The Morality of Dishonesty

univestThe Morality of Dishonesty

The following story was relayed to me in a somewhat cruder form last week. The original author is unknown to me. However it had some interesting observations and so I have edited it into a relevant form for today’s society.

A few years ago two armed thieves robbed a bank – one of them shouted: “Don’t move! The money belongs to the bank. Your lives belong to you.”  Immediately all the people in the bank laid on the floor quietly and without panic.

This is an example of how the correct wording of a sentence can make everyone change their world view.

One woman lay on the floor in a provocative manner. The older robber approached her saying, “Madam this is a robbery not a rape. Please behave accordingly.”

This is an example of how to behave professionally, and focus on the goal.

While running from the bank the younger robber (who had a University degree) said to the older robber (who barely finished basic education): “Hey, maybe we should count how much we stole.” The older man replied: “Don’t be stupid. It’s a lot of money so let’s wait for the news channels to be told how much was taken from the bank.”

This is an example of how life experience is more important than a degree.

After the robbery, the manager of the bank said to his accountant: “Let’s call the police.” The accountant replied “Wait – before we do that let’s add to the robbery the £800,000 that we took ourselves a few months ago and claim that it was stolen in the robbery.”

This is an example of taking advantage of an opportunity.

The following day it was reported in the news that the bank was robbed of £3 million.  The robbers counted the money, but they found only £1 million, so they started to grumble. “We risked our lives for £1 million, while the bank’s management stole two million pounds without blinking? Maybe it’s better to learn how to work the system, instead of being a simple robber.”

This is an example of how knowledge can be more useful than power.

Moral:  Give a person a gun, and he can rob a bank – at great personal risk. Give a person a bank, and he can rob everyone – with little personal risk.

Where are the banks today?

univestWhere are the banks today?

Having explained the history associated with where the banks are today, I would now like to examine the current situation.

Ironically the banks are essentially in the same situation as they were in 1986/87. Then they had spent enormous excesses preparing themselves for the new era of investment and corporate banking, they needed more capital to expand into new business opportunities, and remuneration packages reflected the desire to attract the most prolific profit generators. Today we have the enormous losses of the banking collapse in 2008/2009, enormous sums paid to regulators in the form of fines, large claims for damages including large legal bills, demands for more capital adequacy, and remuneration packages still need to attract profit generators.

There are essentially two ways to increase capital: a) asking investors for more investment, or b) translating profits into capital. The latter is by far the easiest with no impact on existing investment returns. The former puts pressure on profit generation to maintain a good dividend yield, which then places pressures on costs to support the remuneration required by the profit generators.

But are some of these profit generators really worth the cost? How many of these profit generators produced large profits through excessive risk or even market manipulation, have been paid their bonuses and moved on, leaving the bank with credibility problems and fines exceeding the benefit of the profit generator.

Let us look at an extreme example. Interest rate swaps are a sophisticated instrument that should only be sold to qualified professionals. Yet some profit generator convinced someone in the banks that these instruments should be sold to small corporates (SME’s) that would have difficulties even qualifying for a straight-forward interest swap under normal corporate banking rules. The structure of interest rate swaps are so complex that there should be more pages of cautionary notes attached than explanation of the mechanism of the instrument. And the banks would know that base interest rates are not going anywhere fast. So do we assume any interest rate movement is geared towards the bank’s borrowing cost? If so then manipulation of these rates by the banks must also be an issue.

Last year I designed a Documentary Credit solution for a tri-party tolling deal (a raw material supplier provides materials of a given quality to a producer of goods with a third party guarantee buyer of the finished goods thus guaranteeing payment to the raw material producer, i.e. guaranteed cash flow) over three countries. The safest mechanism was a conditional tri-party letter of credit which is only a small step removed from a conventional letter of credit. Although the banker to the third party buyer was completely satisfied with the structure they were not convinced that the financial director of the third party buyer fully understood the structure, and thus would not engage. An interest rate swap is streets ahead in complexity to such an instrument, and I would be very surprised if any of the financial directors of these SME’s remotely understood what they were being sold. Even worse I would doubt that the corporate banker selling this product knew any more about these instruments than the script provided by the investment bank. As swaps are purpose designed for a specific need on a Balance Sheet, who was looking at the SME to define their need, and to ensure their understanding of what was being offered?

I think it is clear that the banks are totally focussed on income generation from wherever it thinks it can be obtained. In too many cases the mavericks are still in control. So how can they generate these much needed profits?

Firstly, and foremost, they cut operating costs. Within investment banks this is most certainly a false economy, but it suits the mavericks. A professional operations director, properly respected by the Board, is the first line of defence to protect the bank from abuse. If we look at the problems over recent years in the likes of UBS, BarCap, SocGen, Deutschebank, JP Morgan Chase, et al, none of these problems could have occurred had a solid operations base been in situ. When I ran operations for various banks there was no possibility that a trading director could override any decisions by me on credit, risk, trading volumes, trade procedure, compliance, discipline, funding, hedging, and systems. My head of settlements, who knew more about the markets than any trader, attended the morning strategy meetings with the traders. If he said that trading could not occur in certain instruments, or specific securities issues, or ticket sizes, this was not a request but an instruction. Trading was not allowed over mobile phones. No dealer could get into the dealing room before 7:30am unless by specific authorisation, and only with a settlement clerk present. Our systems had artificial intelligence monitors on all traders, positions, risk, and credit in real time, monitored by me, head of settlements, and financial controller. Traders did not have autonomous computer systems, yet we always had the most sophisticated trading systems on the street. Our counterparties knew that if they did not confirm a trade with our settlement department during the same trading day then we had the right to void it, so dealers could not hide deals. All funding, own book hedging, and bond borrowing was undertaken by settlements on a book basis to ensure that we were properly covered at minimum cost.

Now the mavericks having taken control of, or suppressed, the operations base, what I see today horrifies me in that there is little or no real control over what many business generation platforms are doing in the name of the bank. They are treated like gods, or at least divas, and anyone who speaks out against what they are doing is destined for unemployment. The senior management have a fixation that if they do not comply with the absurd requests of these people that they will take their ‘skills’ elsewhere (and thus risk their own personal rewards). However, put a senior operations person in place in every bank, and who knows what they are about, make them more powerful than the trading director, and the mavericks have nowhere else to go. Alternatively if they are likely to leave you with a horrible mess to clean up after they depart do you want them in any event?

Having entered investment banking in the mid-1970’s with Citicorp, now CitiGroup, my first job was to find a way of providing Walter Wriston, the Global CEO, with global real-time positions of the bank in all markets. This is before the internet – indeed we created the first global corporate intranet in 1978 to achieve this requirement. With today’s technology this task is not only simple, but should be fundamental if any control is to be placed on banking activities.

What about the banks engaged in corporate business? Again horrific. Many so-called corporate bankers that I have encountered in recent years are no more than information gathers for some faceless people hidden from view in dark places. These faceless people are the arbiters of all activity with corporate clients, yet have never met any of them. Gone are the days when a corporate banker, certainly in the SME arena, can read financials better than the financial director of the company, and actively advise on how the financial position can be improved prior to bank lending. Now it is more akin to lending against security without any consideration as to the quality of the lending instrument – just the level of income that can be achieved. Surely it is in the bank’s interest to have quality people guiding their corporate clients and thus protecting their investment, not merely taking security and destroying people’s lives.

Just as an illustration of how dire the training within banks really is, I went into a large branch of Barclays bank in Holburn in London where their principal client base is likely to be corporate clients. I wanted to send a SWIFT payment in USD. I was told, by their resident corporate banker, that Barclays Bank do not send SWIFT payments. This is a sad reflection on where banking is today, and it needs to change quickly. My next blog will look at the way forward.

‘Interest Only’ Project Finance

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‘Interest Only’ Project Finance

Insurance instruments can provide valuable credit enhancement to capital risk, especially in environments such as, but not limited to, emerging and developing economies. Having mentioned ‘Interest Only’ financing in my last blog a description of this technique can only add weight to the intelligent use of the insurance markets as a valuable aid to project finance.

One of the major problems encountered with developing/emerging economies is that long-term capital for business development would be a preferred solution under normal circumstances, but the instability risks dictate short-term exposure. For certain types of project ( typically < USD 50 million requirement) where, for instance, there is a quality Western off-take to cover debt service, there is a technique that can be applied that utilises insurance products to change the country risk profile of the project and thus permit long-term financing on an attractive risk profile. This technique involves over-lending and traditionally works on the basis that the advance to the project includes an amount that is specifically used to purchase an asset, in the form of a deep-discounted instrument, to insert into the Balance Sheet of the borrower and which is pledged to the lender, and has a guaranteed maturity value equal to the total capital lending. The deep-discounted instrument is usually a stripped-USD Treasury or zero-coupon bond thus changing the risk profile of the borrower to that of the US Government for capital purposes. The borrower pays interest (albeit at a premium rate over a comparative rated borrowing, but much lower cost of finance than a straight borrowing) on the total borrowing through a lien over the off-take proceeds. (Please do not confuse this process with so-called leased assets that cannot be pledged)

The benefit of this structure is that all debt service by the borrower (which is all interest) is normally tax deductible, thus making the effective cost of money relatively cheap. Furthermore, so long as the borrower has no beneficial interest in any excess value of the US Treasury on maturity then it is normally possible to negotiate a tax exemption with the relevant tax authorities relating to the capital gains over the lending period. In reality all that has happened is that the lender has inserted a valuable asset, that can be pledged, into the borrowers Balance Sheet that otherwise would not be capable of providing suitable security.

The advantages of a stripped Treasury solution is the fact that it provides an “AAA” rated security which is easily disposed of in the event that the lending terminates early. What is not known is the discount price at the time of such disposal, or the value of the security/collateral at any point in time throughout the term. This can be a problem with booking such a transaction. Furthermore the current 10 year yield on US Treasuries is too low for such purposes making the over-borrow costs too expensive.

Let us examine how we might improve on this situation using insurance products rather than a stripped-bond.

There are a number of insurers that offer guaranteed growth funds in various guises currently producing yields in excess of 8% p.a. Many are investment grade credits and, over a 10 year term, tend to out-perform bond yields. What is more interesting is that many of these insurers are also now owned by major banks. If the lender were to use the over-lending amount to invest in such a fund and use the policy as the Balance Sheet asset with assigned rights to the total value of the proceeds (which are generally tax-exempt) then two prime advantages exist. Firstly, the value of the policy cannot reduce in value irrespective of market conditions as the price of units cannot go down in value. The only factor that can affect the value is if surrender occurs early in the term in which case there are likely to be early surrender penalties (around 5%). Secondly, as such a fund will normally out-perform bond yields, there is likely to be a profit which can be secured as a maturity fee. Therefore, for a reduction in credit rating from “AAA” to probably “AA” we have achieved a far more stable collateral value and with a probable profit.

