Project finance

The added value of insurance

Project finance
The added value of insurance
Table of contents
Foreword 5
Project Finance 6
Definition 6
History 7
Parties involved 7
Structures 10
Project phases 12
The role of the insurer 14
History 14
Operating field 14
Traditional approach 15
Recent developments 15
Limits of insurability 17
Risk analysis 18
Risk situation 18
Four dimensional model 19
Application of our model 22
Risk transfer 23
Risk transfer solutions 23
Conclusion 33
3
WilliamShakespeare, 15641616
TheMerchant of Venice
Men that hazard all do it in hope of fair advantages
4
5
Large industrial and infrastructure projects are always somehow fascinating. The
diversity of technical, financial and economical aspects stimulate our curiosity and
open the prospects for the creation of new business opportunities.
We believe that insurance underwriting offers the unique opportunity to merge
technical, financial and economical experience and to form an integrated view of
projects. Following this idea we are inevitably confronted with the question what
could be done better? or, in business terminology what is the value added that
could be generated out of it?...
In order to answer the above questions it is necessary to tackle the role of insurance
in Project Finance and to investigate the insurance opportunities in this financing
field.
The variety of risks is decisive for the success of Project Finance. Nowadays, by the
time the parties involved in a project decide to issue an insurance tender, the details
of the financial deal have already been concluded. Insurance underwriters receive
a submission where the exact requirements and scope of cover are already finalised.
More often than not their performance is measured as to how accurately they can
meet the coverage requirements laid out in the submission.
As a result, the sources of innovation (regarding the risk transfer) are limited to the
sponsors or in the best case to financial, legal advisers and a risk consultant such
as a broker. But some of the important know-how and risk bearers, insurers and rein-
surers, are not involved in the structuring of the deal; their innovation potential is left
idle. Consequently the covers offered seldom constitute the perfect fit for a project.
This is a very crucial point. Innovative solutions lead to a more sophisticated risk-
financing architecture and often to a higher degree of risk transfer. However, if
an insurer takes on too much of a risk from one particular project party, this might
threaten the delicate risk balance between the stakeholders, thus threatening the
success of the whole project (risk equilibrium). Only when insurers have full
knowledge of the finance structure can they judge how much risk transfer they may
accept without upsetting this equilibrium.
This interesting subject was the topic of the recent MBA thesis at the University
of St. Gall (HSG). The thesis The Value Added of Insurance to Project Finance
was written by Mladen S

