Construction Insurance and UK Construction Contracts

Marshall Levine and Roger ter Haar KC

Document

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CHAPTER 27 PFI/PPP projects in the United Kingdom

Principles and structures

27.1 The private finance initiative (“PFI”) was introduced in 1992 to encourage private sector businesses to tender to local and central government authorities for the provision of public infrastructure and services. Since then, over 700 projects have been completed and the total value of projects falling under the PFI/PPP umbrella in the United Kingdom exceeds £68 billion. 27.2 Many people find the terms PPP and PFI confusing as they are often used interchangeably. Public private partnership or “PPP” is the term used for this type of project in most other countries and we have accordingly used PPP throughout this chapter. PFI can be regarded as the UK “brand” of PPP. 27.3 PPP projects typically involve a contract between a public sector client, such as a central government department or a local authority, and a private sector partner, usually a company set up for the purposes of the project. In this chapter we have used the term “the authority” for the former and “Project Co” for the latter.

Reasons for the introduction of PPP

27.4 For many years there had been dissatisfaction with the process for procuring large capital projects by the government. Cynics had long taken the view that the most profitable way of conducting public sector work was to bid aggressively with a tightly defined specification. The contractor trusted that the client’s eventual requirements would differ significantly from those set out in the tender documents and that change orders (issued post-contract, with a lack of competitive pressure) would make the job profitable. As a result, many public sector contracts were fraught with difficulty and overran both financial and time estimates. The need to improve the way in which the public sector worked with private sector contractors was one of the main drivers behind the creation of PPP. 27.5 Furthermore, traditional capital procurement had failed to make provision for the future repair and maintenance costs associated with the new asset. The public sector client could raise the capital for the initial construction but in later years there was never enough funding available in the revenue account to maintain the structure adequately. One of the key aims of PPP was to create a procurement policy that encouraged decisions to be made on the basis of the whole life cost of an asset as opposed to its initial cost. It encourages long-term decisions to be made rather

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than considering only the current financial year. It also spreads the cost of a major facility over 25 or 30 years.

The PPP procurement process

27.6 In the United Kingdom, the procurement procedure for contracts placed by public sector clients is covered by the EU procurement rules, which in most cases require a notice to be published advertising the project. Following publication of the notice in the Official Journal of the European Union (“OJEU”), the basic stages are:

(1) prequalification and short-listing of bidders;
(2) invitation to negotiate or participate in dialogue;
(3) final offer;
(4) contract award.

27.7 The procurement process for public sector authorities, which is beyond the scope of this chapter, is regulated by EU Directives1 and English Regulations.2 The PPP contract will be awarded to the bidder that offers the procuring authority the most economically advantageous tender. This is not the same as the lowest construction price. PPP contracts are awarded based on the concept of value for money over the full life of the assets.

Funding a PPP project

27.8 The defining characteristic of a PPP project is the fact that it is the private sector partner that is responsible for arranging the funding. In a conventional government capital project, the authority makes stage payments to the construction contractor, with funding raised through taxation, borrowing or other traditional sources of “government” funds. PPP projects may be funded in a number of different ways: in some cases, mainly in the IT and waste management sectors, using the balance sheet and equity of the main or sole sponsor; more usually, projects are funded through a combination of equity and external borrowing, with the use of a special purpose vehicle or “SPV”. 27.9 The structure is recognisable as a conventional limited recourse project financing. The type of assets financed through project finance techniques have traditionally included power plants, infrastructure projects (roads, water and waste plants) and transportation projects. Where a contractor enters into a contract in its own name, the contract is said to be “on balance sheet”. The counterparty, in this case the authority, has full recourse to the contractor (through an action under the contract) in the case of breach or non-performance. Limited recourse structures, on the other hand, involve the sponsors (usually a consortium of two or three companies) forming an SPV to enter into the contract with the authority. 27.10 The authority has no direct contractual recourse against the individual sponsors, who as shareholders in the SPV are protected by the corporate veil.

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Similarly the lenders to the SPV have no direct contractual recourse against the shareholders, unless the shareholders have expressly agreed to provide direct support in the event of the SPV getting into financial difficulties. The lenders are advancing the funding against a package of security, with the main collateral for the banks being the regular payments due to Project Co under the project agreement, provided it delivers the services specified under the contract. From this it will be appreciated that the lenders have a strong interest in the insurance arrangements for the project: any delay in completion of the building works, or interruption in the delivery of services, will delay or reduce Project Co’s income and (if not compensated for by some type of insurance or claim against a subcontractor) potentially threaten the overall solvency of Project Co.