This type of structure only really works for financings of 10 years or more but demonstrates that the insurance market can facilitate financings that otherwise would not have been possible on very attractive terms to both borrower and lender. Some guaranteed growth funds will also provide life assurance cover as part of the fund package thereby allowing the lender to assure the lives of key borrowers at no extra cost yet provides more risk mitigation.

We have successfully executed such structures where the lending bank has used its own subsidiary insurance company investment funds to generate the capital redemption amount thus accruing all of the fund fees and charges for their own institution.

Let us extend this type of structure one step further to provide some interest cover in the event that the off-take does not generate enough cash flow to service debt financing. Most of these guaranteed growth funds have an encashment facility which can be used by the policy holder to draw regular income up to a certain percentage of the profits of the fund. A very simple calculation will determine by what ratio the initial premium needs to be leveraged in order to secure the require exit value whilst providing the capacity to draw income for both the interest cost of the leverage, and any underpayments on debt service. This would be invisible to the borrower, and would not remove the liability on the borrower to make good any short-fall. However it would prevent the need to reclassify the risk on the original loan in the event of an interest payment default.

Let us now attempt to define the benefits to such a financing through an example of a privately (socially) owned food processing factory in a emergent economy that suffers from the aftermath of a period of undemocratic control where asset values are difficult to define, and the legal framework makes any form of security charge unacceptable. The company requires to modernise its facilities in order to comply with the requirements of its major (good covenant) Western customers. The company has exported over 70% of its production to these customers with hard currency payments for a number of years, and their customers are prepared to enter into long-term off-take contracts with the company. The cost of the required modernisation is $25 million which would require a term of 10 years to service with no capital repayments in the first 2 years. Political Risk insurance is available at 2.75% p.a. but only for 2 years with renewal options at the discretion of the insurer. The off-take commitments would provide at least 2.5 times debt service cover after operating costs over the term. There is no active bourse. Corporate tax rate is 48%. Local borrowing costs, if such funds were available, would exceed 16% p.a.

As a banker this is an attractive project, and if this was a company located in a stable Western democracy this requirement would be a reasonably trivial project finance possibly using a combination of export credits, leasing structures, equity placement, term loans, etc. Given the environment in which the company resides, and through no fault of the company, the required financing using conventional finance solutions is practically impossible, especially with the lack of term political risk (primarily business disruption) cover. Even if a two year rolling facility were negotiated the company would be restricted on what it could do knowing that there was a possibility that the facility could be called if the political risk cover were withdrawn. Furthermore the combination of high interest rate charges and insurance premiums would make the cost very unattractive in terms of cash flow and investment strategy for the borrower.

We need to change the risk profile in order to structure a financing that will provide a financial environment that can reasonably be supported by the borrower, and will be an acceptable credit to the lender. Having determined that we can achieve the tax exemption for a stripped-Treasury solution on condition that we advance 10 year term funds we establish that the deep discount price is 44¢ thus requiring $22.5 million of over-lending. Let us assume after all costs and fees the total advance is US$ 50 million. Using a real template from a suitable guaranteed growth fund using a conservative 7.5% growth (8.5% yield) our $22.5 million will grow to US$50,659,488 after 10 years after all costs. As this yield is only nominally above bond yields it would be reasonable to suggest that expectation would be for a higher return. I should mention that once the gains in any years are rolled into the capital amount the guaranteed amount by the insurance fund is the new capital amount. We have now moved most of the capital risk to a friendly domicile and enhanced our credit rating to investment grade.

We now need to structure the interest payments. As we have an investment grade covenant on the capital repayment the interest rate can be set at a level which reflects this partial credit enhancement. If we assume that an “AA” rated lending would be LIBOR+1%, the covenants from the borrower’s customers would warrant no more than LIBOR+2%, and we can achieve cover for political risk inclusive of business disruption and force majuere albeit on a renewal basis at 2.75% on exposure adding 21 bps to the cost. Therefore we calculate that LIBOR+2.5% would provide an attractive return to the lender.

Banker’s Perspective

Loan:               US$ 50,000,000

Term:              10 years, bullet repayment at maturity secured by major insurer

Interest:          3 month LIBOR+2.5%, payable quarterly in arrears

Security:          “AA” covenant on capital, Quality off-take covenants for interest,

“AAA” rated political insurance for disruption of business

Fees:                US$ 2,500,000

Bonus:             Uplift on Guaranteed Growth Fund policy proceeds

Borrowers Perspective

Loan:               US$ 25,000,000 for modernisation, US$ 22,500,000 asset purchase

Term:              10 years, interest only

Fees:                US$ 2,500,000

Assuming for simplicity of illustration that US$ LIBOR was 5% throughout the term which would result in a total repayment by the borrower over the 10 year term of US$37,500,000

Equivalent Cost of funds pre-tax;     8.6% + Insurance Premium of 21bps

Equivalent Cost of Funds post-tax:   4.5% + Insurance Premium of 10bps

As can be clearly seen the introduction of insurance products has made an otherwise difficult transaction into a very attractive proposition for both the borrower and the lender. Furthermore there is the goodwill element between the bank and borrower for future business as the emergent country stabilises. As a footnote, the fund management fees indicated by the example were US$18,383,979 thus making this financing substantially more rewarding for all financing parties than an alternative conventional lending.

There is a further level of sophistication to this solution which reduces the initial capital risk to the lender, but requires more attention to the capital risk at the ultimate exit. If it is anticipated that the instability of the country of the borrower will significantly improve over the financing period, and the insurance fund is a consistent performer, then it is possible to reduce the over-borrow amount by gearing the amount placed into the insurance fund at a much lower cost (capital and interest of the gearing amount guaranteed by the insurance fund and thus LIBOR+1% is achievable) benefiting from the yield on the growth of the gearing amount less the interest cost). We have successfully geared at 3:1 with good results but a full explanation of the dynamics of this enhancement is beyond this blog discussion.

The superior nature of Syndicated Insurance for Project Finance

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The superior nature of Syndicated Insurance for Project Finance

Syndicated Insurance for construction projects is well defined for projects throughout much of the world. However other types of project require a tailored approach depending upon the defined risks involved. But the principle of syndicated insurance for project finance is not just an insurance solution – but a global comprehensive risk management tool for qualifying projects.

 Integrating comprehensive event risks into loan/bond documentation was initiated by myself with invaluable help from Dennis Parker (from Aon in London), and Clifford Chance (law firm) both in London and New York. It took 7 months of negotiation with bankers and underwriters to achieve a wording consistent with formal offering documents such as Trust Indentures in order for acceptance, albeit that it was the important endorsement of investors that finally achieved acceptance.

 It might be helpful to define the diverse range of insurance products available to the project finance specialist to understand the problem with the conventional approach to adding event risks to a financing, whether public or private placement, syndication, or bond issue. I would also include quasi-equity products such as convertible debt structures into this group.

Types of Insurance Products Available for Project Finance

Insurance products for project finance can be conveniently discussed from two different perspectives, i.e. those that require Political Risk insurance (developing and/or politically unstable countries), and those that do not. However the crossover point can be fuzzy as the need for such political risk is not only applied to developing or emergent economies but can vary depending on the term of a transaction for so-called industrialised countries. The fortunes of countries wax and wane, both through domestic political situations, and adverse effects of global economic conditions. The normal determinant is whether or not a country has an acceptable credit rating from Standard & Poor or Moody for the term of the proposed transaction, albeit  such ratings can adversely change for any country very quickly as we have seen in the Eurozone countries.

Just by way of example of how fuzzy the parameters for determining whether or not political risk cover is required in any of its various forms we only need to look at how many major countries or cities in the world would now require civil disruption, riots, or terrorism insurance cover for certain types of project.

Add to this the general myth that a corporate within a country cannot borrow at cheaper interest rates than the Government (sovereign debt) of that country then it is easy to understand why there can be confusion. Utilising insurance-based risk mitigation, which has the effect of credit-enhancing the transaction by effectively moving the domicile and credit rating of part of the risk, can easily result in lower costs of borrowing than the project country risk would otherwise dictate.

The general classifications of insurance products used in project finance are:

  • Investment Risks – Inconvertibility, Expropriation, Creeping Expropriation, War, and other Political Violence
  • Collateral Deprivation Risks – Asset Repossession and Deprivation, Civil Disruption
  • Non-payment Risks – Commercial and Political Causes, short medium and long-term credits, leases, Documentary Credits, Promissory Notes
  • Contract Frustration Risks – Including Wrongful Calling of Guarantees, Non-Delivery
  • Transportation Risks – In-transit risks
  • Credit Enhancement – Third Party credit, asset securitisation, cash flow securitisation
  • Business Disruption – Third party commercial disruption e.g. utility and transportation disruption
  • Transfer Risks – Repatriation of Investments, Debt and Leases payments, etc.

 

Project Finance Requiring Political Insurance

This is a specialised area of insurance as, by definition, the project is in a territory that has less certainty of political stability and/or appropriate legal structure than one would like in order to secure an investment or lending position in the event of problems. Such political insurance is available to cover a whole host of possibilities such as:

  • Confiscation, Expropriation, and Nationalisation
  • Forced Abandonment
  • Transfer Risk
  • Refusal of host Government of Repossession and Disposal Rights
  • Contract Repudiation
  • War, civil war, civil unrest,  and terrorism

However there can be a number of interested parties that need cover within any one project, and there can be a number of different scenarios that require the security of a political insurance wrap in order that they are effective. This is further complicated by the fact that it is not always possible for any one insurer to assume the total insurance package thus various legal platforms for each insurable risk need to be interpreted and reconciled.

Bonding

One of the prevalent features of international commercial life is the need to issue on-demand guarantees to satisfy advance payment, performance, and warranty obligations. Bank bonding has been the traditional source of such bonding but this is another area where insurers can provide a far more reasonable and appropriate instrument.

If we consider conventional bank demand bonds it is easy to understand why they are an onerous burden on the provider, and gross overkill on the part of the receiver. The onerous burden on the provider includes the capability of the receiver to call the bond at will without declaration of default, and the burden is then upon the provider to prove whether or not there is good and reasonable cause, and if not then the burden is upon the provider to reclaim their money which is both time consuming and expensive. Banks do not generally accept any responsibility for payment under an invalid presentation of such bonds. Although such risks as invalid presentation can be covered through insurance this is yet a further unnecessary and avoidable cost.

Having studied this problem for some years it became apparent that it is frequently possible to clearly define the conditions that would reasonably justify a call on such a bond. Therefore it has been possible to negotiate with insurers the development of a demand bond that is more reasonably aligned with the purpose of its existence, and callable on demand by the receiver given a specific event of default by the provider. This bonding has a number of significant advantages over bank bonding namely:

  • The bond is an off-Balance Sheet instrument for the provider and thus no adverse gearing implications;
  • It does not consume valuable bank facilities that might otherwise be better utilised;
  • They are more flexible in that there can be a number of callable events with different levels of monetary penalty;
  • It is usually cheaper.

