With infrastructure projects facing increasing exposure to political and economic risks worldwide, demand for innovative insurance products has grown, writes Helen Yates.
In May, the Romanian government cancelled a highway construction contract with US engineering and construction giant Bechtel. The US$2.8bn contract to build the 415km Transylvanian road network had been signed 10 years earlier. At the time the contract was cancelled, just 52km (around 13% of the project) had been built. Romania has agreed to pay Bechtel US$48.5mn in compensation and another US$65.2mn in debts owed.
Bechtel’s experience in Romania highlights a creeping exposure for infrastructure projects. In a changing world with shifting macroeconomics, the political and economic risks involved in major construction projects have evolved. Events such as the Arab Spring, political tensions between North and South Korea as well as unrest in Turkey have heightened risk perception. At the same time, increasing activity in new and emerging markets has made construction firms more inclined to proceed with caution.
As a result, demand for specialist insurance products that can transfer some of these political and economic risks has grown. And not all the demand is coming from traditional markets, an increasing proportion is from emerging market-based firms. Ace Global Market’s political risk insurance (PRI) team has offices in London, the US, Singapore and Hamburg and has just opened an office in Brazil to take advantage of emerging market demand.
“There are world class construction companies in Latin America and the ‘south-south’ trade and investment flow is on fast-track since the financial crisis of 2008; we are keen to develop opportunities from this trend,” says Julian Edwards, head of political risk and credit at Ace Group. “These companies are now building large infrastructure projects in Africa and Asia. This is creating new business for the market from LatAm companies that understand the use of our products in supporting finance and protecting their balance sheets – they have matured to a level of sophistication where they understand the need to cover country risk. So we see this as a great opportunity to grow our market, by selling products to new and emerging companies in Asia and Latin America.”
Emerging market investment
Globally, spending on infrastructure is set to reach approximately US$70tn over the next 40 years, according to the OECD. The BRIC economies and countries of the Gulf Co-operation Council (GCC) are the powerhouse behind this investment as their economies and cities expand. The World Bank estimates that core investment requirement of developing countries amounts to 7% to 9% of their annual GDP, or approximately US$400bn a year.
Looking at just energy, over 90% of global energy demand growth is expected to come from emerging markets in the future, led by China. The Asian Development Bank estimates at least US$8tn in infrastructure investment is needed for Asia to sustain its economic growth.
Brazil is setting the pace in Latin America, where the government expects around US$100bn in annual investments through 2017 to help overcome the country’s ageing roads, increasing logistics costs and meet its energy needs. The World Cup in 2014 and Olympics in 2016 are attracting US$60bn of investment while high-speed railways, airports, urban regeneration programmes and massive energy projects are in the pipeline for the coming years. Across the region there is increased infrastructure spending to the tune of US$1.5tn.
Alongside the traditional construction insurance – coverages such as construction-all-risks (CAR) and erection-all-risks (EAR) – there is also demand for specialist solutions to country and trade risks. Unlike manufacturing premises, infrastructure investors cannot avoid political risks by changing location.
Also, the high viability of foreign investments’ involvement in such projects can amplify political risks for foreign investors. Typically, contractors tend to buy three types of political risk cover if they are undertaking infrastructure projects in emerging markets. These are:
Comprehensive contractors plant and equipment (CCPE) insurance: This protects all a contractor’s mobile assets and covers political risks in the forms of confiscation, nationalisation, expropriation or requisition by the host country government. It also covers deprivation, or the inability to obtain an export licence from the appropriate authority, and typically includes an element of forced abandonment.
Contract frustration: This product protects again pre and post-shipment risks of a government cancelling or failing to repay their debts for a contract.
Unfair or wrongful calling of bonds: This protects contractors against unexpected losses which arise from the calling of a performance bond or guarantee due to no fault of the insured.
“The banks dictate a lot of the insurance purchasing when they provide finance,” says Mike O’Connor, political risk and terrorism underwriter at Ascot. “When you are dealing with emerging markets you need to go into it with your eyes wide open as there are some very difficult territories to trade with.”
Demand for forced abandonment – where a contractor is forced to leave assets behind if political unrest or war breaks out – has grown since the Arab Spring. “Forced abandonment had been around for 20-odd years and was specifically designed for when you’ve got equipment in a location but you’ve got to leave it because it’s too dangerous for your personnel to stay,” explains Rupert Cutler, managing director of Newman Martin and Buchan’s financial and political risk division.
“But you could be forced to abandon an asset – a factory for example – and then there’s forced divestiture which is when your government says you can’t work there anymore, so there’s been more of an evolution of existing products,” he adds.
Contractors may be under the mistaken belief they are covered for political unrest under their all-risks policy. While this typically provides cover for strikes, riots and civil commotion (SRCC), larger-scale upheavals including insurrection, rebellion, civil strife and coup d’état are not covered.
“It boils down to the more specific definition on what these events are,” says Guido Benz, head of engineering and construction at Swiss Re Corporate Solutions. “They may fall outside of the SRCC-type clauses but I would definitely say there is an increased awareness for that kind of exposure and also an element of to what extent traditional insurance products can actually respond to that.”