os i c, Andreas Hauri and Christian Noelting in February

1999, and mentored by Prof. Dr. Axel Lehmann.
The intention of the work is, from the insurers/reinsurers point of view, to explore
the possibilities of a broader minded approach to Project Finance, giving the most
justifiable answers to the stakeholders demands. With the focus on the individual
stakeholder this approach is expanding the area of coverable risks, thus opening up
an additional business field for the insurance/reinsurance industry.
This publication is very much based on the main findings of the thesis and intended
to represent an overview of the recent development in this business field.
Richard Glckler
Division Europe, Special Lines
Foreword
6
Definition
Although the word project has a variety of meanings, we are confining it to the
planning, realisation and operation of large engineering works. At one time Project
Finance simply meant the financing of a project. But soon it adapted a more specific
meaning for a financing structure where the lenders only had the assets and the
expected cash flow of a project to secure and repay their loans. The US Financial
Standard FAS 47 defines Project Finance as follows:
Thefinancingof major capital projectsin which thelender looksprincipally to thecash
flowsand earningsof theproject asthesourceof fundsfor repayment and to theassets
of theproject ascollateral for theloan. Thegeneral credit of theproject entity isusually
not a significant factor, either theentity isa corporation without other assetsor because
thefinancingiswithout direct recourseto theowner(s) of theentity.
Peter K. Nevitt gives another definition in his bible of Project Finance:
A financingof a particular economic unit in which a lender issatisfied to look initially
to thecash flowsand earningsof that economic unit asthesourceof fundsfromwhich a
loan will berepaid and to theassetsof theeconomic unit ascollateral for theloan.
Project finance
Chart 1
The difference between
conventional financing and
Project Finance of a project.
Lender
Borrrower/
Sponsor
Project
Internal
and external
funding
External
funding
Conventional
financing
Borrower is
responsible for
the debt, not
the project
Lender
Borrrower/
Sponsor
Project
External
funding
Internal
funding
Project finance
The project is an
independent
business unit
and is responsible
for the debt
7
Later in our work we will show the organisation of a typical Project Finance struc-
ture. But it is not the primary aim of this study to observe the different financing
techniques and the variety of deals. Instead we would like to focus on the risks
involved and the role of insurance/reinsurance in Project Finance.
History
Long before the first forms of insurance and financial institutions emerged, people
started trading across borders and over long distances, shifting values around the
world. The primary needs arising from these activities paved the way for what is
today known as Project Finance.
The ancient Greeks used to lend money to traders enabling them to purchase their
goods for trading. One of the conditions was that the repayment of the loan was not
guaranteed in the event of the shipment being lost at sea. Therefore, recourse to the
borrowers assets was limited, which is the first basic principle of Project Finance.
The second basic principle of repaying the debt from the revenue stream generated
by the project is also an old idea. In the Middle Ages road and bridge tolls were used
to finance the construction of the road network. These old financing techniques are
the first examples of limited recourse financing for individual projects.
The development of our civilisation and industrialisation during the past 100 years
entailed an increasing need for funds to finance the growing number of infrastruc-
ture projects. As a result, the financing structures for such projects have become
more and more important. The early examples of Project Finance for railroads in
the United States and Great Britain and for the oil fields in the United States paved
the way for similar finance structures of large infrastructure projects and independent
power producers all over the world, which today represent the most common exam-
ples of Project Finance.
Parties involved
The main stakeholders in Project Finance are:
The project sponsor(s) are parties with a direct or indirect interest in the realisation
of the projects such as contractors, suppliers, purchasers or users of the projects
products or facilities. Their goal is theoretically to obtain limited recourse (non-
recourse) financing so as not to influence their financial statements (so called off-
balance financing), but they often have to compromise for partial recourse financing.
The project or vehicle company, also called vehicle or special purpose vehicle (SPV)
or company (SPC), is a legal entity, whose existence is usually limited in time, estab-
lished for the purpose of channelling funds from borrowers to lenders and carrying
out regulatory requirements. It will eventually be awarded a concession and be
referred to as the concessionnaire. It will realise and operate the project, contract the
debt and collect the generated cash flow. It will act as a legal buffer and immunise
the originator or sponsor from recourse by investors. A vehicle will not always be
required for a project. A single sponsor may decide to carry out the project himself;
other sponsors may decide to participate in the project in other ways than by invest-
ment. SPVs or SPCs are often based in low or non-tax locations, have nominal
capitalisation and are set up for a single purpose.
Sponsor
Project or vehicle company
8
They offer opportunities to access finance that would not necessarily be available
through traditional channels. They may be off-balance sheet from the ultimate hold-
ing companys view point and need not be rated by credit agencies. They usually per-
mit minimum tax liability and can be highly leveraged. They permit an identifiable
stream of inflows and outflows for securitisation purposes and they may be less liable
to regulatory controls and provide limited recourse finance.
The operator: the operator is the entity assigned by the SPV and is responsible for
the operation and maintenance of the project once it is realised.
The captive finance company or trustee borrowing vehicle: 100% owned and con-
trolled by a parent company (sponsor), a captive finance company can enhance its
total borrowing capacity and provide off-balance sheet financing. A so-called trustee
borrowing vehicle functions along the same lines but its role is to make it possible
for state entities to borrow or give guarantees.
The lender(s): a syndicate of banks from different countries may be required to
gather together the huge amount of money necessary for the project and act as
lender(s). Other lenders may be contractors, individual and institutional investors
and the World Bankor other International Agencies. The bank which has arranged the
financing and syndication may act as the arranger and take a leading role in the
negotiation. Monitoring the technical progress and performance of the project and
liaison with the project engineers and independent experts may be carried out by one
of the banks which will be called the engineeringor technical bank. The agent bank
will communicate finance documentation and disseminate information.
The financial adviser is usually an investment or a commercial bank and will prepare
an information memorandum and sell the project to the lending banks.
The technical expert(s) or consulting firm(s) are individuals or firms with interna-
tional recognition and will be involved in the feasibility study and concept engineer-
ing. They will assist in the technical, financial and operational side of the project.
International law firm(s) and local lawyer(s) are required to review the legal, tax and
regulatory system and the complex documentation involved.
The host government: objectives of the host government are to satisfy national inter-
ests and to bring the project into public ownership once the lenders have been repaid
with the cash flow provided by the project.
The raw material supplier(s) and customer(s) of the project are an important part
and need to be carefully assessed in the planning stage.
The rating agencies may be involved if securities are used for the financing.
The insurer(s) [by insurer(s) we understand the insurance and reinsurance industry]
are required to help in identifying and covering the risks, a crucial aspect with lim-
ited or non-recourse projects. We will focus in particular on the role of the insurers
in Project Finance in the following chapter.
Operator
Financial adviser
Captive finance company or
trustee borrowing vehicle
Lender (financing, bank
syndicates)
Technical expert or
consulting firm
(engineering study)
International law firm
(consulting lawyer)
Host government
Supplier and customer
Rating agencies
Insurer (insurance and
reinsurance industry)
Contract for long
term sales and
management
Project Company
Sponsors Operator G o v e r n m e n t
Raw material
suppliers
Customers and/or
business partners
Insurance
company