The practical application of such bonding is fundamentally unchanged other than the bond will be defined in a contract which will also define the events under which the bond can be called, and the associated amount. In the event of a claim by the receiver the only change is that the receiver must lodge a formal notice of specific default with the insurer to invoke the demand for payment. Such payment will be made upon presentation of such claim. In the event that the claim proves invalid then it is the insurer, not the provider, who will pursue recovery. This takes the burden from the provider and imposes a more disciplined attitude to default claims by the receiver.

There are a small number of specialised brokerage houses in London that specialise in the arrangement of such bonds.

Problem Summary

Albeit that there is a whole spectrum of insurance-based products available that can be beneficial to a project financing the problem is that we have a multitude of insurers/underwriters using different types of wording on different platforms, and even in different legal jurisdictions. This does not make lenders very comfortable as they do not know which insurer is assuming what risk, or whether there are gaps between the various wordings that potentially leave the borrower, thus lender, exposed. Furthermore many of these products are annual renewable whereas a typical project will involve 5 – 10 years of debt service. The downside for the project promoters is that they would not benefit from the potentially large discounts from consolidated premiums, nor the benefit of reduced debt pricing because of the lack of confidence in the event risk integrity.

A Practical Example Using Syndicated Insurance to Credit Enhance Capital Risk

One of the major problems encountered with developing economies is that long-term capital for business development would be a preferred solution under normal circumstances, but the political risks dictate short-term exposure. For a lender or investor to consider long-term capital the event risk cover must look like an integral part of the asset risk financing, and be of a quality that the integrity and robustness matches that of the financing terms. Thus we need, at the very least, the matching concept of a single underwriter assuming the lead in the event risk package, i.e. syndicated insurance.

Rather than consider how to build a syndicated insurance product for a generic project I would like to demonstrate how this product was derived for the very first complete application of syndicated insurance. I had already used a subset of this idea for previous projects in Eastern Europe, and successfully applied it for an Interest Only financing that I devised and structured for a capital financing in the former Czechoslovakia written by Deutsche Bank, Frankfurt (look out for ‘Interest Only financing’ as a future blog).

The project presented to me was a requirement of USD 100 million for an oil & gas development and production project in Western Siberia, Russia and in which Deutsche Morgan Grenville was already an equity investor for the exploration phase, and a solution would have a co-lead of HSBC and Deutsche Bank. It was in the Yeltsin era in Russia and no-one wanted to invest or lend for Russian projects. The company was a joint venture between a USA company (provider of finance and drilling expertise) and a Russian company (owner of a valuable Exploration, Development, and Production Sharing Agreement (EDPSA) negotiated by the USA company). Even though the assets (oil & gas) were proven and considerable they were in the wrong place at the wrong time and thus conventional funding did not arouse any interest. At that time no public bond offerings had been successful.

An overview of the primary criteria that needed to be considered:

  • The terms of the EDPSA stated, as a condition, the need for evidence of the availability of all of funding needed to develop the field. Funds were needed for 3 years with repayment within 5 years.
  • The joint venture company was Russian (this was not safe then, and recent problems encountered by BP in Russia confirm that not much has changed). If USD 100 million was injected into the joint venture company it could easily disappear.
  • All oil had to pass into the state-owned Transneft pipeline as Urals blend and could be diverted to Russian refineries (payment issues & business disruption if otherwise sold)
  • Western Siberia is a frozen wasteland in the winter, and a swamp in the summer thus sand pads with interconnections would be required (transportation issues)
  • There was only one power station in the region – very old, and the workers had not been paid in over 3 months (business disruption risk as surface equipment such as separators and compressors need energy supplies)
  • Third party transportation risk of piping crude oil to Novorossiysk on the Black Sea.

In spite of the considerable proven oil reserves even the hardened oil & gas investors had no appetite for this financing unless the risk profile could be dramatically improved. It was obvious from the outset that merely attaching a number of insurance products to the investment would still not attract interest. The conventional source of a political wrap for this financing, MIGA (the insurance arm of the World Bank), wanted a 3 – 6 month review period and a large amount of money in fees with no commitment to provide anything.

Thus a different approach was needed if we were to credit enhance this offering to make it attractive. It was clear that we needed, at least, to tap into just about every insurance product in our tool chest, and which ordinarily would provide a complex mix of wordings, platforms, and jurisdictions.

Some of the primary considerations were:

  • This financing could not be a conditional debt structure as this would not satisfy the terms of the EDPSA.
  • Asking investors to provide equity (conventional financing for oil & gas for pre-production activity) would not work. Thus a convertible debt structure would be needed through a public offering to capture the largest market of investors available, and providing an element of liquidity to investors.
  • The USD 100 million could not be placed into the Balance Sheet of the Russian j-v company. A trustee arrangement would be needed where a credible third party acceptable to all parties, and especially the Russian partners, could provide confirmation of available funds, but only release funds against confirmation of agreed deliverables. This trust arrangement would also have to provide unconditional comfort to the investors that their money was safe from unauthorised call by anyone, including a Russian court.
  • In order to achieve the comprehensive range of event risk protection needed we would need to convince the underwriters that every risk that could be mitigated through good corporate governance has been identified and addressed, e.g. placement of a generator on the field to satisfy the energy requirements of the array of separators and compressors needed to keep the oil flowing to the pipeline.
  • A secure off-take of the oil from Novorossiysk by a trusted Western company well placed in that arena.
  •  All oil payment receipts would need to be directed to the trustee with the full co-operation of the Russian j-v partner, and the Russian authorities (payment of their share of the oil revenues plus any taxation due from the j-v company)
  • Managing cash flow to keep the fields producing in the event of any third party business disruption

Having agreed these requirements in principle with all relevant parties, Dennis Parker and myself prepared a single event risks policy inclusive of all political risks and bonding requirements (irrecoverable political disruption, i.e. forced abandonment, would trigger a full refund to all investors). Insurance risks had never previously been included in the main body of a Trust Indenture but I knew that if we could achieve inclusion for this issue the financing would be significantly more attractive to investors. Clifford Chance provided oversight to this process to ensure that the drafting was consistent with Trust Indenture requirements. This process was complicated by the fact that the chosen trustee was Bank of New York who wanted their obligations written under US law, and specifically New York State law, whereas the main body was under English Law with Norwegian Arbitration.

Whereas I was concerned that we would not find a suitable single lead underwriter for such a comprehensive package I have the competence of Dennis Parker to thank for a relatively easy task.

Both HSBC and Deutsche Bank agreed to put the package to the appropriate authorities for consent to launch the issue. The road show would be the litmus test. We organised presentations to investors in 14 cities in just 28 days. We were oversubscribed after the eleventh city, Toronto – we had a product that satisfied the most hardened of investors.

This project financing demonstrated that event risks and asset risks can rank pari passu with each other providing integrity into project finance that fits the requirement in difficult environments, and at an affordable price. The credit enhancement meant that we could set a coupon yield at 10% against sovereign debt of 14.75% for Russia at that time, and with a total insurance premium of just 1.75% per annum of actual exposure for the term of the issue. This is the power of syndicated insurance for project finance.

The superior nature of Syndicated Insurance for Construction Projects

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The superior nature of Syndicated Insurance for Construction Projects

Syndicated Insurance is not so much an insurance solution – more a global comprehensive risk management tool for qualifying construction professionals. The application to major construction projects was developed by myself and John Curran, an expert in construction risks insurance, to provide banks with a quality event risk package in order to facilitate rapid financing at a lower cost to developers. It took 2 years of negotiation, cajoling and proving in whole or part with construction professionals.

It would also be reasonable to acknowledge David Barnes, Executive Director of Construction Risks at Willis in London who championed this product within Willis.

Having been asked to explain Syndicated Insurance I would suggest that this blog is for the spectrum of construction finance professionals as I must assume a reader knowledge of the conventional process of construction finance and construction risks insurance. Thus this blog will outline the features, scope, comprehensive nature, and benefits of Syndicated Insurance for construction projects.

The objective of this approach was to provide a totally comprehensive, all-inclusive insurance package that would include, and commit the lead underwriter to provide all requirements throughout the debt service period regardless of when, in the project timeline, certain requirements need to be activated. This provides security to a lender that all event risk requirements are guaranteed throughout the debt service period. 

Features

The ultimate global comprehensive and integrated insurance solution, designed with project finance specialists to address principal and bank requirements with unparalleled service and risk management delivery

Specifically designed to incorporate all development risk mitigation requirements for the larger contractor, property developer, and construction professional 

Flexible in its application – select what is required in the most applicable form – with consistency in delivery and cover 

Aligned with concepts such as long-term finance initiatives to offer long-term indemnity up to 30 years to satisfy bank finance requirements, and maintain a consistent bank risk profile, even during delays and disputes 

Comprehensive inter-laced cover with a single, major underwriter to emulate the way that bank’s syndicate the debt financing component thus simplifying risk assessment, cover, claims and disputes

A comprehensive solution for the construction professional throughout the world with valuable new features not currently available with any other product

Non-collateralised bonding facilities available to limit unnecessary use of working capital – the financial and security benefits are immediate and considerable 

Many of the difficulties encountered in construction litigation are avoided, significantly reducing the possibility of lengthy disputes, or project delays 

Added value benefits include 3 or 5 year fixed pricing with a share of insurers profit, loss control and evaluation services provided without charge, 24-hour helpline World-wide including collateral warranty advice and claims services. 