The economic crisis has also heightened contractors’ risk awareness to the potential financial consequences if a project is delayed due to problems in funding. The eurozone crisis and construction slowdown in Europe’s PIIGS economies is one example.
And at the height of the crisis the US$10bn bailout of Dubai by sister city Abu Dhabi saw many large infrastructure projects put on ice. Large infrastructure projects depend increasingly on private financing. In addition, principals often collateralise loans with project assets and repay them on the basis of projected earnings. Therefore, the revenue generating capability of a project becomes a critical financing factor. In a project is delayed, the principal’s financing risk involves revenue loss and cost overruns. The contractor is faced with risks such as additional construction costs, material and labour in addition to rental and lease expenses and loss of bonus.
This has prompted a sharp increase in delay in start up (DSU) insurance, which is designed to indemnify for loss of revenue and cover other costs until production begins again. It is typically provided in conjunction with CAR and EAR, material damage insurance. It can be extended to include delays due to failure of public water gas or electricity supplies or denial
of access among other things.
“There’s been a certain increased interest in financial consequential loss type covers but it’s mostly driven through the financing schemes of infrastructure projects,” explains Benz. “Whenever we have lenders involved in financing infrastructure projects we see a stronger push from financing institutions and banks to push back that economic exposure to the owner of the project – to impose on the owner of the project to take out financial consequential loss, or delay in start up insurance. This essentially can be structured in a way where you have a payout if the project is delayed due to a physical loss covered under the material damage section of a construction policy.”
Resource nationalism post-Chavez
How likely an infrastructure project is to suffer from resource nationalisation or political risk often depends on the nature of the project. The bigger the project and the lengthier the construction horizon, the greater the likelihood of the unforeseen occurring. The Arab Spring has shown just how quickly unrest in a country can escalate and how quickly governments can be deposed.
“Some of these projects can be very extended, if you’re building a new power generation plant or something of that scale,” says Jane Johnson, director of special products for Northern Europe and APAC at Atradius. “None of us have a crystal ball. Most of us would say we know what’s going to happen in the next six months with a reasonable degree of certainty, but we don’t know what’s going to happen in the next six years.”
She continues: “Very often major projects are signed with a public buyer. “Certainties have been blown up by the Arab Spring – even the least democratic parts of the world could experience government change and that could leave contracts in a very vulnerable position. Multi-layered problems can turn what seemed like a sure fire contract into a major problem.”
“Even when things settle down after the initial turmoil you’ve probably got a much longer horizon of risk that you foresaw previously,” she adds. “That might place severe strain on the internal financing of the contractor and the overall duration of the contract might be outside what they would have wanted to be exposed to.”
Mining, oil and gas projects are far more likely to suffer from expropriation or creeping expropriation, particularly in Latin America and Africa, as governments that are under revenue stress may be more inclined to renegotiate or repudiate licences or investment agreements. The socialist government of late Venezuelan leader Hugo Chavez nationalised hundreds of businesses during its rule.
“There’s a difference when companies get contracted to build and then operate the asset – that actually has quite a different profile to the mobile assets,” says Nick Ridley, a political risk and terrorism underwriter at Ascot. “You probably find the people who do that are keen to buy insurance cover because they’re often operating in strategic industries. Across the developing world resource nationalism and strategic industries are the areas which are most often the targets of governments in terms of populist policies.”
He continues: “Resource nationalism is all about the government taking control and a larger share of their national exports. It’s the same with power production, it’s so fundamental to any functioning economy that it’s highly strategic and if the government feels like they’re not getting bang for their buck or efficient power generation there might be an increased risk of being expropriated.”
The last five years have seen a number of claims linked to power purchase agreements where governments have changed the contractual agreement within power purchasing. “From a pure PR standpoint a lot of this business is interlinked with the credit book,” says Ridley. “Looking at the Lloyd’s triangulations for loss ratios for political risk they’ve been performing rather well – PR business has been propping up the credit book.”
There have been claims to the tune of US$1bn over the past couple of years. Excess capital in the industry as a whole has meant there is plenty of capacity for political risk and trade credit insurance. These claims have emanated from a wide range of countries, including Algeria, Libya, Mali, Guinea, Syria, Pakistan, India and Cameroon. Nevertheless, prices are low and insureds are in a good position to demand broader terms and conditions.
“It will continue to get more competitive,” predicts Ascot’s O’Connor. “Transaction flows are increasing, but people are getting very premium hungry and that is driving rates in lots of parts of the world. “There’s a lot of capital in the insurance business at the moment globally. Nobody is getting an investment return and insurance is seen as a place where they can get some return for their capital.”
“The capacity in our market has grown by about half a billion dollars in the last three years,” adds Ace’s Edwards. “We’ve got about US$2bn per risk capacity in our market worldwide and the pricing is obviously much more competitive despite the fact the market has been paying out significant claims.”
