21 February 2024
How should lenders react to the hard insurance market?
Having years’ of experience providing independent insurance advice to lenders that provide debt financing to global infrastructure projects, Gallagher Specialty’s Construction division have witnessed periods when the insurance market has become particularly concerned about specific risks which could cause large unpredictable losses.
Asbestos, terrorism, floods, cyber-attacks and natural catastrophes, such as storms and earthquakes, in certain geographical locations; all of which have been subject to some form of restricted insurance cover over recent years. Understandably, the insurance market will eventually become reticent to provide insurance cover for risks which they consider will inevitably lead to substantial claims.
The challenge in arranging suitable insurance for debt-financed projects
Recently there have been concerns from borrowers, lenders and their advisers regarding the difficulties they have been experiencing in sourcing adequate insurance for debt-financed projects.
Whilst conditions in the insurance market have now begun to stabilise, the insurance market has for several years struggled to regain profitability and has been characterised by reduced insurance capacity; higher premium rates; restrictive coverage; increased deductibles; and in some instances, an inability to insure certain risks. Limited insurance cover will inevitably conflict with the interests of lenders to debt financed projects who would obviously favour projects that are ‘de-risked’ as far as possible. Traditionally, this de-risking has in large part been achieved by project companies arranging comprehensive insurance cover with as much risk as possible being transferred to the insurance market.
With the global drive towards net zero, lenders are being presented with a substantial number of requests to provide debt funding for renewable energy projects located in all areas of the globe. When considering these requests, lenders prefer to see a high degree of project de-risking to maximise security of the project assets to ensure that the project has a continuing ability to service its debt obligations. What happens if the insurance market is reticent to provide the level of cover expected by lenders?
The unique challenges lenders face for their Renewable Energy projects
Looking specifically at the renewable energy sector, insurers’ reticence to provide the levels of insurance cover that had traditionally been available has probably been most apparent in the offshore wind power sector. Offshore wind power projects present a unique and complex combination of risks such as those arising from land and sea transportation, offshore construction, the technology employed and exposure to the natural elements.
Insurers have become increasingly concerned about specific issues affecting the offshore wind power sector that have led to numerous and substantial claim payments. One such example is, insurance policies now commonly exclude all losses that in any way involve the cable protection systems or the protective covering employed to minimise physical damage to undersea power transmission cables. This exclusion applies to any cable protection system despite the fact that the problems that have led to insurance claims seem to be largely limited to protection systems provided by a single specialist manufacturer.
Restrictions are also now often imposed on insurance cover for damage caused by defects in cables and turbines. Serial losses, meaning losses arising from the same defect in several project components, are a particular concern to insurers. Another area of concern is potential revenue losses arising from damage at the premises of suppliers and power off-takers where cover is often based on lower loss limits and reduced perils than had been previously available.
Geographical location will also dictate an insurer’s attitude to risk. A good example, is the burgeoning offshore wind power sector in Taiwan where a combination of reduced insurance capacity driven by the volume of local projects in development and insurers’ fear of future increased frequency and severity of natural catastrophes, has significantly reduced loss limits for typhoons and earthquakes. Additionally, the well documented geopolitical tensions in this region have led insurers to consider the extent to which they are willing to provide cover for terrorism, war risks and abandoned munitions.
Insurers’ hesitance to provide cover for certain risks is not, however, limited to the offshore wind power sector. Many other sectors that commonly involve debt financed projects also have their own set of unique risks that cause insurers concern. Examples include accidents involving the hub-locking devices employed on turbines of onshore wind farms and failure of welds and steel corrosion on storage tanks, including tanks used at water desalination plants. Regional tensions have resulted in some projects experiencing difficulties in securing insurance cover for terrorism risks and also, in some cases, even cover for strikes, riots and civil commotion. All of these risks have been subject to some level of restrictive cover in the current insurance market.
What are the solutions?
What are the solutions in situations where there is a divergence between the lenders expectations of substantial insurance cover and the insurance markets unwillingness to provide that level of cover?
Initially, lenders, in consultation with their insurance advisers, must develop a clear understanding of the level of insurance cover that is now the current norm in the insurance market. This will facilitate a re-set of lenders expectations of the level of insurance cover available for any given industry sector. For projects where insurance cover may not be as comprehensive as anticipated based on historic precedent, lenders, together with their insurance and other advisers, should take time to assess the true level of risk threat to the integrity of the project to which they are considering financing. Ultimately, it is the project company’s responsibility to manage risks and insurance should only be one element of the project’s risk management programme.
Lenders should work with their advisers to confirm the extent to which the project company has appropriately transferred risks to project contractors, for example under EPC and O&M Agreements. Lenders’ technical advisers will be able to provide an assessment of the efficacy of the project’s proposed physical protections such as fire prevention/minimisation mechanisms and cyber risk barriers.
Returning to insurance protection, the project company and their brokers can negotiate with insurers to develop an equitable compromise for risks that are of particular concern. An example would be arranging insurance cover with specified loss limits, rather than with full reinstatement values, for certain assets. This loss limit approach is routinely adopted by insurers for natural risks such as typhoons, hurricanes and seismic events in geographical areas where such risks are prevalent, although such loss limits are significantly reducing. However, lenders can work with their insurance and technical advisers to review estimated maximum loss studies procured by the borrower to assess if the proposed loss limits are adequate.
Sometimes insurers will allow cover for problematic risks with increased deductibles, the first amount of each loss that is the responsibility of the project company. This could be a solution if the project company can demonstrate that it holds adequate reserves to meet potential deductible liabilities within opex budgets or if the project owners, within the confines of non-recourse financing, can guarantee provision of funds.
What are the solutions in situations where there is a divergence between the lenders expectations of substantial insurance cover and the insurance markets unwillingness to provide that level of cover?
There may not always be immediately obvious answers to lenders’ concerns over the restrictive nature of the current insurance market, but experience has shown that solutions and suitable compromises are available.
Working with their advisers, lenders should undertake an assessment of the project company’s mechanisms to reduce exposure to risk and to minimise the actual potential impact of the risk should it occur. It is often the case that a rigorous assessment of the risks facing a project will show that perceived deficiencies in a project’s proposed insurance programme may not be as relevant as initially feared and a project’s bankability is not compromised. The lenders’ insurance adviser will play a key role in assisting lenders to understand the salient risks to the project and ensuring that borrowers arrange the optimum insurance programme with the appropriate level of cover to address these risks.
We offer independent insurance due diligence consultancy services on a global basis to our clients involved in a range of construction or acquisition/divestment projects, if you wish to discuss this article or anything else regarding the insurance programmes in which you have an interest, get in touch with one of our Due Diligence specialists.
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