Contractual structure

27.11 The typical contractual structure of a PPP project is shown in the following diagram:

PPP contractual structure

Types of funding

27.12 The proportion of equity in a PPP scheme has in the past generally been 5-15% of the capital costs of the project. The balance of the financing is made up of senior debt, although on some projects there is a combination of mezzanine and senior debt. Senior debt is that which is not subordinated in terms of repayment or acceleration rights. Senior debt ranks above the claims of other lenders. 27.13 Any debt that is not senior debt will rank behind the senior debt and is referred to as subordinated, junior or mezzanine debt. The shareholders in Project Co often make subordinated loans to Project Co since this is more advantageous for Project Co than equity (Project Co’s interest payments on loans are deductible

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against its profits). An intercreditor agreement will set out the terms of the subordination, including provisions covering the entitlement of a lender to accelerate its loan (demand early repayment), take enforcement action against the borrower or share in any recovery following enforcement action. 27.14 As an alternative to bank debt, there has been some growth of funding of projects through the capital markets, i.e. bond issues. Raising funds on the capital markets has opened up a major new source of finance for project companies and often the interest rate obtainable compares favourably with the cost of bank debt. Note that when Project Co borrows from one or more banks the loans are normally provided on a floating rate basis. Project Co executes an interest rate swap at financial close, which converts its floating rate liability to a fixed rate liability. This is so that Project Co is not excessively exposed to fluctuations in interest rates. Where bond funding is utilised, the interest rate is fixed at the time of issuing the bonds. Usually it is necessary for Project Co to arrange a guarantee on the bonds from one of the specialist monoline insurers in this field, such as FGIC or MBIA, since Project Co, being an SPV, has an inadequate credit rating to sell its securities to the public.

The project agreement

27.15 In this section we consider the main contracts that make up a typical PPP project. 27.16 The project agreement regulates all of the arrangements between the authority and Project Co. It is essentially a risk allocation document and is the main contractual document in any PPP project. Project agreements are sometimes referred to as concession agreements. In EU procurement directives a “concession” confers the right on the concessionaire to collect charges from the general public (e.g. to collect cash tolls from road users). Few PPP projects are concessions in this sense, so in this chapter we use the term project agreement. 27.17 Project agreements are lengthy documents, consisting of 200 pages or more of clauses in the “front end” of the agreement, plus over 20 schedules. The contract is lengthy because it needs to contain the arrangements governing a 25- or 30-year project which is divided into several phases. The schedules in particular contain a great deal of technical information, principally relating to the design, construction and maintenance of the physical facility. However a PPP project agreement can broadly be viewed as covering the following areas.

The design and construction phase

27.18 In this section of the agreement, there are clauses imposing the requirement on Project Co to design and build the physical facility (school, hospital or road), which is required to enable Project Co to deliver the specified services. Many of these provisions are therefore similar to the clauses to be found in a design and build contract.

The operational phase

27.19 Once the physical facility has been completed, Project Co is responsible for providing a range of services at the site. These services may include cleaning, catering, grounds maintenance and IT services, together with repair and maintenance

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obligations. This section of the agreement imposes the necessary requirements and quality standards on Project Co.

Property provisions

27.20 Project Co will be given a licence to enter on to the project site to carry out the necessary construction works. It may be granted a licence for the whole of the project period, or a lease of the project site may be granted to Project Co once the construction period is finished.

Payment provisions

27.21 The project agreement will contain a fairly complex payment mechanism, which provides the basis on which the provision of services is monitored, measured and paid for by the authority on a monthly basis. The monthly payment, or unitary charge, is Project Co’s mechanism for recovering the cost of constructing, operating and financing the project. The payment mechanism contains provision for the authority to make deductions each month for unavailability of spaces (for example, a classroom is unavailable for use because all the windows are broken) or for poor delivery of the services (for example, a hospital meal is cold when it reaches the patient).

Changes

27.22 Over the life of a 25- or 30-year project, there are likely to be changes, both in the law and in the requirements of the authority. This section of the agreement contains provisions dealing with such changes and providing a mechanism for adjusting the unitary charge when changes take place.

Termination

27.23 In rare cases, the project agreement may terminate prior to its expiry date. Reasons for this might include contractor default or a voluntary termination by the authority because it no longer requires the facility. This section of the contract therefore deals with the mechanism for terminating the project and for calculating any termination payment to be made by the authority.

