Construction

The race is on in the UK for councils to implement 'waste to energy' schemes. This year is the first deadline for EU Landfill Directive targets aimed at reducing biodegradable municipal waste and the UK is way behind.

When bidding for projects the costs of insurance remain a risk in themselves.

Fixing a price for insurance 2-3 years before construction commences brings risks, as you don't want the cost of insurance eating away at your margin once the project is operational.

The 6 key ways to manage your risk on insurance cost for your Waste to Energy Project Finance Initiatives (PFI) are:

- Ensure you have a robust premium sharing agreement that reflects market changes within the market that you will be using.

- Review and identify all factors that could affect the costs.

- Nail down your risk management and address key areas of concern to Insurers.

- Have an open dialogue on insurance with the Authority and agree at what point insurance costs should be fixed.

- Consider whether savings can be made an operational premiums by including it in a PFI portfolio with a range of other PFI projects.

- Factor in the insurance market cycle by having a good understanding of its current stage and knowledge of the potential variance.

The more information provided to the broker and the more experience the broker has within the sector, the better they will be able to understand the project and get it priced effectively.

This is just one of the issues explored in this month's PFI Bulletin: Waste to Energy, PFI in 2010. Here, I review the main risk management and insurance challenges facing those involved in PFI Waste to Energy projects. Please click here to read more.

The sense of dread hanging over the UK Construction Market before this week's emergency budget seems to have receded somewhat.  Projects worth several billions of pounds have made it over this first hurdle and the 1% increase in Insurance Premium Tax could have been considerably worse. 

Over £7 billion of spending on construction projects was approved last week following the review of projects award between January 2010 and the May General Election including:

- 7 Building Schools for the Future projects
- 3 major hospital projects
- £5.67bn of transport spending including the recently closed Birmingham Highways
- Projects and the proposed Tyne and Wear Metro Project.

Although Contractors are now looking for clarity on which projects are going to be pushed through first, they are also keeping a wary eye on the Autumn spending review which may crystallise some of the current uncertainty.

The rise in IPT in the June 22nd Budget has been long foreseen by insurance brokers, but has been an awful long time coming - the last increase we saw was as far back as 1999! However, our new rate of 6%, effective next January, is still far less than our European counterparts, where rates are often equivalent to VAT levels.

Although the increase comes into effect in January 2011, the impact on instalments and extensions on existing project policies will fall within the anti-forestalling measures under the Finance Act 1994. However, more importantly, the answers to the impact will depend on how the insurer's accounts for the premiums.

Insurers may use either:

1. the cash receipt method of accounting - in which case the new rates will take effect for premiums received on or after 4 January 2011; or
2. the special accounting scheme - in which case the new rate will apply to premiums written in their (i.e. the insurers) books on or after 4 January 2011.

Notwithstanding this, the anti-forestalling measures (which were included in FA 1994) to cover increases in rates may apply such that certain premiums received between the date of the announcement (22 June) and the date of change may be subject to an increased rate.
 
The key factor, on the tax treatment will be dependent on how the insurer accounts for the premium, so it is important that clients obtain their own independent tax advice in this regard if they are concerned with the proposal from insurers.

In relation to PPP projects, the increase in IPT has a couple of obvious implications:

- Current bids will need to take into account the higher rate - projects already at preferred or   selected bidder phase may need to swallow the increase as the insurance costs are normally set before this stage unless the project company can demonstrate that there is significant project change or project delay.

- Existing Projects will need to pay more in terms of overall premium

It is this point where our clients need to consider the effect of any insurance premium risk sharing schedule (IPRSS) in their contracts. The later versions of the IPRSS, for example in the SOPC4 drafting exclude the effect of IPT entirely, leaving this increase as a pure Project Company risk, but earlier versions put in place post 2001 in many cases incorporated the total cost of premiums inclusive of IPT. In even earlier projects, there was complete pass through of premiums in certain cases. 