Construction
contractor
Lenders
(financing, bank
syndicates)
Trustee borrowing
vehicle
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Environmental
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Engineering study
Consulting
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Writing of the
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memorandum
Contract for the
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project company
Publication of the
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concession
Publication of the
conditions of the
concession
Government
Contract for long
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Financing
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Fixed cost
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Raw material
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Chart 2
The main parties involved in Project
Finance
10
Financial structure
As we shall see later, it is important for the insurer to know the financial structure of
Project Finance in order to be in a position to develop an appropriate and innovative
solution. Some important/key aspects are:
limited recourse or non-recourse financing;
repayable out of project cash flows;
an interest in the output of a project.
Building on these basic characteristics, every project has its own special features
tailored to the individual situation. In some cases tax implications might lead to a
leasefinancingstructure. In projects where export creditsare used, the structure might
have to be adapted to suit the requirements of the export credit agency. For large
enough projects it might even be possible to securitisesome of the financing, ie to
issue negotiable securities. No matter what these individual (special) features look
like, the typical basic Project Finance structure remains the same. Normally sponsors
would try to launch a project with as little equity as possible. This reduces their own
risk and at the same time enhances the possible yield, provided the expected return
on investment is greater than the interest for the loans (leverage effect). On the other
hand, the lenders carefully analyse the project, its expected returns and the risks
involved. Based on their findings they decide whether or not to finance the project,
and to what extent. Of course they will insist on a substantial commitment from the
sponsors in the form of equity to make sure that the sponsor has a large enough
interest and cannot easily abandon the project. The greater the equity, the smaller the
lenders risk. Just how important it is for the lenders to pay attention to the equity
issue may be illustrated by the following well-known saying in project circles:
At thestart of theproject financing, thesponsor hastheexperienceand thelender hasthe
money, whereasat theend thelender hastheexperienceand thesponsor hasthemoney.
No lender will have the ambition of proving the truth of this.
The following chart shows the typical financial structure of a project, indicating a
common percentage range for each financing level. The subordinated debt may
be used to bridge a gap between equity and senior debt and, as we shall later see,
can possibly be replaced by an insurance solution. In case of project failure, the
equity is consumed first, followed by the subordinated debt, before the senior debt
is eventually used up.
0%
20%
40%
60%
80%
100% Senior debt (6090%)
Loans from financial institutions
Subordinated debt (015%)
Project sponsors, capital markets
Equity (10 30%)
Sponsors, risk capital, capital
markets, investment funds
Chart 3
Typical financial structure
in Project Finance
Special purpose
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Operator
Bonding institutions
for contractors,
subcontracors and
suppliers
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Sponsors Government agency Lenders Insurance
Suppliers
Chart 4
A typical BOT
project structure
11
As an example of a Project Finance structure we can consider a so-called BOT (build
operatetransfer) structure. BOT is particularly suitable for large infrastructure
development projects but is also applied to private sector investments. Having been
used to finance large infrastructure projects in developing countries, BOT has recently
caught the interest of politicians world-wide (including the most developed countries)
and could become a viable alternative for undertaking costly infrastructures without
burdening the public sector balance sheet.
BOT is a method of turning over to the private sector, for a limited period,
the development and initial operation of what would otherwise be a public sector
project. The BOT approach is particularly attractive if a government seeks:
to minimise the impact on its capital budget, thus enabling it to allocate its
resources to other projects which might be less suitable for a private sector project;
to take advantage of the greater efficiency of the private sector;
to encourage foreign investment and the introduction of new technologies
(particularly in developing countries).
Typically a BOT structure is based on a concession agreement between a host govern-
ment (or a government agency) and the project company (SPV, Special PurposeVehicle)
established by the sponsors to carry out the construction and operation of the project.
Due to the large investments of most projects in the public sector (infrastructure,
power...), the concessions are often granted for long periods in order to allow the
sponsors to repay their loans and to earn a profit. The periods can be up to15 or
20 years, or for some special infrastructure projects such as hydro power plants, even
30 years or more. Given the large amounts at stake and the long-term character
of the concession agreements, both sides are concerned to limit the risks involved.
The following chart shows the typical structure of a BOT project.
BOT
(build operate transfer)
12
Project phases
The following chart should help to illustrate the planning and progress of a project:
15 years
Site work
Fabrication
Erection
Constructions
costs
Development
fees
up to 20 years
or more
Commercial
operations
Punch list
Final acceptance
Maintenance
Transfer (BOT)
Liquidation
Operating
expenses
Fuel
Maintenance
Operating
revenues
Equity sell down
Time period
variable
Activities
Initial
development
Identify a
project
Request for
authorisation
Go ahead
approval
Costs
Pre-develop-
ment cost
Revenues
none
23 years
Feasability study
Partner search
Form project co.
Financing
negotiations
Design
Bid,
procurement
Development
costs and
expenses
Financing costs
Recoup from
partner (?)
16 month
Startup, testing
Provisional
acceptance
Comissioning
adjustments
Operating
revenues
Project phases
Pre-project
Development Construction Testing Operation
Chart 5
The typical progress
of a project
13
In the pre-project phase, different alternatives for projects are actively or passively
considered. Once an interesting project is found, a project promoter writes a request
for authorization where he basically presents what the project is about, the alterna-
tives, why the project has to be carried out, how much it will cost, and how it will be
financed.
The development phase begins with a feasibility study, which determines the
possibility of carrying out the project. The project is analysed and evaluated and
a profitability study is performed. The conception of the project can be started
simultaneously.
In the development phase the promoters issue the tenders. These are based on
technical specifications and drawings for the supply of raw materials, equipment or
for the construction of parts of a plant or entire plants. Based on the bids, the
contractors, subcontractors and suppliers are determined. The necessary equipment
is produced, shipped and then installed. Negotiations are made for the acquisition
of land and other resources.
Probably the most important phase is the construction phase, where the site is
prepared and fabrication and erection are completed.
The construction phase is followed by the testing and commissioning phase (start-up).
This phase is of particular interest for the risk analysis.
The project is then ready for the operational phase, which will generate cash to repay
the debt. At the end of the operational life the project will be liquidated.
Development phase
Construction phase
Testing and commissioning
phase
Operational phase
Pre-project phase
14
The role of the insurer
History
As mentioned in the history of Project Finance the volume of trade and the value of
the traded goods has increased constantly over the centuries. This development
marked the beginning of the long quest to avoid, control or minimise the exposure
to loss or damage of their goods.
What had begun as a simple sharing of risks or joining forces, developed into the
sophisticated process of risk allocation and risk transfer, meaning the transfer of
risks from the primary (traditional) carriers such as lenders, borrowers or sponsors to
professional risk carriers (insurance and reinsurance syndicates or companies).
Operating field
We shall now take a look at the aspects of professional risk transfer (the key element