Insurance

27.24 The project agreement will contain certain requirements in relation to insurance for the project. This area is covered in more detail in paragraphs - below.

Subcontracts and direct agreements

27.25 Bidding consortia form following publication of the OJEU notice advertising a new project. The initial alliance develops until the parties become investors in Project Co shortly before financial close of the project. Typically, a construction

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company and an FM (facilities maintenance) company, with perhaps a third arm’s length equity investor, will collaborate on a project and form the bidding consortium. There will often be no formal arrangement, except perhaps a bid agreement, between these parties until shortly before financial close. At financial close, shortly before the signing of the project agreement, the investors in Project Co execute a shareholders’ agreement and incorporate the SPV to enter into the project agreement.

The construction contract

27.26 In most PPP projects, there are two principal subcontracts that are executed at the same time as the project agreement (see diagram on page 348). These are the construction contract and the FM contract. The design and construction obligations imposed on Project Co in the project agreement are passed down to the construction contractor. The interests of the construction contractor and Project Co will be very different. The construction contractor will have a short-term interest (it will be interested in the design and build process only), whereas Project Co is responsible for the project for the entire term. Broadly speaking, any risks which Project Co cannot pass down to the construction contractor will need to be passed down to the FM contractor. This is why these subcontracts are difficult for the consortium to negotiate. Frequently, investors in the SPV will be part of the same corporate groups as the construction contractor and the FM contractor. In addition, due to the emphasis on risk transfer in a PPP project, the construction contract will depart from the traditional standard forms of construction contract used in the United Kingdom such as the JCT and NEC contracts.

The FM contract

27.27 The obligations of the FM contractor commence when the buildings have been brought to practical completion by the construction contractor. One of the difficult areas in drafting the documentation is always the interface between the construction contractor and the FM contractor during the commissioning and “handover” period. The FM contractor will normally be required to bring in equipment and fit out the buildings after practical completion has been achieved under the construction contract, but before full completion (as defined in the project agreement) has taken place. The FM contractor then has the obligation to provide the FM services for the remaining life of the project, which could be 25 years or so. In practice the FM contractor acts as a lead manager of the services and frequently it will enter into individual subcontracts, of shorter duration, with a variety of service providers in order to procure the FM services such as cleaning, grounds maintenance, buildings maintenance and catering. 27.28 Like the construction contract, the terms of the FM contract are based on the drafting of the equivalent clauses in the project agreement. Relevant obligations are “stepped down” to the FM contractor using exactly the same drafting as the way in which the obligations are imposed on Project Co in the project agreement. Lenders check that the step-down of risk to the FM contractor is complete and that no risks are left with Project Co.

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Interface agreement

27.29 This is designed to streamline disputes that may arise between the two main subcontractors, namely the construction contractor and the FM contractor. Sometimes additional subcontractors such as a provider of IT services will be joined as parties. The authority may during the operational phase make deductions against Project Co for lack of availability of the facilities or for poor performance. The FM contractor may blame the fault on poor design or construction. In the absence of an interface agreement, the FM contractor and the construction contractor are not directly linked in contract, so resolving such a dispute would fall on Project Co. An interface agreement permits the subcontractors to negotiate directly to resolve areas of difference. The two contractors will agree in the interface agreement issues such as cross-indemnities and appropriate caps on liability. Also dealt with will be restrictions on amendments to each party’s contract with the authority and how to deal with liabilities arising from delays to completion of the works. 27.30 Project Co must be a party to the interface agreement, in case there are allegations that Project Co itself is to blame, for example through failure to serve notices. Project Co will wish to have the right to set off any deductions from the unitary charge made by the authority against the subcontractor that it reasonably thinks is at fault.

Direct agreements

27.31 In addition to the two main subcontracts, there will be several “direct agreements” (as shown in the earlier diagram). One of these (the “lenders’ direct agreement” or “LDA”) is between the authority, Project Co and the senior lenders and allows the lenders to step into the shoes of Project Co if the project runs into trouble. There are also direct agreements between the authority, Project Co and each of the subcontractors. These allow the authority to step into the shoes of Project Co in its relationship with the subcontractor should that relationship be at risk (usually because Project Co is not paying the subcontractor). There are also direct agreements between the subcontractors, Project Co and the lenders, which form part of the lenders’ security package.