Cover Synopsis

Contractors “All Risks”Includes full cover for works, temporary works, materials & plant, whether owned or hired whilst at the contract site, in transit to or from the site, or temporarily stored away from site

Financial Risks – Takes the pressure off the Balance Sheet by avoiding the unnecessary use of working capital and bank bonding – Annual bonding facilities for Performance, Bid/Payment, Maintenance/Retention, Highways Act and other commercial guarantees

Advance ProfitsEmployer and contractor indemnified against consequential losses following contract delay – Exceptionally wide cove including interest on loans and loss of rent

Building DefectsUp to an initial 12 years’ cover with options to roll – initial technical audit uniquely leads to an automatic option to purchase for all projects – electrical and mechanical services can be included – enhanced value to completed construction sites – immediate compliance with requirements such as the Latham report objectives and anticipated EU directives – includes post-development efficacy of new technologies

Professional IndemnityLiability arising from architectural surveying and other agreed professional activities – High premium discount for modest voluntary excess – wide subrogation waiver agreement

Public and Products LiabilityIncludes contractual liability and indemnity to principal – World-wide coverage – optional excess levels

JCT Clause 21.2.1Automatic annual facility – No individual Surveys – No specific contract underwriting

Directors’ and Officers’ LiabilityComprehensive cover for the obligations of Directors and Officers to meet existing legislation, company and employee reimbursement – World-wide coverage – no excess option

Employers’ LiabilityIncludes cover for labour-only sub-contractors, hired or borrowed persons, all other self-employed persons, and authorised work experience schemes. World-wide coverage

Property DamageA wide range of financial protection opportunities for completed off-site properties occupied by you or leased to other parties – consequential loss – contents and other assets

Fidelity GuaranteeNo mandatory system of check – generous discount for voluntary excess options – automatically includes money and goods for first and third party fraud

Motor FleetIncludes courtesy vehicles – third party claims management – automatic repair authorisation – no excess option

Terrorism & Civil CommotionIncludes Terrorism, Riots, Strikes, Civil Commotion and Malicious Damage including fire

Brown FieldIncludes latent defects arising from assuming certified brown field sites for development including asbestos and heavy metals

Environment ImpactIncludes environmental pollution as a direct result of development works

Political RisksFor International projects where the political environment dictates the need for comprehensive cover against Expropriation, War & Terrorism, and Force Majeure

CONTRACTORS ‘ALL RISKS’

Cover

Responds to obligations arising from all standard conditions of contract including:

  • JCT – Joint Contract Works Tribunal
  • ICE – Institute of Civil Engineers
  • GC/Works/1 – General Conditions of Government Contracts
  • Other International contract conditions

Cover is provided in the joint names of the Contractor and/or Principal for unforeseen events causing damage to the works, temporary works and materials, whilst:

  • In transit to, or from, the contract site and while temporarily stored off-site
  • Own plant and hired plant
  • Site huts, Employee’s Tools and Equipment

Extensions

  • Removal of debris following loss or damage to the contract works
  • Professional fees in connection with reinstatement of the contract works
  • Cover for completed buildings pending sale, including show houses and their contents
  • Cover for loss of or damage to temporary works and other equipment during any maintenance period
  • The cost of recovering immobilised construction plant from any site
  • Cover in respect of the liability to meet loss of income claims made by a plant owner following damage to any plant hire

The Policy will automatically reinstate the sum insured following a loss.

FINANCIAL RISKS

Cover

Increasingly developers, banks, investors, local government and private sector employers are demanding the provision of guarantees, which will ensure that, in the event of insolvency, the costs they incur completing a development will be met.

 Bonds

  • The Performance Bond makes available to the employer a sum of money, normally 10% of the contract value in many parts of the World rising to 100% in countries such as the USA, which will facilitate completion of the contract should contractor insolvency occur.
  • Deed or Tender Bond – against withdrawing from a contract and that a Performance Bond is available.
  • Advance Payment Bond – against non-completion of a contract, including repayment of monies advanced by the employer.
  • Retention Bond – replaces the retention fund.
  • Maintenance/Retention Bond – against non-performance of maintenance responsibilities thereby releasing the retention fund.
  • Highways Act Bond – to local authorities against non-completion, to their satisfaction, of roads and sewers within developments.

These bonds can be provided through insurance companies. The advantage over banks, who also issue bonds, is that insurance company bonds are generally unsecured, whereas banks require collateral. Furthermore, bank-bonding facilities form part of a general overdraft facility, which could cause excessive borrowing requirements.

Insurance bonding facilities are off-balance sheet with consequential beneficial impact on statutory accounts.

ADVANCE PROFITS

Cover

Contractor and Principals’ loss of:

  • Rent Receivable
  • Interest Receivable on net proceeds of project
  • Interest Payable on project loans
  • Increased Cost of Works

all as a consequence of a delay emanating from an indemnifiable loss under Contractors ‘All Risks’.

 Definitions:

Loss of Rent – Rental income which, but for the damage, would have been received during the Indemnity Period.

Interest Receivable – The Interest Payable for outstanding loans in relation to the Project which have to be extended or re-negotiated and/or additional loans which may have to be raised to finance other projects which would have otherwise been funded from the net income of the sale of the Project.

Increased Cost of Working – The additional expenditure necessarily and reasonably incurred for the sole purpose of avoiding or diminishing loss of Rent Receivable and/or Loss of Interest Payable and/or Loss of Interest Receivable which, but for that expenditure, would have taken place during the Indemnity Period in consequence of the damage but not exceeding the loss of Rent Receivable and/or loss of Interest Payable and/or loss of Interest Receivable thereby avoided.

Indemnity Period – The period of delay in the letting (or sale) of the Development in consequence of the damage beginning on the date upon which, but for the damage, rent would have commenced to be earned (or the sale of the Development would have been completed).

 

BUILDING DEFECTS

Cover

Physical loss, destruction of or damage to the property insured. This includes the collapse of the building caused by a fault defect, error or omission in design, materials, components or construction of the building, which remain undiscovered on the day of practical completion.

  • First Party cover. Insurers assume responsibility for immediate rectification thereby avoiding the need to rely for compensation upon litigation against a Third Party.
  • Policy fully assignable for the benefit of future owners, tenants and occupiers.
  • Twelve-year period to comply with legislation such as the Latent Damages Act 1986, automatically extendable for up to 30 years to provide cover throughout various national financing initiatives and bank financing requirements.
  • Technical Auditing carried out by Insurers and included in premium thereby avoiding high cost of appointing independent consulting engineers which has previously made cost of cover prohibitive.
  • Initial Technical Audit leads to a facility for all projects, which avoids the need to audit each project, thereby reducing the cost and greatly simplifying arrangement of cover.

Extensions

  • Roof, Cladding, waterproof membrane, and underground services.
  • Electrical and mechanical services
  • Loss of rent, loss of profit and the costs of alternative accommodation.
  • Sum Insured includes demolition costs, Professional Fees, Regulatory Compliance and Inflation Provision.
  • Efficacy of new technologies post-completion
  • Premium Instalments

PROFESSIONAL INDEMNITY

Cover

In respect of the Insured’s legal liability for negligence in the conduct and execution of their professional activities and duties involving design or specification, supervision of construction, feasibility study, technical information calculation, always under the direction and control of a qualified architect, engineer or surveyor.

In addition to meeting costs and expenses in respect of damages and defense of a claim or potential claim, the cover may also be extended to meet those expenses which you may incur as a result of any action you take to reduce the cost of a claim or potential claim.

Extensions

  • Libel and slander
  • Loss of documents
  • Dishonesty of employees

 PUBLIC AND PRODUCTS’ LIABILITY

Cover

Liability to third parties following accidental bodily injury, loss of or damage to material property or accidental loss of amenities, trespass, and nuisance arising out of your normal business and site operations.

Extensions

  • Liabilities arising from defective design, specification or workmanship in respect of any structural materials or goods that you supply erect or repair.
  • Liability arising out of the use of mechanically propelled contractors’ plant on site.
  • Contingent liability arising out of employees using their own motor vehicles on company business.
  • Liability for loss or damage to premises which are leased or rented.
  • The Financial Loss Public Liability cover provides for financial losses but only arising out of loss of, or damage to, property. This Extension provides cover for liability in respect of accidental financial losses suffered by third parties where damage to property has not occurred.
  • Automatic Indemnity to Principals
  • Cross liabilities

 JCT CLAUSE 21.2.1 (OR EQUIVALENT)

Cover

Loss resulting from damage to property caused by collapse, subsidence, heave, vibration, weakening or removal of support, or lowering of ground water arising out of, and in the course of, carrying out the works.

 As there are various contractual clauses necessitating this cover, it requires each to be considered on an individual basis. This would not stop work on site commencing but it may mean after a risk assessment, that the final terms and conditions will be finalised subsequently.

The period of insurance cover will equate to the contract term.

 DIRECTORS’ AND OFFICERS’ LIABILITY

Cover

Protecting Directors and Officers of the Company, and the Company itself, in respect of claims made against them for any wrongful act in their capacity as Director or Officer.

A “Wrongful Act” is defined as breach of contract, breach of duty, act, neglect, error, omission, mis-statement, misleading statement or breach of warranty of authority.

Extensions

  • Shadow directorship
  • Costs of representation at official investigations into the affairs of the Company or its subsidiaries
  • Outside directorship
  • 12 month discovery period
  • Spouses of the Directors and Officers
  • Pollution defence costs

EMPLOYER’S LIABILITY

Cover

Provides against the cost of claims for bodily injury or disease, sustained by employees during the course of their employment, for which there is legal liability. Cover includes the actual damages awarded plus the cost and expenses incurred in defending a claim.

 An important feature of the Policy is that “employee” is widely defined and includes:

  • Labour only sub-contractors
  • Any other self-employed person
  • Employees hired or borrowed from another employer
  • Anyone participating in authorised work experience

 Extensions

  • Liability to employees and the public
  • Contractual liabilities and indemnity to Principal
  • Additional liabilities in respect of bodily injury or loss of or damage to property you assume under contract
  • Health and Safety at Work Act (1974), or national equivalent
  • Kidnap and Ransom

 PROPERTY DAMAGE

Cover

Comprehensive cover for all buildings upon Practical Completion. Cover is available for a single building or any number of buildings, with emphasis on flexibility to accommodate a diverse range of properties, resulting in tailoring cover to meet specific requirements. To obtain the optimum level of protection, a number of invaluable extensions are included as standard, removing unnecessary complication and outlay involved in purchasing additional policies, resulting in overlapping or duplication. Conversely, gaps in cover, which may only come to light at the time of a claim, are avoided.

  • Consequential loss – advance rental
  • Property owners & employers’ liability
  • General interests
  • Denial of access
  • Automatic reinstatement
  • Trace and access
  • Capital additions
  • Internal maintenance contracts
  • Loss of metered services
  • Loss of keys
  • Unauthorised use of services
  • Landscaped gardens

 FIDELITY GUARANTEE

Cover

Loss of money or goods caused directly by an act of first or Third Party fraud, theft or dishonesty by an employee provided the loss is discovered within two years of the termination of the Policy or the period during which it occurred.

An “employee” is widely defined and includes:

  • A person under a Contract of Service or apprenticeship with the Insured
  • Trainee under work experience schemes
  • Directors under a Contract of Service who have a shareholding in the Company
  • Temporary employees provided by staff agencies excluding computer staff, warehouse staff, drivers and others where special consideration is required
  • Staff retired on a pension still working on a consultancy basis

Extensions

  • Auditors’ fees in substantiating the amount of claim, or amending or re-writing computer programs or security codes following fraudulent use.
  • No compulsory requirement to prosecute defaulting employees.
  • Defaulting employee not required to be identified if proven loss was caused by an employee.
  • Cover provided on each and every basis not restricted to an aggregate.