of good, contemporary, risk management). Firstly, we summarise the traditional
approach of insurers and reinsurers to the risk transfer in Project Finance. Secondly,
we describe the more recent developments, including alternative methods and capital
market solutions. And finally, we define the spectrum of risks which are today classi-
fied as uninsurable.
Comprising the three aspects in one single picture, we define the operating field of
todays insurer.
Uninsurable
to be borne by equity, debt etc.
Contingent capital
Traditional risk
transfer (insurance)
Surety bonds
and financial
guarantees
(bank and
Insurance)
Derivatives
(capital
markets)
Securitisation
(capital markets)
Finite
solutions
(financial
insurance)
Chart 6
The landscape
of insurability today
The above chart shows the areas which are to be explored and might offer potential
for further services and capital support for the participants in a Project Finance
transaction. Later on, we intend to evaluate the whole range of insurance products
currently offered in this area of business.
15
Within this approach the role of the insurer is quite limited to that of a provider of
underwriting capacity. The products to convey this underwriting capacity were
mostly standardised policies such as contractors all risks, erection all risks, advanced
loss of profit, marine cargo, marine loss of profit, fire and allied perils, business
interruption etc. The advantage of this standardisation is that it makes it easier to
compare offers from different insurers and check prices. The disadvantage is that
innovation is hindered and the opportunities to draw substantial advantages for the
overall project are not seized. This standardisation of the insurance side of Project
Finance contrasts with the fact that each and every project financing deal is different
and that there is often very little in common between financial arrangements for two
projects, even if they are in the same country and industry.
The perception of the insurers role in Project Finance has changed over recent years.
Problems in emerging markets, mergers among financial institutions with subsequent
change of business policy and/or downsizing of existing capacities, generally
increased volatility of financial markets, increasing size of individual projects and a
tendency to push market risk into single projects have increased the pressure on
insurers to assume more and more risks which they have not traditionally insured.
With the attention of top management the traditional view of insurance gave way to
a more financially driven approach often referred to as risk financing. Risk
financing is part of a long-term strategic corporate plan with specific and defined
financial objectives. It includes a broad range of risk management tools including
self-financing, insurance, capital market solutions, credit financing, and finite risk
solutions.
Applied to Project Finance, this risk financing approach opens a wide area of possi-
bilities for insurers to play a more active role in projects and to move away from
their traditional domain as providers of standardised insurance capacity. At this point
we would like to give a very brief overview of some recent techniques which might
be used to secure risk transfer by alternative methods:
A Financial Guarantee Insurance means a surety bond, insurance policy or, when
issued by an insurer, an indemnity contract, and any guarantee similar to the
foregoing types, under which an insurer is obliged to indemnify a creditor, insured
claimant, obligee or indemnitee, for a loss, upon proof of occurrence of a financial
loss. It guarantees the timely payment of principal and interest due on a specific
maturity date in exchange for a fee.
For example a Credit Enhancement in the form of a third party credit enhancement
can improve the creditworthiness of Project Finance loans or securities. An insurance
company thereby pledges its own creditworthiness and guarantees repayment of
outstanding principal and interest in exchange for a fee. The actual risk can in return
improve its own risk profile to an investment grade rating and at the same time
improve the marketability of the obligation.
Capital markets are increasingly offering a wide range of derivative instruments
which enable project participants (equity and debt holders) to minimise their risk
exposure.
Traditional risk transfer
Recent developments
Surety bonds and
financial guarantees
Derivatives (capital market
solutions)
16
Interest rate hedges and currency swaps, but also derivative instruments to manage
commodity risks are today an integral part of managing the risks of a project. With
the opening up of new markets, new risk hedging instruments and risk carriers
are being sought. For instance the liberalisation of the energy markets prepares the
ground for the further development of energy trading and the subsequent use of
new instruments. Insurers are increasingly taking part in this fast growing market
often as important risk takers.
The principle of this idea is not new. With the use of financial market products a
risk is split into small negotiable units which can easily be bought and sold on the
capital markets. One example is mortgage-backed securities. Instead of keeping long-
term mortgages until maturity, the banks securitise and sell their mortgages on
a large, liquid mortgage-backed securities market.
Consequently, insurance risks can be transferred to the capital markets by transform-
ing them into securities. In the insurance area, the most common securitised product
is the catastrophe (CAT) bond, where interest payments and/or principal repayment
depend on the (non-)occurrence of a clearly defined triggering event.
Insurance companies, in underwriting insurance policies aresimilar to banksacting
as originators and intermediaries. It can easily be imagined that the securitisation
and selling of these risks to the capital markets can open up massive additional under-
writing capacity, making it possible to write risks which are traditionally considered
uninsurable due to lack of capacity.
Owing to the fact that these products are not directly linked to insured losses, they
are not suitable for individual projects. However, some of the risks of projects may
indirectly be covered through catastrophe bonds and futures.
A Finite Risk solution is a financing concept with a risk transfer through which the
insured company funds part of the risk itself. In contrast to traditional insurance,
which is based on the principle of large numbers where the risk is spread over a huge
number of insured, a finite risk program is generally geared to a single risk or a well-
defined basket of risks.
With the advance financing element of a risk borne by the insured, a finite risk
solution is a blend of banking and traditional insurance, combining the advantages
of both areas. With this concept, risks which have traditionally been considered
uninsurable can be mitigated and spread over a period of time. Moreover, this
concept usually bears an additional tax saving.
However, in the case of Project Finance these solutions are much more tuned to deal
with a problem of a single stakeholder holding an entire portfolio of risks, and are
rather limited or indirectly applicable for a number of parties (stakeholders) involved
in an individual project.
For a project company (SPV), one way to seek protection against adverse factors
which may not traditionally be insurable, is a put option on a debt instrument or
package of preferred stock. The option includes/envisages the right of the project
company to make use of funds after the occurrence of a predefined event. It may
borrow money on pre-agreed terms. Contingent funding can be considered as an
insurance coverage, where funds injected into the project company are not lost for
the insurer, but are transformed into an equity or debt stake. Risk is financed for a
predetermined period.
Securitisation (capital
market solution)
Finite solutions (financial
insurance)
Contingent capital solutions
17
Contingent capital solutions are cost efficient, and one way to diversify sources of
capital and enhance the liquidity of a project.
While the SPV is normally sufficiently covered against risks directly related to con-
struction, contingent solutions are for example applicable for managerial or financial
risks or to improve either cost or extent of cover in present solutions. Such advantages
can be the reduction of borrowing cost, reduction of negative cost of carry, increasing
the probability of completion while the insurer has the opportunity to participate in
the upside potential of the project.
No matter what instruments we apply for risk transfer, there will remain some risks
which we cannot separate from the primary carriers. The reasons might be different
but the fact is that the risks are not suitable for transfer to any other party. Those
risks are considered to be uninsurable in todays risk financing markets. Given the
speed of development in the insurance and banking industry, this barrier is bound
to be flexible and change steadily. What is today regarded as uninsurable, might
