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.
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.
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.