MOTOR FLEET

Cover

All types of vehicles ranging from private cars, commercial vehicles, special type vehicles or motor cycles or hauliers.

This cover can be diverse to include:

  • Normal Commercial Fleets
  • Industrial Fleets
  • High Performance Cars
  • High Net Worth – Collection of valuable vehicles
  • Plant equipment licensed for road use

Extensions

  • Unlimited third party property damage
  • Unlimited manslaughter defence costs
  • Full cover for trailers whilst attached to vehicle
  • Courtesy vehicles
  • Automatic repair authorisation
  • No Excess Option

TERRORISM

Cover

Indemnifies the Insured for the Ascertained Net Loss sustained as a result of direct physical damage to or physical destruction of Insured Assets arising directly out of Terrorism, Riots, Strikes, Civil Commotions or Malicious Damage including fire damage and loss by looting. For the purpose of this cover, an act of terrorism means an act, including the use of force or violence, of any person or group(s) of persons, whether acting alone or on behalf of or in connection with any organisation(s), committed for political, religious or ideological purposes including the intention to influence any government and/or to put the public in fear for such purposes.

BROWN FIELD

Cover

Provides full indemnity against any latent problems associated with certified brown field sites including asbestos and heavy metals

ENVIRONMENTAL IMPACT

Cover

Provides for cover against environmental impact of accidental spillage or other non-negligent events that cause environmental problems

 

POLITICAL RISKS

This is a truly International product and thus, for countries for which such cover is required,  provides a comprehensive Political Risks section that covers the full spectrum of risks such as Expropriation, War & Terrorism, and Force Majeure.

Cover

Expropriation – indemnifies the Insured for the Ascertained Net Loss sustained as a direct result of the Insured Events of Expropriation, Selective Discrimination, Forced Abandonment, Forced Divestiture, Cancellation of Concession Agreement, Cancellation of Export Licences or Imposition of Export Embargo

War & Terrorism – indemnifies the Insured for the Ascertained Net Loss sustained as a result of direct physical damage to or physical destruction of Insured Assets arising directly out of the following Insured Events: Political Violence, Civil War, Revolution, Rebellion, Insurrection or any Hostile Act by a Belligerent Power or Terrorism, Riots, Strikes, Civil Commotions or Malicious Damage including fire damage and loss by looting during the occurrence of or following an Insured Event, provided that such physical loss or damage occurs during the Policy Period at the location(s) of the Foreign Enterprise

Force Majeure – indemnifies the Insured for its provable and ascertainable Net Loss resulting from, due to, or in consequence of any cause beyond the reasonable control of the Insured including Business Interruption as a result of emergency partial or total closure of any road or railway line or port of navigable waterway or airport by or under the lawful order of the police, local or national authority or government, or the electricity, water or gas supply authority, and Third Party Blockade (or Quarantine) which means the politically motivated use of military force, or the direct threat thereof, of one or more third party sovereign nations.

FAQ’s

 What are the real benefits to a developer of this package?

  1. A single policy, segmented into chapters relating to the various categories of risk, on one common legal platform with one major rated underwriter, and from which qualifying construction professionals can select their requirements safe in the knowledge that there is no expensive crossover cover, nor unforeseen gaps.
  2. Known cover for all aspects of the development (regardless of the date of required cover activation) from the beginning of the project at a known cost, and not subject to any detrimental market changes throughout the development period.
  3. Latent Defect and Advance Profit features not currently available under any known construction development insurance.
  4. Developers can dispense with the need to negotiate lengthy warranties, and to scrutinise the terms of professional appointments.
  5. As the insurance package is not on a “claims made” basis but is, rather, for a fixed duration and level of cover from the outset, there is no need for the developer to concern themselves with the maintenance of insurance cover by professionals and the contractor nor with the continuity of the professional team in existence into the future.
  6. Many of the difficulties inherent in construction litigation (particularly as the apportionment and extent of liability) can be avoided. This substantially reduces the possibility of lengthy disputes.
  7. The sales process is substantially simplified and the need for additional documents and negotiations is kept to a minimum.
  8. Development financing becomes simpler and quicker as the lender does not have the concern of ensuring that all required risks are adequately covered and on what terms as this package provides a fully uniform and inter-laced insurance platform with only one substantial underwriter, and in a language suitable for bank professionals. This makes financing substantially simpler.
  9. The latent defect aspects of this policy provide for a far wider scope than currently available, and cover is available for up to 30 years before new inspections are required making this a significant sales aid.
  10. All of the above and more at a probable lesser cost than could be achieved using conventional insurance with less cover.

How will this insurance package affect the bid process?

Traditionally, as part of the procurement process, each contractor would factor into their bid the cost of obtaining insurance and obtaining any necessary bonding for their obligations. Contractors with fewer claims and who are more reliable would have access to cheaper insurance which, in theory should give them a competitive advantage. Under this policy the developer would be advised of the insurance cost differentials associated with each bidder and the developer would then use this information in assessing any bid. In this way the developer has total control on insurance costs.

What is different about the latent defect cover under this policy?

In its simplest form the latent defect cover addresses what should be available to purchasers, i.e. full rectification of any and all defects for a period up to 30 years without inspection and subject only to a satisfactory claims history. This cover is flexible in that the developer can provide say, 12 years, as part of the purchase contract with the purchaser having the automatic right to continue such cover on an agreed basis thereafter.

Can the insurance premium be broken down into its component parts for allocation purposes?

Apportionment of premium is essentially a mute point to the developer as it is a project cost, whoever initially bears it. The mechanism of this insurance product reduces the overall cost of insurance, and thus project cost. However each risk component can be separately costed for apportionment purposes.

VALUE ADDED SERVICES

This sophisticated product can only be realistically negotiated, placed with underwriters, and administered by the likes of Willis, Aon, and Marsh. For example Willis, with 300 offices in 74 countries and 14,500 associates serving clients in some 180 countries, have the capacity to provide the following added value services to ensure a quality service to construction professionals:

  • A specialist construction division with staff throughout the World from surveying and/or construction loss adjusting background.
  • Specialist construction claims staff enables a pro-active stance on contentious or complex claims. Integrated computerised systems enables instant access to claims information;
  • Contract conditions – advice on all insurance implications and assistance with negotiating the most effective and beneficial wording for each specific project;
  • Risk Management – advice in compliance with local legislation such as CDM – Health and Safety at Work Act (1974) and general loss control;
  • Production of a service plan which would obligate Willis to implement all elements of service from pre-renewal meetings to site surveys on a specific time scale by way of a detailed bar chart;
  • 24 hour helpline throughout the World including collateral warranty advice and claims services;
  • Dedicated legal services from your usual supplier.

Small Print

  • The very nature of this product means that it is available to qualifying professionals prepared to engage in a technical audit for qualification purposes. This audit is for a developer or main contractor and should only need to be conducted once, irrespective of the number of construction projects.
  • A first time developer is unlikely to qualify if using standard JCT or equivalent contracts. However a non-qualifying developer employing a qualifying main contractor on a full Design and Build basis is likely to qualify.
  • The construction project needs to be agreed by a lender to be commercially viable.

I am happy to address any questions via  ‘leave a comment’ (at top) or by ’email’ (below).

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Aon and Willis provide syndicated insurance – at last!

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Aon and Willis provide syndicated insurance – at last!

Last week Willis announced their initiative to provide syndicated insurance, referred to by the FT as ‘passive’ underwriting. Earlier this year Aon announced the same syndicated insurance methodology. I have seen criticism of this scheme but structured project finance specialists such as myself have been screaming for this methodology since the mid 1990’s.

The reports that I have read attempting to describe this offering do not fully appreciate why this is so necessary in the corporate sector, so a little background might be useful. Banks are in the business of asset risk, whereas insurance companies are in the business of event risk. When a prospective borrower presents a project to a bank, that bank will take the responsibility to evaluate the project and the financing requirement, including the associated inherent direct and indirect risks. The bank will then decide whether or not to fund the project. Little does the borrower know that the bank is likely to syndicate this funding with a number of other banks each taking a percentage of the financing based on the good judgement of the borrower’s bank. If funded through a private placement then this syndication will be invisible to the borrower.

The bank is likely to identify certain event risks, e.g. business disruption, for which it will need insurance cover. Using traditional methodology the borrower will then have an insurance broker approach the insurance underwriters to arrange cover for the various event risks identified. What comes back is a number of policies using different wording platforms, and even different legal jurisdictions. This does not instil confidence into the bank’s risk profile, and why banks generally do not give credence to what these various policies purport to provide. In the event of a potential claim which underwriter does the bank approach?

I would like to introduce 2 extracts from a MBA text book on structured project finance that I co-authored in 1999. Both are from one of the chapters called ‘The Role of Insurance in Project Finance’.

“Our own experience suggests that both insurers and bankers generally state that they are flexible and adaptable, but in practise usually confine themselves to tried and tested solutions. For example it took two years of negotiation, cajoling, and debate convincing insurers that the structure of our “One-Stop” Construction Risks product was a radical and valuable improvement in the provision of a reliable solution for the support of major construction project financing. If I had to identify the major factor in the reluctance to adapt to the inherent changing role of the insurer with such a product it was the degree of change in approach of providing a packaged integrated risk mitigation solution which is flexible, but contained to one major lead underwriter on one legal platform. In essence we did no more than to use tested principles of bank syndication and adapted it to the insurance market. The initial reaction of the bankers was “too good to be true”. The lawyers view was that it would remove at least 80% of construction litigation as many of the difficulties inherent in construction litigation and particularly as to the apportionment and extent of liability could be avoided, but they were not sure that bankers, or even developers, are ready for such a radical shift in thinking.

On the other hand we have produced an integrated insurance solution [with Aon] for a wide range of project risk mitigation including investor risk, cash flow risk, business disruption, all within a political risk envelope, for a Euro-convertible bond offering for a complex project in Eastern Europe which was only acknowledged by the bankers for what the insurance brought to the deal when the issue was very well received and became oversubscribed, whereas prior to the integrated insurance component there was no interest. In this offering the insurance component was an integral part of the Trust Indenture Agreement [a ‘first’ in an international securities offering] which made for a robust structure to which investors could relate and feel secure.

Our resultant observation is that both parties need to be brought together in a spirit of mutual understanding and co-operation if the bankers are to enjoy the value and benefits available through effective risk mitigation insurance tools, and insurers need to adapt to a more flexible approach to ever changing risk profiles. Furthermore there is a language barrier between these two sectors that needs to be overcome by both parties as misunderstanding plays a large part in the lack of integrated solutions.”

Aon and myself wrote the policy wording that we needed, and Hiscox took the lead underwriter role of the event risk requirements for the eurosecurities issue even though there were aspects of this package that they, themselves did not underwrite. They acted as a lead underwriter and placed all the risk within their underwriter community – invisible to us, just like a bank syndication – and only one underwriter for the bank to engage with.