tomorrow be handled by newly developed risk transfer instruments.
We shall try to classify the main reasons why risks are today considered uninsurable:
insufficient actuarial fundament; the most common reason why risk transfer cannot
be offered;
unlimited consequencesof an event; some events could have barely predictable
consequences (nuclear disaster, environment pollution, Y2K ...etc.) and the assess-
ment of risk-adjusted capital is, therefore, almost impossible;
therisk can bedirectly influenced by thebeneficiary; the interest of the beneficiary
party generates so called moral hazard. In this constellation the risk is inextricably
linked to the primary risk carrier;
thecoversexceed theavailablecapacity; obviously some events could cause losses
exceeding the existing capacity of the insurance industry including the current
support from capital markets (eg EQ Tokyo, Storm Florida, EQ California ...etc.);
the covers beyond these limits would be uninsurable for the time being.
The above are only the main reasons, but some other reasons could also lead to
uninsurable risks. The status of an uninsurable risk is something temporary and is
always to be verified in the light of recent developments in the insurance markets.
Limits of insurability
(uninsurability)
18
Risk situation
In project financing it is important to have a structure which uses the undertakings
and guarantees of several parties to ensure a stream of revenue and cash flow and by
doing so achieve the equivalent of a bankable credit. Therefore it is essential that the
investors (sponsors and lenders) thoroughly review and address all the risks involved.
Due to different types of investments, the situation for the lenders and the sponsors
is not the same, but the risk identification and possible risk transfer are crucial for
the success of both parties.
Seen from thelenders point of view, the whole Project Finance is a large investment
with an inherent all risks exposure. The good thing for lenders is that the all risks
cover of their investment has a high attachment point which is beyond the amount
of the projects equity (normally 10% to 30% of the total project investment). In
other words, the lenders investment is jeopardised only if the loss, due to any risk,
is higher than 100% of the projects equity. Therefore, the lendersare prepared to
carry a credit risk, but do not want to be involved in any equity risk or venture capital
risk. The lenders are not in the business of taking equity risk, even if they would be
lavishly compensated for it. This is quite understandable, given the banks and the
lending institutions which are typically leveraged in the range of eight to ten to one.
With such leverage, lenders can not afford to take any risk other than a lending
(credit) risk. Correct risk identification and transfer will help lenders to achieve some-
thing near to a bankable credit.
The sponsorsbear the same, all risks exposure for their investment (equity) but
from ground up. Consequently, their risk is higher and they carry an equity riskor
a venturecapital risk. The good thing for sponsors is that in the event of the projects
success they will be over-proportionally rewarded. However, their interest in a proper
and comprehensive risk transfer might be even bigger then in the case of lenders.
The other stakeholders involved in project realisation carry their segments of the
entire project risk. However, all of these risks were originally undertaken by investors
(lenders and sponsors) and are distributed to other parties through the contract
requirements. Nevertheless, all risk carriers would tend to transfer the risk to the
professionals and by doing so increase the possibilities for a successful realisation of
the project.
Risk analysis
19
Four dimensional model
The first step required in order to transfer the risks is to identify the entire risk
landscape. But in our view comprehensive risk identification for Project Finance is
everything but simple. We will be faced with a basic definition of the risk and the
variables which influence it.
We have therefore, developed a model containing the main aspects of the risk. We
would tend to present one particular risk as a function which is determined by the
four main variables, four dimensions of risk, which we describe as follows:
Involved Parties(Stakeholders). Every participant in the project has his own
Archimedean point and his own view of the deal. Most of the risks are common
for all parties but some of them are very specific and focused on one party only.
Project Phases(Timeframes). As mentioned earlier, the project is divided into
different phases. The risks are divided into predetermined time frames (construction
phase, start-up phase, operation phase...etc.).
Endangered Project Factors(Costs, assets). What might be endangered?Material, equip-
ment, (envisaged) revenue, costs due to liabilities arising from the project, Human
Resources...etc.
Perils(Exposures). How might it be endangered?Natural perils, fire, currency
problems, construction, war, nuclear disaster etc.
Chart 7
Endangered project factors
Dimension 1
Dimension 2
Dimension 3
Dimension 4
Danger
of delay
Liquidates
damages,
penalties
Project
liabilities
Loss of
revenue
Revenue
reduction
(Perfor-
mance)
Costs
overrun
Project
Material
Equipment
Human resources
Equipment hours
Labor hours
Revenues
Operation Design, construction, testing
Nuclear disaster
Transport (marine)
failure
Faulty design
Faulty material
Faulty workman-
ship
Moral hazard
(Willfull/Malicious
act of the insured
party)
Suppliers
performance
Off-takers
performance
Contractors
performance
Contractors
insolvency
Natural perils
Fire & Explosion
Handling/Operation
Construction
Riot, strike, civil
commotion
Terrorism
War
Expropriation
Change in law/
regulatory
Foreign law and
legal system
Political instability
and violence
Currency and
interest rate
fluctuation
Inconvertibility
of currency
Disabled currency
transfer
Defects
Force majeure
(environment)
Breach of
conditions
Alterations/
betterments
Reliability of
feasibility study
Projects
performance
Price fluctuations
(commodity price)
Danger
of delay
Liquidates
damages,
penalties
Project
liabilities
Loss of
revenue
Revenue
reduction
(Perfor-
mance)
Costs
overrun
Project
Material
Equipment
Humanresources
Equipment hours
Labor hours
Revenues
Operation Design, construction, testing
20
Consequently, it is possible for each party involved to determine the different
combinations of the other three variables (Assets/Perils/Phases). The sum of those
combinations will represent a bouquet of risks to be borne by this particular party
during the period of the project.
Chart 8
Possible perils of a project
Operation phases
Testing phases
Construction phases
Dimension 1:
Involved paties (stakeholder)
Example: Sponsor
Traditional risk transfer
Alternative risk transfer
Not suitable for risk transfer
Dimension 3: Endangered project factors (costs, assets)
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1m
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1l 1k 1i 1h 1e 1c 1b 1a
2a 2b 2c 2e 2h 2i 2k 2l 2m
3m 3l 3k 3i 3h 3e 3c 3b 3a
4m 4l 4k 4i 4h 4e 4c 4b 4a
5m 5l 5k 5i 5h 5e 5c 5b 5a
6m 6l 6k 6i 6h 6e 6c 6b 6a
7m 7l 7k 7i 7h 7e 7c 7b 7a
8m 8l 8k 8i 8h 8e 8c 8b 8a
9m 9l 9k 9i 9h 9e 9c 9b 9a
10m 10l 10k 10i 10h 10e 10c 10b
11h 11e 11b 11a
15h
12h 12d
15e 15d
17h 17e 17d
18h 18e 18d
19c 19b 19a
20d 20e
21e 21h 21c 21b 21a
22c 22b 22a
23h 23d
24h 24d
25h 24d
26h 26d
27h 27d
28h 28d
29h 29d
30h 30e 30c 30b 30a 30l 30m
31h 31e 31c 31b 31a 30l 31m
32h 32e 32a 32l 32m
Natural perils 1
Earthquake as a special natural peril 2
Fire and explosion 3
Handling/operation 4
Construction 5
Faulty Design 6
Faulty Material 7
Faulty Workmanship 8
Malicious/willfull act of one insured party 9
Nuclear Disaster 10
Transport (marine) failure 11
Reliability of the feasibility study 12
Projects performance 13
Price fluctuations (commodity price) 14
Suppliers performance 15
Off-takers performance 16
Contractors performance 17
Contractors insolvency 18
Defects 19
Force majeure 20
Breach of conditions 21
Alteration/Betterments 22
Currency and interest rate fluctuation 23
Inconvertibility of curreny 24
Disabled currency transfer 25
Expropriation 26
Change in law/regulatory 27
Foreign law and legal system 28
Political instability/violence 29
Riot, strike, civil commotion 30
Terrorism 31
War 32
10a
22
This bouquet of risks is dedicated to an individual party involved in the project
(a stakeholder) and represents 100% of all possible risk transfer requirements.
According to their own risk adversity each party involved will determine its own
catalogue of risks which it prefers to transfer (mostly via insurance/reinsurance).
This maximum of the risk tranfer demand is the starting point of our analysis.
We do believe that insurers, as professionals in risk business, should have an
appropriate answer to the vast majority of our clients needs. By doing so they will
move one step ahead and become an important player in the whole Project Finance
deal. The role of the insurer offering off-the-shelf products, which mainly means
being indirectly involved in the project, has to be reassessed.