Clearly on projects closed under the current SOPC4 guidelines, increased IPT will result in an additional cost to the project Company that is not recoverable under contract, and it is for this and other unforeseen matters that an adequate insurance contingency should be considered for any project.

In conclusion whilst more recent projects will get no relief for the IPT increases due in the future, we recommend reviewing the IPRSS in all contracts to understand whether any premiums can be reclaimed and for any project contingency to consider the effects of future IPT increases.

So the fear factor built into many of the construction related pre-budget announcements seem to more about expectation management than reality, however contractors will be still waiting for the projects to be awarded and closed before breathing a full sign of relief.

A new development in the UK/Europe

The economic recession has placed many contractors in a precarious position with their subcontractors. This issue has been highlighted in the UK which has seen a steady increase in awareness of Subguard over the last 18 months. Subguard protects Main Contractors against subcontractor default, and it is important to understand that the default is not just restricted to insolvency.  Performance, quality and programme issues are also covered.

Many contractors view Subguard as an alternative to subcontract bonds. A bond will typically provide protection up to 10% of the subcontract value.  This is low level protection and will be of little comfort when faced with a substantial default. There are substantial retentions, such as £1M per loss, but the indemnity available in excess of this figure can be as much as £25M.

The difference is clear.  For a comparable cost the Main Contractor is purchasing a substantial level of protection for a catastrophic loss, which is not available utilising bonds. In fact the bond amount could be viewed as protecting the manageable or attritional default cost.

Subguard also comes with other benefits, such as transferability to the Building Contract Employers, who will benefit from the policy in the event of a Main Contractor insolvency.  It is for this reason, tied to the six year period of cover post completion, that it has sparked interest with property developers in the UK.  The policy could effectively provide a form of latent defects insurance in the event that the Main Contractor and its supply chain were to become insolvent.

In order to qualify for the Subguard programme the Main Contractor must conduct a stringent due diligence of subcontract procurement processes and this also provides some independent validation of risk management standards in its supply chain management.
The benefits of Subguard are clear as it provides:

• Greater cover than bonds and at a similar price.
• A long period of cover.
• Transferability

However it is only available from Zurich and the product will need to meet strict due diligence criteria.

Awareness amongst employers means that Subguard is gaining traction in the UK market.  It seems that Subguard is here to stay so Main Contractors would do well to explore it!

For more details on Subguard or to see if you can purchase this cover please contact David Cahill.

Liquidated Damages (LDs) also referred to as Liquidated and Ascertained Damages (LADs) are utilised to provide a pre-determined indemnity to principals for delays in project completion.

LDs are legally required to be a genuine pre-estimate of loss and legally cannot be punitive in nature.

Typically LDs are requested by lenders and generally reflect the debt service associated with a project. Equally, contractors often use LDs as a contractual way of capping their liabilities for consequential financial loss.

Delays for force majeure provide contractual extensions of time for Contractors and are deemed to be delay risk assumed by the employer. Some force majeure risks are obviously insurable under an advanced loss of profits policy, however it should be noted that force majeure risks of a non-damage nature are typically uninsurable in the insurance market.

Is LD insurance available and is it worth buying? Moreover, can it be acquired for non-damage delay or failure to meet performance criteria?

It is an extremely small insurance market, with Zurich being one of the recognised leaders. Typically, LD insurers like projects which have at least 30 days float for every 12 months of project period. Excesses of between 30-60 days are normally required.

Policies can be purchased either on a single project basis or as an annual facility covering all projects. Premium rates are between 5%-8% of the sum insured and the policy form will be bespoke and tailored to mirror the contractual LD provisions.

Insurance contracts are written subject to due diligence, which is performed on the adequacy of the construction programme. The due diligence costs are sometimes paid up-front by the insured and this can be up to USD50,000.

So yes you can insure your LAD exposure but:
1. You need good detailed information on your company's exposure.
2. It's not going to be cheap
3. It's not going to be a quick policy to place

If you want to know more, or want to investigate if you can insure your LAD exposures please contact me.

Give me a call to discuss further.

Andrew Harrison-Sleap