“Project Finance Requiring Political Insurance

This is a very specialised area of insurance as, by definition, the project is in a territory that has less certainty of political stability and/or appropriate legal structure than one would like in order to secure an investment or lending position in the event of problems. Such political insurance is available to cover a whole host of possibilities such as:

 

  • Confiscation, Expropriation, and Nationalisation
  • Forced Abandonment
  • Transfer Risk
  • Refusal of host Government of Repossession and Disposal Rights
  • Contract Repudiation
  • War, civil war, civil unrest,  and terrorism

 

However there can be a number of interested parties that need cover within any one project, and there can be a number of different scenarios that require the security of a political insurance wrap in order that they are effective. This is further complicated by the fact that it is not always possible for any one insurer to assume the total insurance package thus various legal platforms for each insurable risk need to be interpreted and reconciled. It is our firm belief that the current practise with insurers will radically change over time such that one major insurer will assume a lead manager role, much along the lines of a bank lead manager, providing a single source of full insurance cover on one platform.”

It has taken some 13 years for this concept to mature, and I applaud Aon and Willis for their belief and understanding of the need for this approach. I hope that the banks welcome this approach with open arms.

Is there an alternative quality structured product that can achieve ‘Help to Buy’ without a Government guarantee?

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Is there an alternative quality structured product that can achieve ‘Help to Buy’ without a Government guarantee?

We saw in the FT on 13th August an article ‘Ministers deny loan guarantee scheme will cause UK housing bubble’ which challenges the logic of the government providing guarantees for the Help to Buy program.

This got me thinking about the current mortgage lending situation as I am also aware of the dynamics of generating a 20% – 25% deposit to qualify for a mortgage – just saving will not work as annual property inflation keeps moving the goal posts further away whilst wasting valuable cash flow for rent. I have developed an idea that I would like to share with you that removes the need for any government involvement but would achieve the same intent, increase quality lending by banks, and provide a quality product for asset-backed securitisation purposes.

My idea is based on inheritance capital tied in fixed assets, i.e. the parents/family having capital value locked up in a home with little or no mortgage but not enough free liquidity to assist siblings with deposit requirements. Existing equity release products have rightly attracted much distrust.

I have used as a template: first time buyers, couples up-scaling for a family, and moving for career choice purposes, albeit not limited to these. Their parents could be still working, or have retired, but they have more than enough income for their living needs, but not enough liquidity to assist their siblings. Thus the inheritance that would go to their siblings consists mainly of fixed assets in property which can only be realistically liquidated upon the demise of the parents. There is the possibility to create a quality equity release product that might also be very tax efficient for inheritance tax purposes.

The product includes a mortgage extended to the parents for the amount of the deposit required by the siblings. Assuming that this mortgage amount (including any existing mortgage) is significantly less than 50% of the property value and is easily serviced by the parents from their existing income the lending bank have a quality mortgage. Assuming that the couple can easily service the remaining 75% – 80% of the property mortgage that they need then the bank has essentially lent 100% but has 2 or 3 quality assets and income streams to service the debt we have a package that can easily be securitised should the lender need to free capital. This also allows the couple to use whatever capital they do have to furnish their new home without reverting to expensive credit card repayments.

If the financing for the parents is interest only, i.e. the capital amount would be repaid once the mortgaged property is sold as part of the estate liquidation during probate – we have a valuable inheritance tax planning product.

One ideal use of this product would be the situation where 2 young people intend to get married, would like to buy a home to raise a family but cannot afford the 20% – 25% deposit. Both sets of parents own properties of suitable value, but without enough cash assets to help this couple to achieve their dream home, albeit enough income to service a mortgage on their existing properties. Each set of parents could provide 25% between them through a re-mortgage on their own properties and thus give the couple the best wedding present they could wish for. This type of product has great social value as it allows the parents to give a good start to the adult life of their siblings; a concept very much part of the culture in a number of societies around the world.

If all 3 mortgages are tied together as a high quality lending both in terms of debt to equity (asset security value) and debt service capability we have a high quality package for asset-backed securitisation purposes.

If the government wanted to encourage this type of parental support they could give tax relief to the parents on their mortgage interest payments.

Does this make sense as a quality lending product, as it would be less visible than the proposed Help to Buy government scheme (thus removing fears of housing bubbles), and would be a valuable social product.

EU/Eurozone – Start Again or Plod On? – Conclusions

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EU/Eurozone – Start Again or Plod On?

Conclusions

During a speech in Zurich on 19th September 1946 probably the greatest statesman of the 20th century, Winston Churchill, called for the creation of a United States of Europe modelled on the United States of America singling out the essential need for Franco-German co-operation. Churchill did not envisage the UK’s role as anything other than promoter (broker). In May 1950 Robert Schuman, the then French Foreign Minister, took up the idea of Churchill and put forward a plan.  We are now in 2013, some 67 years later, and what do we have that remotely resembles this vision?

On July 2nd 1776, the Second Continental Congress, meeting in Philadelphia, voted unanimously to declare the independence ‘of the thirteen United States of America’. Two days later, on July 4, Congress adopted the ‘Declaration of Independence’. The drafting of the Declaration was the responsibility of a Committee of Five, which included, among others, John Adams and Benjamin Franklin; it was drafted by Thomas Jefferson and revised by the others, and then by Congress as a whole. It contended that ‘all men are created equal’ with ‘certain unalienable rights, that among these are life, liberty, and the pursuit of happiness’, and that ‘to secure these rights governments are instituted among men, deriving their just powers from the consent of the governed’.

In spite of a ravaging war to overturn the Declaration of Independence, (the Revolution War involving both the British and the French), a new Constitution was adopted in 1789. It remains the basis of the United States federal government, and later included a Bill of Rights. With George Washington as the nation’s first president and Alexander Hamilton his chief financial advisor, a strong national government was created. In the First Party System, two national political parties grew up to support, or oppose presidential policies. This was achieved in just 15 years during a ravaging war, and this was all managed without telephones, internet, air travel, motorised transport systems, etc.

Peace and prosperity cannot be achieved merely by the creation of a political and economic framework if the people themselves play no active part in shaping society or in living together in harmony, i.e. without the consent of the governed. In the current EU system little or nothing of significance has been determined by the people and thus they rightly feel disillusioned and disenfranchised. It is a certainty that if the UK were to vote today on staying in the EU the vote would be a resounding ‘NO’. I am informed by my connections in Germany that the vote of the German people is fractured, and could go either way. The Mediterranean states would almost all vote ‘NO’ in spite of reliance on Germany for finance. So when do the politicians stop playing their fiddles whilst Rome is burning, and start to address the real issues, not least that the current framework does not, and will not work. Then sit back and ask the people what they need from a united Europe for themselves, their children and grandchildren. If the people elect for a United States of Europe, something similar as outlined in this series of essays, or as envisaged by Churchill, then fix a date and do it. If the people know and agree the plan, and the target date, they will respond.

And when the politicians start to address this plan they need to look at it from an outward perspective, i.e. how the world will see it, in order to guide thinking to maximise the value drivers available. For example who in the world knows where Brussels, Strasbourg, Frankfurt or even Berlin are, or that they even exist? The most known cities in Europe are Paris, Rome, London, Madrid and even Vienna. How many people do you know that, having visited Washington, the capital city of the USA, came back very disappointed with that city – even the White House is actually much smaller than pictures would have you believe. But Europe has stature with its historic cities so any plan must consider how these cities can be used as value-added drivers to the outside world. For example most people in the world know where London is, and that it is one of the most influential capital cities of the world. This is the strength of the UK, a maritime nation having built longstanding reputation and networks throughout the world, and thus a major value driver. Of course this assumes that we expand Churchill’s vision to include the UK – not a given in my thinking.

One important aspect of the plan for a united Europe was to prevent conflict in the form of another major war. With the ever growing disparity of European nation states, especially within the Eurozone crises, it is not inconceivable that conflict can occur in the form of civil insurrection, or even civil war, (history shows that civil insurrection starts with the disadvantaged versus the rich, and I do not sense that ‘love thy neighbour’ is much in evidence at this time). Was this caused by the banking crisis or, as more likely the case, the shambolic mismanagement of entry into the Euro. At the end of 1996 the European member states supposedly faced a tough test to determine which of them fulfilled the strict convergence criteria laid down for participation in the Euro. Very few passed the test as defined by the strict rules, so the rules were thrown out of the window to allow all who wanted involvement to adopt the Euro – and now we know the reality of allowing totally disparate economies to attempt to converge. What makes any European politician think that they can adopt a single currency without central control of fiscal policy and management of all states involved, and the safety nets in place such as described in my essays ‘EU/Eurozone – Start Again or Plod On’ – ‘A Social State’ and ‘Taxation’.

A major crisis would create a good framework to focus minds on an integrated approach. When Churchill gave his speech in Zurich the conditions in Europe would have been ideal to create the United States of Europe – an opportunity lost. Perhaps if the Eurozone implodes the situation will present the opportunity for a ‘clean sheet’ approach, and a rapid implementation.

Should the UK join a United States of Europe? There are two ways of looking at this. Integrating Europe without the UK would probably be a much easier task, not least because of its unique position in the world. It has protectorates, protected states, mandated territories, the British Commonwealth, etc. to consider involving some 1.6 billion people. What would happen to them in our United States of Europe? In this case the UK could act as independent broker (as envisaged by Churchill) to the creation of the United States of Europe ensuring that its Constitution and political systems are not unduly influenced by national interests of stronger nation states, and is outward looking to ensure that there are no difficulties integrating further countries in the future. The initial United States of America was just 13 states, but the Constitution was structured to be inviting for other states to participate – 50 states plus a federal district to date, and counting.

The alternative is that, as so many of the pillars of a United States of Europe exist, at least in part, within the UK system, finding solutions at the outset for the peripheral issue of integrating the UK will create a comprehensive framework that would accommodate any future entry of additional members, including Russia. I see the inclusion of Russia, at some point in the future, to be the completion of a United States of Europe that can compete with any other nation in the world. However, and unfortunately, the UK has too many of the value drivers needed in a United States of Europe – difficult for the other nation states of Europe to swallow. Looking at it from the rest of the world’s viewpoint London would be the logical capital. London is the largest financial centre in the world by far thus it would also be the home of the European Central Bank and the banking regulators. We could, but not necessarily, add the Supreme Court, and even the European Parliament, – and what about a monarchy head of state?

Another solution that would have a significantly better chance of success would be the integration of just a few fully committed nation states capable of convergence in order to create and refine the structure – and then invite other members as per the USA. However I cannot emphasise how important it would be to have an outward looking, and simple Constitution friendly to all. If it looks like, e.g. an expanded Germany and/or France then I see further membership as limited.