Application of our model
In order to present our Four Dimensional Model we will illustrate our analysis
with a practical example. It is an example of a toll highway to be built and operated
as a BOT (build, operate and transfer) project.
In order to simplify the analysis, we have chosen to fix dimensions 1 and 2. There-
fore, we chose to focus on only the sponsors risks (Dimension 1 with a sponsors
eyes) and the risks during the construction phase (Dimension 2 is period
of construction):
Chart 9 (left page)
Risk analysis: sponsor in
construction phase
23
Risk transfer solutions
Based on our example of Risk Analysis by four dimensional model (the spreadsheet
with a risk landscape for a Sponsor in the Construction Phase) we would like to
analyse the different segments of the spreadsheet. The spreadsheet as an entire risk
landscape will be divided into different segments. For each segment we determine
the range of risks and indicate possible solutions for the risk transfer of these risk
segments. The sequence of segments in this analysis does not follow any particular
order.
Analysing the risk exposures and security requests we hope to give an overview of the
different techniques applicable for risk transfer.
Summarising this analysis we would like to give a decisive impulse (kick-off ) to the
rethinking of the insurers and reinsurers position towards limited recourse financing
of large projects.
Risk transfer
Segment 1
The Sponsors can transfer all their here
defined risks to the insurance industry in
the traditional way.
The traditional insurance products (poli-
cies) are well known as Contractors All
Risks policy (Erection All Risks policy) or
Builders Risks policy in the North Ameri-
can market.
Some of the risks can be endorsed on a
case per case basis only. As an example
the Manufacturers' risk (ie design, mater-
ial, workmanship) as well as terrorism
are of particular interest.
Sponsor in construction phase
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1a 1c
2a 2c
3a 3c
4a 4c
5a 5c
6a 6c
7a 7c
30a 30c
31a 31c
8a 8c
Natural perils 1
Earthquake as a special natural peril 2
Fire and explosion 3
Handling/operation 4
Construction 5
Faulty Design 6
Faulty Material 7
Faulty Workmanship 8
Riot, strike, civil commotion 30
Terrorism 31
24
Sponsor in construction phase
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Natural perils 1
Earthquake as a special natural peril 2
Fire and explosion 3
Handling/operation 4
Construction 5
Faulty Design 6
Faulty Material 7
Faulty Workmanship 8
Riot, strike, civil commotion 30
Terrorism 31
Sponsor in construction phase
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Natural perils 1
Earthquake as a special natural peril 2
Fire and explosion 3
Handling/operation 4
Construction 5
Faulty Design 6
Faulty Material 7
Faulty Workmanship 8
Malicious/willfull act of one insured party 9
k
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Segment 2
The Sponsors can transfer all their here
defined risks to the insurance industry in
the traditional way.
The traditional insurance products (poli-
cies) are well known as Contractors Plant
and Equipment policy endorsed by
Machinery Breakdown policy. This cover
can be integrated by means of an
endorsement into the CAR/EAR policy as
well.
Segment 3
The Sponsors can transfer all their here
defined risks to the insurance industry in
the traditional way.
The traditional insurance products (poli-
cies) are well known as General Third
Party Liability policy endorsed with terms
and conditions in respect of the Seepage
and Pollution Liability.
This policy is transferring the risk that
anybody involved in the project will be
legally liable towards the third parties
during the defined period (construction
phase).
25
Sponsor in construction phase
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6l
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1m
2m
3m
4m
5m
6m
7m
8m
9m
Natural perils 1
Earthquake as a special natural peril 2
Fire and explosion 3
Handling/operation 4
Construction 5
Faulty Design 6
Faulty Material 7
Faulty Morkmanship 8
Malicious/willfull act of one insured party 9
Riot, strike, civil commotion 30
Terrorism 31
War 32
30l 30m
31l 31m
32l 32m
Sponsor in construction phase
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11a 11b Transport (marine) failure 11
d h
11d 11h
Segment 4
The Sponsors can transfer all their here
defined risks to the insurance industry in
the traditional way.
The traditional insurance products (poli-
cies) are well known as Employers Liabil-
ity policy and Workmen's Compensation
policy.
The policies are transferring the risk that
the employers (contractor, subcontrac-
tor...) will be legally liable towards their
employees during the defined period
(construction phase). The Sponsor as the
owner of the Project Company (SPV) has
a vital interest to transfer this risk to pro-
fessional risk carriers.
Segment 5
The Sponsors can transfer all their here
defined risks to the insurance industry in
the traditional way.
The traditional insurance products (poli-
cies) are well known as Marine Cargo
policy followed by Marine (Advanced)
Loss of Profit or Delay in Start Up policy.
The majority of the transportation risks
are during the development phase, but
some of the transports proceed during
the construction phase as well.
26
Sponsor in construction phase
10a 10b 10c 10i
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Nuclear Disaster 10
c k l m
10k 10l 10m
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Sponsor in construction phase
9e
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1e 1h
2e 2h
3e 3h
4e 4h
5e 5h
6e 6h
7e 7h
9h
10e 10h
8e 8h
15e 15h
30e 30h
31e 31h
Natural perils 1
Earthquake as a special natural peril 2
Fire and explosion 3
Handling/operation 4
Construction 5
Faulty Design 6
Faulty Material 7
Faulty Workmanship 8
Malicious/willfull act of one insured party 9
Nuclear Disaster 10
Suppliers performance 15
Riot, strike, civil commotion 30
Terrorism 31
Segment 6
The Sponsors may have a requirement to
transfer the risk (or a part of the risk)
connected with nuclear energy to the
insurance industry.
The insurance industry can offer an indi-
rect solution for the risk transfer. Due to
rather high and unpredictable exposure
(on the liability side), these risks are nor-
mally insured through the nuclear pools
where the professional insurers are par-
ticipating. In some countries the local
government participates in risk as well
(risk mitigation).
Segment 7
The Sponsors can transfer most of their
here defined risks (green area) to the
insurance industry in the traditional way.
The traditional insurance products (poli-
cies) are well known as Advanced Loss of
Profit policy or Delay in Start Up policy.
Some of the risks can be endorsed on
a case by case basis only (eg riot, strike
and terrorism, faulty design).
The Sponsors' risk of the loss of revenue
due to willful/malicious act of one
insured party is evident. However in our
understanding the transfer of this risk
can substantially influence the risk bal-
ance among the project parties and
therefore might jeopardize the whole
venture.
27
Sponsor in construction phase
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17d 17e
18d 18e
15h
17h
18h
h
Suppliers performance 15
Contractors performance 17
Contractors insolvency 18
15e 15d
Sponsor in construction phase
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25e
26e
24h
25h
26h
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24e
27e 27h
28e 28h
29e 29h
Inconvertibility of currency 24
Disabled currency transfer 25
Expropriation 26
Change in law/regulatory 27
Foreign law and legal system 28
Political instability/violence 29
Segment 8
The Sponsors can transfer a part (per-
centage) of their here defined risks to the
insurance industry through credit and
bonding insurance.
The Sponsors will require a Performance
Bond from the Contractor in order to
minimize the risk of contractor's (or sub-
contractor's, supplier's) poor perfor-
mance and possible insolvency during
the construction phase. During the ten-
dering stage (development phase) the
Sponsor will require a Bid Bond for the
same reason.
The insurance products (policies) can be
used as collateral to cover (to back) the
Performance Bond (or Bid Bond) issued
by a bank or an insurer.
Segment 9
The Sponsors (as well as the Lenders)
are in general faced with a wide range of
political risks. They prefer to mitigate, or
even entirely transfer, this risk to a third
party.
The Political Risk can be transferred to
various political insurers, grouped as
follows:
a. Multilateral Sources (MIGA, World
Bank Guarantees)
b. Bilateral Sources (OPIC(US), MITI(J ap),
ECGD(UK), Export Credit Agencies)
c. Private Insurance Sources
The private insurance industry increas-
ingly penetrates this area and offers
arrangements with comprehensive cov-
ers. Long-term commitments, as often
required for Project Finance, are still lim-
ited and/or expensive. Therefore, tradi-
tional insurance products (policies) can
also be a valid solution for the risk trans-
fer.
28
Sponsor in construction phase
T
o
t
a
l

