Project insurances and the revised Government guidance

United Kingdom
The 3 years since the first edition of the Office of Government Commerce guidance on the Standardisation of PFI Contracts have seen dramatic changes in the insurance market as a whole and considerable changes in the approach taken to insurance in PFI projects.

Hardening markets and innovative solutions

Even before September 11th, the insurance market had begun to harden; that process was accelerated rapidly following September 11th and the market now has few players (particularly in the projects sphere) and is demanding considerably higher premiums than 3 years ago when the first edition of the guidance was published.

At the same time, the Contractors taking out project insurances have become much more sophisticated in their approach. More and more, insurance is being seen as the solution to unusual risks (rather than just the standard material damage and third party liability risks), such as absolute time-criticality of completion of the construction phase. In some instances, innovative insurance solutions have been the only thing which has enabled the project to go ahead.

These significant changes mean that revised guidance was much needed: the old guidance was prepared at a time when the insurance market was so soft that virtually anything was insurable at reasonable rates. The reality of the market had moved on considerably and the new guidance provided an opportunity not only to reflect the current situation, but to attempt to reflect likely future trends.

Features of the new guidance

The new guidance includes significant revisions to the indemnities and insurance provisions. (These should always be read together as the indemnities are the starting point for defining the risks to be managed by insurance). Unfortunately, in many instances, the guidance has missed the opportunity to catch up with reality, let alone get ahead of the game.

Some welcome changes …

The news is not all bad; there have been some welcome changes to the guidance on indemnities and insurance. For example:

  • Authorities should now give consideration to caps on the level of indemnity to be given by the Contractor for third party liabilities. This opens the way for Contractors to cap their liability under the indemnity at the limit on the third party liability insurances. Careful drafting is required, however, if such caps are to be enforceable; unfortunately, this issue is not dealt with in the guidance.
  • One of the old chestnuts of whether the Authority should be co-insured, joint insured or a loss payee has been laid to rest. The guidance now makes it clear that the Authority should be co-insured for its own insurable interests. The comments as to non-vitiation cover are, however, somewhat of a red herring as, if the Authority is co-insured for its own rights and interests, there is effectively a separate contract of insurance which cannot be vitiated by the acts of another co-insured.
  • There is acceptance that business interruption insurance ("BII") should be added to the list of "Required Insurances" so that it can be covered by the uninsurability provisions. (This is because BII is crucial to the financial viability of a project). Unfortunately, this recognition has not been carried over into the drafting of the uninsurability provisions, which may prove problematic for Contractors (and Senior Lenders) dealing with Authorities which refuse to move from the recommended wordings.

… and some missed opportunities

Unfortunately, and perhaps inevitably for a document compiled over a long period attempting to deal with a fast-moving area, there are a number of aspects where the new guidance still does not reflect the realities of the insurance market and the needs of projects at present.

Uninsurability
One of the big concerns at present is the issue of uninsurability. Uninsurability takes two forms:

  • First, insurers may not be willing to take on a certain type of risk. There were concerns following September 11th that this might become the case for certain aspects of terrorism cover, particularly for MoD projects. There are also concerns about certain types of professional indemnity cover becoming unavailable as the insurance market hardens and turns away poor risks: IT services and facilities management services are currently perceived as being unattractive risks. This sort of unavailability is catered for by allowing sector specific risks to be identified in the uninsurability wording.
  • Second, a risk may become uninsurable because the premium required by insurers is simply too high to be commercially acceptable. The guidance takes the approach that an authority should only step in and take over this risk where "the Contractor and third parties operating the same or substantially similar businesses in the United Kingdom would "cease to operate" instead of paying the premium demanded. There are a number of difficulties here. What happens when the project is very specialist (such as many MOD projects), so that there are no comparable businesses in the UK? How is one to judge whether a business "would" cease to operate?

There is a further issue as to which insurances are covered by the uninsurability provisions: if a novel solution has been used to ensure that the project is viable, isn't it important to have a means of managing the risk if the insurance solution becomes unavailable?

Benchmarking and increases in premiums
The recent rapid change in insurance market conditions has highlighted the fact that the cost of insurance can change dramatically over the lifetime of a project. Further guidance is being prepared on the issue of benchmarking of insurances, but it is an issue which is proving problematic on projects now and it is disappointing that the revised guidance has not addressed the issue in detail.

Excesses
There are a number of other issues that the guidance has either sidestepped entirely, or dealt with only superficially.

There is, for example, no guidance on the issue of which party is to bear the excess or deductible if a claim is made on one of the project insurances. One of the ways in which insureds have attempted to manage the rising cost of insurance is by taking on larger excesses. (Some design and build contractors now have deductibles of up to £5 million each claim). In those circumstances, responsibility for any excess is critical, particularly if, as recommended by the guidance, the Authority is giving no indemnities, so that the Contractor must claim on the insurances for losses caused by Authority default.

Resolving the differences

The new guidance does contain some welcome changes, but as a whole the insurance provisions do not reflect the realities of the insurance market or of the more sophisticated approach which is being taken on complex and novel projects. For the best risk management model to be achieved (which includes value for money for the Authority), the Authority and the Contractor together need to take a sensible approach to the insurances and not follow the guidance slavishly. Perhaps the best advice given in the guidance is that Authorities and Contractors alike should seek specialist insurance advice.

For further information please contact Sarah Thomas at sarah.thomas@cms-cmck.com or on +44 (0)20 73672094.