On balance, and in spite of the fact it would leave the UK disadvantaged in some respects, especially if Europe became a fully-fledged 27 member United States of Europe, instinct suggests that the UK should not participate, and certainly not in the EU as it stands today as it is a very expensive club with little or no return on investment. I do not see a massive migration of companies from the UK into Europe for a number of practical and economic reasons. Businesses always find a way to deal with other nations, in spite of politicians.

If we discount the nation states who benefit substantially from membership what proportion of the people (not the politicians) of the other member states would today think that the EU was anything other than a faceless, expensive enterprise causing unrest throughout Europe and continually imposing unnecessary and expensive interference in their lives? What about countries like Switzerland, who traditionally have been very much aligned with Germany, but sitting on the sidelines, and not now considering entry at any time in the near future.

The UK is ideally and uniquely positioned to act as nation broker, as was the case in the removal of the Berlin Wall and reunification of the Eastern states of Europe with the West. The UK would be a natural broker to act between the USA and Europe, and between Europe and Russia and the Black Sea and Caspian states.

Any European integration plan needs a people’s champion who will stay with the plan until achieved. As the natural process is for politicians to come and go, and they are certainly not neutral in their approach, this people’s champion is unlikely to be a politician. This champion could be an individual, a small group (the Group of Five structured the USA system), or even the UK as an independent broker. This champion must have an integration plan endorsed with the full consent of the people of the countries being integrated, not just their representative politicians – the people need to be directly engaged with the process.

The failure of politicians to agree a sound plan for Europe devoid of national and personal self-interests, and to engage with the people, is an affront to democracy for such an important project, and has led to the hotchpotch of a European disintegration that we see today. Now nation states want to revisit treaties, and the people of the UK might have the chance, at last, to make their voice heard. The German government states ‘no’ to revisiting treaties and, by the way, has put everything on hold for 2 months because of German elections – what about the people out there who are hungry and need medicine?

Politicians come and go, but the process of European integration cannot change every time there is a change of political guard. Europe needs a plan, ambitious and exciting, for full implementation within 2 years, fully endorsed by the people’s vote, and it needs a people’s champion to oversee the implementation. In the hour of need cometh the ‘man’, but where is he/she for this project?

I am unexpectedly fortunate to be able to conclude this series of essays in much the way they started; with an episode of Top Gear, the UK motoring programme. Last week Jeremy Clarkson, a presenter of Top Gear had the notion to determine how much automotive manufacture took place in the UK, and asked each manufacturer to contribute a selection of what they produce to a parade in The Mall in London one Sunday morning. The TV pictures of the quantity, quality, and variety of automotive products made in the UK was truly staggering and presented a message to the people of the UK more about the state of UK manufacturing in those picture than any politician could ever explain. To these pictures Clarkson added that:

  • A new car rolls off UK production lines every 20 seconds
  • Honda produces 5 of their car models in Swindon
  • The Toyota plant in Derbyshire exports cars to Japan
  • Nissan make more cars per year in just one plant than the total car production of Italy
  • Of the 11 F1 racing teams 8 are based in the UK
  • Cars such as Rolls Royce, Bentley, Aston Martin, Range Rover are the cars of choice by the rich throughout the world
  • Aston Martin has been voted the coolest brand in the world for 5 of the last 7 years

This was such a powerful 15 minutes of inspired broadcasting that the BBC repeated it again, and again as the message spread and the people connected with this better than any political message, and the resulting well-being of the people was noticeable. Contrast this with the political diatribe that comes out of the EU and it is not unreasonable to expect that the people of the UK will vote ‘NO’ to membership of the current EU disintegration.

Links

George Papandreou: Imagine a European Democracy without Borders http://www.ted.com/talks/george_papandreou_imagine_a_european_democracy_without_borders.html

Epilogue

Thank you for participating in this series of essays, and I hope that you found the debate interesting. It is very difficult within the reasonable scope of a blog to include or expand all of the arguments and debate, and thus what to include, and what to leave out. For example, with my understanding of market economies, I could have written more than the accumulated word count of all 11 essays. The key for me was to find some of the fundamental triggers of a reasonable United States of Europe that at least cause people to question what is happening in their name, and at the expense of the people. Having managed a number of very difficult, multi-faceted problems during my career, not least with disenfranchised people, and time being of the essence to find workable and accepted solutions, I have developed methods to include even the most pessimistic of people, and in timeframes considered unachievable.

The most important part of any solution was the need to explain to all of the people involved (globally in some cases) where we were, and where we needed to be. These people needed to be persuaded to engage in the process knowing some would not understand and/or believe, especially when, for two such problems, the technology we needed did not exist when we started, but we had a fixed and unmoveable delivery date. In such cases it was important that they knew that I would take full responsibility for the outcome – all I wanted from them was commitment and belief. I had one IT manager, very capable but a staunch Trekkie (as in Star Trek) who, when attending a strategy presentation, would write and speak the words ‘Star Date: (whatever the date)’ and then ‘About to go where no man has been before’ as per the start of an episode of Star Trek. This action enabled him to move beyond his anxiety, and he always delivered, albeit sometimes not quite knowing how. All I did was to instil confidence and commitment into people – what I term ‘removing constraint’ – shared my vision, and took responsibility for the result, but vesting the success in them. Such people never failed to deliver, and the sense of well-being of all at delivery was uplifting. People can be mobilised to achieve great things so long as they are properly engaged, motivated, and committed.

EU/Eurozone – Start Again or Plod On? – Market Economy

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EU/Eurozone – Start Again or Plod On?

Market Economy

Is the so-called European Union worthy of all the time, trouble and cost, all fully funded by the people of Europe? Firstly let me clarify the value-added components of a market economy worthy of the time trouble and cost of our United States of Europe. I refer to a secure, self-sufficient, free market economy consisting of a secure and sustainable supply of raw materials and energy, a relatively cheap labour force, innovative skills (excellent education), technology transfer skills, manufacturing, marketing, and with stable and effective financing (banking).

An economic definition of a Free Market Economy is a system in which decisions regarding resource allocation, production, and consumption, and price levels and competition, are made by the collective actions of individuals or organizations seeking their own advantage, i.e. profit. In all market economies, however, freedom of the markets is limited and governments intervene occasionally to encourage or dampen demand or to promote competition to thwart the emergence of monopolies. Also called free economy, or free market (ref: BusinessDictionary definition). But this can occur at the nation state level, or as a collective of nation states such as NAFTA.

The free market viewpoint defines ‘economic freedom’ or ‘economic liberty’ or ‘right to economic liberty’ as the freedom to produce, trade and consume any goods and services acquired without the use of force, fraud or theft. This is already embodied in the rule of law, property rights and freedom of contract, and characterized by external and internal openness of the markets, the protection of property rights and freedom of economic initiative.

However in this world of globalisation recent history has shown that uncontrolled greed by the few can have devastating impacts on the many. The most obvious of these is the banking crisis where a few greedy investment bankers, interested only in their personal wealth, saw the opportunity to use their banks as casinos. When they were winning everyone was happy, ignorant of the fact that it could not last. The effects of this have caused widespread hardship, putting excessive stress on all of the welfare initiatives inherent in a democratic system.

We also see this excess in the boardrooms of major corporates who award themselves excessive bonuses, pensions, and salary increases whilst the workers, who actually create the wealth, have to suffer wage increases below inflation, i.e. they get poorer.

Clearly entrepreneurs and wealth creation are at the heart of any free market economy and must be encouraged and rewarded. Furthermore it is arrogant of politicians in general to think that they can outsmart the clever people whose sole intent is to make money regardless of consequence, and avoid or even evade taxes where possible. However united political systems throughout the global economy can take steps to close many of the gates to ensure that such excessive freedom is not available. For example investment banking is a global business so governments throughout the world need to legislate in tandem that banks cannot act as casinos, and must contain their activities to creating economic value and global liquidity. We need the creativity of investment banks, but we do not need their casino activities.

Likewise we now see moves by various governments to give stakeholders, the owners of the company, more powers to curb the excesses of the executives. However this is not the part of a market economy that I wish to address in this essay.

I want to refer to our template of the USA and examine the parameters that fuelled their economy, especially throughout the 20th century. If we refer back to the opening paragraph of this essay we will see a definition of a secure and self-sufficient, free market economy. If we examine the components of this definition there is one which can be considered as deficient within the EU as it is today, i.e. a secure and sustainable supply of raw materials and energy. My use of the word ‘sustainable’ in this context relates to volume rather than the Kyoto concept of ‘renewable’, especially for natural minerals. This component was fundamental to the industrial development of the USA and, indeed I am aware of expansionist plans of the USA to restock when they are close to exhausting their own supplies. For example we see how fast the USA has embraced fracking for both oil & gas exploration and development resulting in the material reduction in energy costs in the USA. This enables the USA to resume as a competitive manufacturer and supplier, thus reducing imports. This is a win-win-win for the US economy and its people. It is very refreshing to see that David Cameron has fully embraced this technology as a counter to the usual doomsayers who would have people starve rather than benefit from this technology.

So where does the EU find secure supplies of raw materials? The logical choice is to look east to our neighbours in the outposts of Eastern Europe. Russia has already demonstrated that it does not understand how to engage in secure supply, thus can only be considered a secondary source for the time being. It is possible to engage with countries such as Ukraine, Azerbaijan, and Kazakhstan albeit with caution bearing in mind their continued alliance with Russia.

We cannot assume that the plundering the natural resources of third world countries as with Bougainville Island can continue. For those who do not know this story Bougainville is a small island state near to the Solomon Islands in the Pacific south of the Philippines. Before the war it was placed under administration of Australia under mandate of the League of Nations, but was invaded by the Japanese during the war. After the war Australia did not officially resume its role of administrator but, as soon as Rio Tinto found that Bougainville had enormous reserves of copper ore and gold in the 1990’s Australia went into business with Rio Tinto and passed statutes giving the mining rights to Australia who then gave Rio Tinto the exploration and development agreements without any regard to the people of Bougainville. The process of extraction polluted large tracts of the island until the people of Bougainville forcibly removed the Rio Tinto personnel (who were supported by Australian police and the Philippine army) from the island, with many dead. There is much on the internet about this tragedy for those interested. Rio Tinto and Australia are still looking at reparations of some USD 8 billion to the people of Bougainville.

Parts of Africa are also rich sources of minerals, but the Chinese have secured much of these for their own industrial requirements, as is the case with Brazil.

Thus the EU will primarily have to compete in the open market – not the strongest base on which to build a United States of Europe, especially with competing countries as large as China and India, both willing to secure as many resources as they can find to fuel their own needs.