c
o
s
t

o
f

p
r
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j
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c
t

(
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v
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)
L
o
s
s

o
f

r
e
v
e
n
u
e
e
23h
h
23e Currency and interest rate fluctuation 23
Sponsor in construction phase
P
r
o
j
e
c
t

s

m
a
t
e
r
i
a
l
P
l
a
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q
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u
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i
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p
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P
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R
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d
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C
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n
a b
2a Earthquake as a special natural peril 2
c e h i k l m
2b 2c 2e 2h 2i 2k 2l 2m
Segment 10
The Sponsors are generally faced with a
wide range of financial risks which they
would prefer to mitigate or even entirely
transfer to a third party.
The insurance industry offers some
solutions in this field.
The Currency Fluctuation and Interest
Rate Risk can be hedged with Currency
and Interest Rate Swaps. This would
allow the swapping of the cash flows of
the two currencies / interest rates.
Segment 11
The Sponsors have a demand to transfer
the risk of Natural Perils to the insurance
industry. But in some geographical areas
there might be a capacity shortage.
One of the possible solutions to gain
additional capacity would be the securiti-
zation (Cat Bond issuance based on EQ
risk). Therefore the insurance can provide
risk transfer for the entire project, how-
ever part of the risk (the additional capac-
ity) will be transfered to the capital mar-
kets.
A Cat Bond Issuance is marketable on a
portfolio basis only.
29
Sponsor in construction phase
T
o
t
a
l

c
o
s
t

o
f

p
r
o
j
e
c
t

(
o
v
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r
r
u
n
)
L
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s
s

o
f

r
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v
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n
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e
d
12d Reliability of the feasibility study 12
h
12h
Sponsor in construction phase
P
r
o
j
e
c
t

s

m
a
t
e
r
i
a
l
R
e
v
e
n
u
e

d
e
l
a
y

(
d
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l
a
y

i
n

s
t
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t
-
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p
)
L
o
s
s

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f

r
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v
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n
u
e
a
32a War 32
h
32e
e
32h
Segment 12
The Sponsors are in general very much
dependent on the reliability and feasibil-
ity study. Their decision to start the
venture is based on this study and a
simple error in it could be fatal. Therefore
they would prefer to mitigate or even
entirely transfer this risk to a third party.
The problem is complex due to the
fact that it is quite difficult to distinguish
between an error and a completely
unprofessional estimation.
Nevertheless, the insurance industry
could offer some solutions in this field.
It is possible to offer Contingent Capital
in order to provide liquidity to meet the
current needs in a case of catastrophic
failure in the R&F study. The Sponsor
buys an option (option premium) for the
right to access capital.
Segment 13
The Sponsors are in general faced with a
wide range of political risks as described
in Segment 9. But, the risk of war is still
evident. The Sponsors definitely prefer to
mitigate or even entirely transfer this risk
to a third party.
Due to the nature of the risk and interna-
tional agreements, today only few insur-
ers are prepared to offer such cover. Con-
sequently the capacity is rather limited
and the cover is bound to restrictive
terms and conditions.
30
Sponsor in construction phase
P
r
o
j
e
c
t

s

m
a
t
e
r
i
a
l
P
l
a
n
t

a
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d

e
q
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i
p
m
e
n
t

u
s
e
d

i
n

p
r
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j
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c
t
P
r
o
j
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t

s

l
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c
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t
s
R
e
v
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n
u
e

d
e
l
a
y

(
d
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l
a
y

i
n

s
t
a
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t
-
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p
)
L
o
s
s

o
f

r
e
v
e
n
u
e
a
9a
c
9b
b
9c Malicious/willfull act of one insured party 9
Breach of conditions 21 21a 21b 21c
e
9e
21e
h
9h
21h
i k l m
9i 9k 9l 9m
Sponsor in construction phase
T
o
t
a
l

c
o
s
t

o
f

p
r
o
j
e
c
t

(
o
v
e
r
r
u
n
)
R
e
v
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n
u
e

