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Commercial insurance- Tool to minimise project risk

A potential win-win technique for lenders to manage and minimise project risks 

“The man who knows it can’t be done counts the risk, not the reward” says Elbert Hubbard, a renowned US author. 

One of the key features of infrastructure project financing is that, financiers allocate the large quantum of risks involved to various parties who have a vested interest in the project.

Commercial Insurance is one of the most important risk management tools, which can be utilised by both project sponsors and lenders to allocate risks to a third party. 

The specific scope of insurance policies and amount insured, varies from project to project. Some project finance transactions include detailed insurance provisions in the main credit agreement, while others have a separate insurance agreement governing related issues. 

Commercial insurance as a tool to manage project risks is used extensively in the US and European markets. This tool is implemented by means of the following clauses:

Clauses of commercial insurance used to minimise project risks are…

Reinsurance

  • A reinsurance policy is an indemnity contract between the primary insurer and the reinsurer. It is distinct from the original insurance policy issued to the project company, and does not create any privity between the reinsurer and project company. 

    In the emerging market scenario, project companies may be required by law to cover a portion of the commercial insurance via domestic insurers. If it not compulsory legally, exchange controls involved in international insurance may require the project company to maintain domestic insurance.

    Why…
    the sheer size of many infrastructure projects may make reinsurance necessary, as individual primary insurers may not have the financial capacity to insure the entire project. 


    Issues involving the legal framework, financial capability and reputation of the domestic insurance industry, force lenders to insist on an insurance programme that includes reinsurance of a substantial portion of the risk.

    To avoid credit risks of the primary insurer, cut-through endorsement provisions must be included in the insurance programme-
    the basic function of this clause is to ensure that, in the event of the primary insurer’s insolvency, the reinsurance proceeds are paid by the reinsurer directly to the lender rather than to the primary insurer, hence eliminating the insolvency risk at the primary insurer level. Without this provision, financiers take on the credit risk of the primary insurer and project company as well as the specific project risk.  

  • Subrogation waiver

    A ‘waiver of subrogation’ is usually required by financiers to protect themselves from the possibility of any action by an insurer, who, upon payment to an insured project company would become subrogated[1] to any and all of the project company’s rights against third parties. 

  • Security interests

    In many project finance transactions, the project company must assign all its rights and title in the insurance proceeds to the lenders, either as a part of the general security agreement governing the project, or under a separate insurance assignment agreement.

  • Non- vitiation (breach of condition) clauses

    Any mistake or misrepresentation of a material fact by the project company gives sufficient reason for the insurance company to prove the insurance policy to be void. This could harm the interests of the financers who in the normal course of investigations prior to lending, would not be in a position to identify this breach. Including a non-vitiation clause in the insurance policy prevents the insurer from refusing to pay the project company on the basis of defences based on such mistakes or misrepresentations.

    An alternative to this clause could be a standard mortgage insurance cover. This cover is obtainable at the cost of the project company. This mortgage covers the financer for the risk of loss as between the insurer and the mortgager. This is the risk that the insurer may have good reasons to void the insurance policy. 

  • Loss payee

    A ‘loss payee’ is entitled to the entire insurance proceeds, or amounts exceeding certain limits, irrespective of whether he has an interest in the insured property. The loss payee has no obligations under the insurance policy and is not liable to pay premium amounts. This policy protects the lender, as he obtains the insurance proceeds. 

  • Additional insured clause

    This is an entity other than the project company, which is specified in the insurance policy. The lenders given this status are separately covered under the insurance policy. The additional insured does not have any obligations to the insurance company and need not make premium payments. The insurance policy must clearly state that the insurance proceeds will be disbursed among the project company and the additional insured according to their interests in the project.

    This enables the lender (named as an additional insured) to receive payments of insurance to the extent of their interest in the insured property ahead of the project company in the event of loss.

Conclusion

Using the techniques stated above, commercial insurance could be successfully used to allocate risks to those parties who are most appropriate to bear them. 

[1]  Subrogation is the substitution of one person or group by another in respect of a debt or insurance claim, accompanied by a transfer of any associated rights and duties. 

Related Reading:

‘Using commercial insurance to avoid project risk’ : Ayali, Noam : International Financial Law Review : April 2000.

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