It is worth returning to the situation in Brazil, one of the so-called BRICS, as an example of not understanding the economics of owning raw materials. Currently in Brazil they mine their raw materials and export them to countries such as China at Rial:USD exchange rates that do not optimise value to Brazil. They then have to import finished goods made with these raw materials thus consuming more than their receipts from the raw materials to satisfy their own internal market demand for goods. This is a sad reflection of a country with outdated fiscal and social policies, woeful internal transport systems, and that cannot attract large-scale manufacturing industry because cost of production could not be competitive at current exchange rates. Contrast this with the USA who would use their capitalist economy to convert these vast reserves of raw materials into goods for both internal consumption and export thus reducing the need to import, and receiving export income. Think of the employment difference between Brazil and the USA – Brazil only engages nominal labour in mining the materials, whereas the USA would also engage the manufacturing design and process people, distribution, etc. The market economy of the United States of Europe needs to resemble the USA model to satisfy the definition that I have proposed. Indeed if Brazil were a direct neighbour of the EU they would be a ‘must’ to be a member as the EU could provide all of the market support to Brazil that it lacks in exchange for its raw materials – this would be a fantastic outcome for our United States of Europe. It does not matter that Brazil is a developing economy as the capabilities within the other member states could rapidly transform Brazil into a vibrant economy having all of the infrastructure necessary for a 21st century country.

Therefore I would suggest that we consider the current 28 member states as phase I of European integration, or even phase I and phase II if we adopt a more pragmatic plan of integration. I see phase II (or III) as the inclusion of Ukraine: (coal, iron ore (5% of world reserves), manganese, nickel and uranium, mercury ore (2nd largest reserves in the world) and sulphur (largest reserves in the world)), Azerbaijan: (rich variety of minerals, oil & gas), and Turkey: (many types of minerals, and close links to the Kurds in northern Iraq and their large oil & gas reserves). Before anyone asks, Turkey would have to commit to continue as a fully secular democracy as part of membership, but having worked with Turkey since the late 1970’s I do not see this as a problem, and as is evidenced with the current unrest in Turkey. Just as we have seen in Egypt the majority of people in Turkey value a free secular society, and will fight to keep it.

Ultimately I see the integration of Russia with its vast mineral wealth (our local equivalent of Brazil) thus placing the United States of Europe as a significant self-sufficient market able to compete with any other economy in the world. As improbable as this seems today, if Europe can achieve a United States of Europe similar to what is proposed in these essays, then a more pragmatic regime in the Kremlin will see the advantages of being within, rather than the vast costs to create their own economic system – especially if Europe can substantially reduce its need of oil & gas supplies from Russia.

The value of a market economy, as per my definition in the opening paragraph, to our United States of Europe is the lack of dependency (and thus exposure) to any other country for the supply of materials strategic to the economy of the nation. This is also applicable to agriculture, but in this regard I do not anticipate any problems with capacity to feed the people of the United States of Europe today or in the foreseeable future. For example we have not yet begun to properly and fully exploit the vast black gold agricultural regions around the river Danube throughout the former Yugoslavia and Romania, and which could potentially produce a significant amount of the produce required. They call the soil in that region ‘black gold’ for a reason, and most of this region is organic soil.

Thank you for your continued interest in this European venture.

This blog is part of a series of blogs called ‘EU/Eurozone – Start Again or Plod On?’ and which examine the framework for a truly United States of Europe, and what would be needed to achieve it. Look at the archive index to find other blogs in this series.

I hope that you found this blog interesting, and will give it the Like It ‘thumbs up’ below, and/or become a follower so that you receive notice of further essays in this series.

You can also use the share options below to share your interest in this blog with others you know.

These blogs are intended to provoke thought and ideas so I look forward to any comments about the content. Just move to the beginning of the blog, click on ‘Comments’ and you can record your views, or ask questions.

EU/Eurozone – Start Again or Plod On? – Taxation

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EU/Eurozone – Start Again or Plod On?

Taxation

Taxation is the instrument of State that provides the income to service the functions of government. It can also be used to incentivise investment, to change behaviour, and to redistribute wealth.

Within the EU today each nation state has its own tax regime plus a tax to fund the various organs of government of the EU – notionally VAT.

The disparity of tax regimes and the effectiveness of collection throughout the EU is almost a north/south divide. The Mediterranean nation states have proven poor at tax collection much through corruption and black economies, and thus their current dilemma. The more Northern nation states have reasonably good collection and little or no corruption.

Years of attractive stimulus for businesses by providing complex tax incentives are now coming home to roost. The desperate need by governments for new sources of tax revenues has unleashed wrath on major corporations who are certainly exploiting the available tax incentives albeit, by and large, they are not contravening statute. However politicians are suggesting that these businesses have a moral duty to pay more tax, thus whipping up the flames of anger among the electorate, and working with other governments to do the same in order to close the door on these businesses relocating – a coup. It will be interesting to see how these corporates respond to this approach as they have a right to think it a breach of faith. Not that I support their position as I have seen smaller, developing states essentially raped by corporates forcing their terms onto inexperienced struggling governments just trying to bring some wealth creation to their country. Furthermore I have already mentioned in a previous essay that corporates have a moral duty to the welfare of their staff and immediate environment – something that has substantially diminished as a result of globalisation, but needs to be reintroduced.

I think it justified within a discussion about the EU to include the converse of taxation in the form of nation state subsidies from the EU government. The most contentious of these is the Common Agricultural Policy (CAP) a mechanism created to normalise competition in farming output whilst markets adjusted, but which has not yet gone away. Indeed the CAP still accounts for some 50% of the EU budget. The French appear to use the substantive revenues they receive under CAP to put off the fateful day of much needed social reform in France. It is easier for the French government to plead with the EU Commission to keep this subsidy than it is to break the stranglehold grip over social policy of the trade unions in France. This has been a thorn in the side of EU integration for too many years. A unified tax system throughout Europe, applied equally to all, could address this problem without any reasonable objections from any trade union movement.

If we refer back to our corporate structure described in ‘EU/Eurozone – Start Again of Plod On – A New Government’ it is easy to see that tax revenues yield the income streams that provides for the State to function. A nation state, just as with a corporate, has a Balance Sheet showing all State assets and Liabilities, an income statement showing all tax receipts and the costs government and the social state, and a cash flow statement showing tax receipts versus expenditure on a timeline indicating when the government coffers will be short of funds to meet its commitments (and thus the need to visit with the Central Bank to cover any shortfall), and when it will be in surplus. The theory is that good government will result in balanced books, something Margaret Thatcher was forever reminding her colleagues in the House of Parliament when they wanted yet more money for some social crusade, and something Tony Blair just ignored in favour of expensive social engineering intended to buy popularity and the votes of the people. Thus the infamous note left by Labour MP, Liam Bryne, former Chief Secretary to the Treasury at the time of the general election in 2010 which stated ‘Dear Chief Secretary, I’m afraid that there is no money. Kind Regards and Good Luck’ – a very different situation to the one Labour inherited when they came to power.

What about the rest of Europe? We know that Germany has probably the most austere tax regime, albeit that the Scandinavian countries make take exception to this statement. The most lax at tax collection is probably Greece where, by all accounts, tax officials are readily corrupted, and the ruling elite are part of the problem. As far back as ancient Greece Aristotle knew that no freedom is limitless. The negative aspect of too much freedom of economy was an issue already recognised by the ancient Greeks, and proves to be one of major reasons for the current huge crisis in Greece today. As in ancient Greece it is still typical that very rich people think that is very natural not to pay taxes, and not even to have a conscience about it.

Clearly entrepreneurs and wealth creation are at the heart of any free market economy and must be encouraged and rewarded. Furthermore it is arrogant of politicians in general to think that they can outsmart the clever greedy people. However a united political system in the form of a simple and unified tax structure applied throughout our United States of Europe could close many of the gates to ensure that excessive freedom is not available.

In our United States of Europe the whole tax system would have to be overhauled in the name of equality for all. Thus what might a centralised tax system look like so that it is seen to be balanced between rich and poor states?

Within a framework of subsidiarity the central government would need funds, and each member state would also need centrally allocated funds to operate State policies. Furthermore each member state could raise taxes specific to the requirements of each state, with the consent of the people of the member state. There are a multitude of cultures within Europe having different requirements in the name of well-being and quality of life. These should not be stifled by an overbearing central government, and thus allow the state assemblies to respond to such requirements through a democratic process of state taxation.

Thus we would need State taxation in the form of corporation tax, income tax, investment income tax, duties, levies, etc. The rate of taxation on these sources would need to be the same for everyone, and collection would be controlled by a central government revenue agency. For example all employed people would have income tax and national insurance (for healthcare and pensions) deducted monthly at source thus providing central government with a constant stream of income, easy to collect, and overcoming the existing difficulties presented to citizens in some nation states who are paid their salary gross of deductions and then have to find funds to pay their taxes at the end of the tax year. Income tax thresholds, i.e. the minimum salary to attract any income tax, should be set at a liveable level (thus optimising the tax collection body to a cost effective level), and national insurance contribution up to this level should only include a pension provision – healthcare should be free for the poorest.

VAT could be transformed into a tax to allow for redistribution of wealth to poorer sectors. For example VAT, being a capitalist tax and applied to purchase power (consumption), should have its bounds set such that the essentials of life should not attract VAT. This means that most food, anything to do with rearing children, books, newspapers, etc would be exempt from VAT. Indeed VAT could be seen as a luxury tax and thus only paid by people who had enough disposable funds to afford the items. This means that poorer people would pay little VAT as a percentage of their disposable income, and richer people would pay substantially more. These funds could be used to improve the environment of the poorer people, and help poorer member states to raise the standards of living for its citizen by providing necessary infrastructure to encourage wealth creation.

The essential requirement of the system of taxation within our United States of Europe is that it is seen as unified and fair to all people thus preventing unnecessary competition between member states, and to prevent artificial migration of people. For example, the extreme application of subsidiarity in Switzerland has provided a bizarre situation where people will move just a few streets in the same city for the sole purpose of achieving lower taxation in a different municipal system, but still work in, and enjoy the benefits of the higher tax municipality within that same city. This level of subsidiarity could be compared with tribalism and thus is very undesirable, and should be avoided.

Thank you for your continued interest in this European venture.

This blog is part of a series of blogs called ‘EU/Eurozone – Start Again or Plod On?’ and which examine the framework for a truly United States of Europe, and what would be needed to achieve it. Look at the archive index to find other blogs in this series.

I hope that you found this blog interesting, and will give it the Like It ‘thumbs up’ below, and/or become a follower so that you receive notice of further essays in this series.

You can also use the share options below to share your interest in this blog with others you know.

These blogs are intended to provoke thought and ideas so I look forward to any comments about the content. Just move to the beginning of the blog, click on ‘Comments’ and you can record your views, or ask questions.