d
e
l
a
y

(
d
e
l
a
y

i
n

s
t
a
r
t
-
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p
)
d
20d 20e
e
Force majeure (environment) 20
Segment 14
The Sponsors might have a need to avoid
the risk arising out of willful/malicious
acts of other insured parties (Contractors,
Subcontractors). This event would
normally not be covered by an insurance
policy due to the fact that it is an insured
party (Contr., Subcontr.) which breaches
the conditions of the policy.
Nevertheless, the Sponsors themselves
can buy additional cover known as
Breach of Conditions policy on the tradi-
tional insurance market.
Segment 15
The Sponsors normally carry the risk that
the project cannot be continued due to
causes beyond the Sponsors control and
could not be avoided by excercise of due
care eg the blockade of the main access
road, strike, riot etc.
The traditional insurance product (policy)
is known as Force Majeure cover.
The Sponsor has the option of insuring
a large part of the force majeure risk ie
delays caused by physical loss or dam-
age within the scope of a Delay in Start
Up Policy.
31
32
33
At the onset, the project risk is the investors risk. By means of contract conditions,
investors (sponsors and lenders) transfer segments of risk to other parties involved,
in order to optimise their profit potential. This process of risk spreading is typically
top-down orientated.
Traditionally, the insurance/reinsurance industry has always been in a position to
consider individual segments of risks and to calculate the price for these. This per-
spective of project risk was rather bottom-up orientated.
With their bottom-up view and top-down understanding, insurers are well placed
to analyse and recognise the risks of all parties involved in project financing. With
the help of our risk analysis model (Four Dimensional Model) we try to identify the
overall demand for risk transfer among the project stakeholders. Consequently, the
insurance industry has the advantage of being able to identify the mosaic of different
risks and still maintain an overview of the Project Finance risk as a whole. Further-
more, the insurance/reinsurance industry today has a variety of solutions and instru-
ments at its disposal for transferring or bearing risks in the most efficient way.
On the other hand, it is very important for the insurer to be in direct and constant
contact with the investors (sponsors, lenders and their financial advisers). Early
involvement of the insurer can avoid risks being divided and allocated before proper
risk analysis has been undertaken. Only the parties which are involved in the early
(investment) stage of the project have the opportunity to steer this process efficiently
and avoid costly and unproductive overlap and shortcomings in the risk coverage.
In our understanding, the insurance/reinsurance industry has the perfect match
of tools and know-how, generating added value for all parties involved in Project
Finance. But in order to actually produce this added value the insurers will be
challenged to do more than just bear risks. The insurers role should be that of an
overall risk specialist which provides the services and resources for:
risk identification (the role of investor)
risk management (the role of financial officer or risk manager)
risk handling and risk-bearing (the traditional role of insurer/reinsurer)
risk financing(providing contingent risk capital therole of contingent sponsor)
risk transfer to the capital markets (the role of originator and broker)
Comprising all the different roles and based on the above-mentioned advantages, the
insurer should be able to exploit the synergies and offer the most competitive price
for risk in general. Thanks to the finely tuned use of capital from different sources
(insurance, reinsurance, capital markets, sponsors, lenders, contractors... etc.) risk-
adjusted capital will be minimised and the price for capital consequently optimised.
The economic performance of the project will be improved, with an additional
economic value. This economic value is the insurance contribution to successful
financing theadded valueof theinsuranceindustry to Project Finance.
New approaches, mainly to thebenefit of the sponsor and lenders, focus on the
financial structure and certain business risks of a project. Such involvement of the
insurer can be considered as direct Project Finance, but it is not focused on in this
brochure. It includes the provision of contingent capital, weather, currency or raw
material hedges, the insurance of generic project risks, the protection of revenue
streams, and insurance of the residual value of the key asset of a project or credit
enhancements of certain layers of debt. These solutions make an insurer a very
attractive player in the context of large international projects.
Conclusion
1999
Swiss Reinsurance Company
Zurich
Title:
Project finance The added value
of insurance
Authors:
Mladen S

osi c, EN/M3
Lorenz Albisser, ES/IP
Werner Baumgartner, SRNM
Rico Baumgartner, SRNM
Published by:
Swiss Re Publishing
Editing and production:
Corporate Communications
Graphic design:
Markus Galizinski, Zurich
Additional copies of this brochure,
as well as an overview of Swiss
Res other publications (Swiss Re
Publishing our expertise for your
benefit) can be ordered from:
Swiss Reinsurance Company
Mythenquai 50/60
P.O. Box
CH-8022 Zurich
E-mail publications@swissre.com
Swiss Re publications can also be
downloaded from our Website
www.swissre.com
Order no.: 210_99209_en
CC, 11/99, 3000 en
Werner Baumgartner graduated
from the University of Bern with a
degree in law.
He then joined Credit Suisse where
he worked in different positions in
Zurich, NewYork and Latin Amer-
ica gaining experience in struc-
tured finance and credit business.
In spring 1997 he joined Swiss Re
where he works today as a mem-
ber of senior management in
the Structured Credit Underwriting
unit of Swiss Re New Markets.
Lorenz Albisser, (dipl. Masch. Ing.
HTL), graduated in 1978 with a
degree in Mechanical Engineering.
After having worked 9 years in the
power industry he joined Swiss
Res Engineering Department
in 1987. Through his many years
working as an underwriter he
acquired a broad knowledge in all
classes of engineering insurance.
Lorenz Albisser is a member
of Swiss Res senior management
and is in charge of the Inter-
national Projects Engineering
Desk.
Mladen S

osi c was born in Sarajevo

and has lived in Zug, Switzerland,
since 1989. He joined the Engi-
neering Department at Swiss Re
in 1994. Since 1998 he has been
working in Client Management for
Central &Eastern Europe in Zurich.
He gained his Bachelor of Science
degree in Civil Engineering at the
University of Sarajevo and his
executive Master of Business
Administration at the University of
St.Gall (HSG). He is a member
of the Swiss Engineers and Archi-
tects Association and registered
in the REGA of Swiss Consultant
Engineers.
Mladen S

osi c gratefully acknow-

ledges the support of all collea-
gues at Swiss Re who contributed
to the success of this publication.
However, a special thank you goes
to Ren Bolliger who gave his
decisive input in the initial stage
of this work.
Rico Baumgartner holds a Masters
degree and a Doctorate in Law from
the University of Zurich, a Masters
degree in business administration
from IMD (International Institute
for Management Development),
Lausanne and was admitted to the
Zurich bar as an attorney-at-law.
He has been working for SRNM
since 1998. As head of the Industry
Practice Construction & Engineer-
ing he is currently responsible for
the development of ART solutions
for corporate clients in
the industry as well as for Project
Finance across industries.