.

In conclusion, there is a fundamental imbalance at present between the international insurance industry offering increasingly short-term solutions to insureds who want longer-term certainty in risk transfer. Whilst to a degree understandable because of their global underwriting results, it is particularly unfair on the Middle East which has contributed little to their woes. The situation is unsatisfactory for insureds who have no certainty of coverage or premium levels at each renewal and a nightmare for lenders financing many of the projects in the region. They can no longer rely on the adequate transfer of fortuitous risk to the insurance industry, but cannot reflect this uncertainty in the loan rate. Like all crises, there is an opportunity, in this case to reassess attitudes towards risk and treat insurance as just one of many tools to manage it.

Mike Bignell/Martin Benatar of Dawson Risk Management Services. Both specialise in lenders' due diligence work and have considerable experience in the Middle East including RasGas, Qatargas, Oman Gas Company, Omifco, Sidi Krir, Qabico, Rades IPP, Gaza CCGT IPP, Dhofar Power and just recently Ajaman Wastewater.

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