Lenders’ direct agreement

27.32 This is a direct agreement between the authority, Project Co and the senior lenders. The LDA deals with the relationship between these parties following a termination or threatened termination of the project agreement on the grounds of Project Co default. 27.33 The lenders’ concern is that they have financed the project on the basis of projected cashflows from the authority and if the project agreement (under which the cashflows are paid) is terminated, the lenders will only have rights against Project Co’s subcontractors (the construction contractor and the FM contractor) and to amounts in the bank accounts of Project Co as security for their financing.

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27.34 In a situation where the project is getting into difficulties, the LDA gives the lenders an opportunity to step in and rescue the project and avoid the disruption that would follow termination of the project agreement. If the project can be restored with minimal disruption to the services and there is no need for the authority to get involved to ensure that this occurs, then both the authority and the lenders will benefit. 27.35 During the step-in period, the lenders are incentivised to ensure that a remedial programme is implemented and that no new breaches occur. If there are further breaches of the project agreement then a new right to terminate the project agreement can arise for the authority. The LDA provides that the step-in will end if the lender steps out or if a novation of the project agreement takes place to a new vehicle set up and controlled by the lenders. If the lenders cannot rectify the original default or save the project then termination of the project agreement will occur and the authority’s claims against Project Co will be set off against any termination payment due to Project Co from the authority.

Insurance provisions in the LDA

27.36 The LDA will typically contain a number of provisions dealing with insurance. 27.37 The project agreement generally contains a requirement that the proceeds of any claim made under project insurances are paid into the joint insurance account (sometimes known as the insurance proceeds account). This is a bank account held jointly in the names of the authority and Project Co. The equivalent LDA clause requires that the agent or trustee acting on behalf of the senior lenders must only permit amounts to be released from the joint insurance account in accordance with the requirements of the relevant clause of the project agreement. The agent or trustee undertakes not to exercise any security rights over the amounts contained in the joint insurance account or to take any steps to prevent amounts being released from the joint insurance account in accordance with the relevant clause of the project agreement. 27.38 The parties to the LDA also normally agree to ensure that all insurance proceeds received by Project Co under the project insurances are paid directly into the joint insurance account and applied in accordance with the terms of the project agreement. These provisions are necessary because otherwise the amounts in the joint insurance account would be covered by the banks’ security under their security documents and this might prevent the operation of the relevant clause of the project agreement.

Commoditisation/standardisation

27.39 In the first years of the private finance initiative, individual awarding authorities such as NHS trusts and government departments were left to negotiate and document their transactions, assisted by appropriate external advice from financial advisers and lawyers. Inevitably this led to differences of approach from deal to deal, even within the same sector. In addition, because each awarding authority was essentially starting with a clean sheet of paper, transactions took longer to

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complete than was necessary. Accordingly, the government decided that efforts should be made to bring an element of standardisation into the process. Various panels and organisations were created to formulate guidance on matters relating to PPP, starting with the private finance panel. This was succeeded by the Treasury Taskforce which in turn was followed by Partnerships UK, which has now in turn been replaced by Infrastructure UK. 27.40 Although the make-up and the membership of the organisations has changed, their raison d’être remains the same, namely to issue guidance to the PPP market on “best practice” in structuring and closing transactions. The guidance issued ranges from memoranda addressing particular difficult issues (e.g. the accounting treatment of PPP transactions for public sector clients), recommended drafting for legal contracts such as project agreements and, increasingly, procurement packs that include not just standard form drafting for the main contract but a range of supplementary documents such as invitations to tender and model output specifications. 27.41 Increasingly the drafting and issuing of guidance have been taken forward on a sectoral level, with each central government department having its own private finance unit responsible for monitoring and guiding new PPP transactions within its field. For PPP projects with local authorities, an organisation called 4ps takes on the same responsibilities and has issued procurement packs covering a number of significant sectors for local authorities, such as street lighting and social care projects.

Programmes not projects

27.42 As a parallel development to the standardisation of contracts, the government has increasingly moved towards the concept of “programmes not projects”. To take a practical example, in the schools sector there was a thriving market for individual schools projects, which were taken forward by one local educational authority (LEA) and covered between one and 20 secondary schools within that LEA’s district. The projects generally created new build schools and/or extensive refurbishment of existing schools. These projects did not address the ongoing problem that most LEAs have with their schools estate, namely the need to carry out regular refurbishment and maintenance across the whole estate and the need to place contracts for small building works such as the construction of one or two classrooms, or the replacement of windows in two blocks of a school. That sort of small-scale construction work was not catered for by the typical PPP schools project, which concentrated on the delivery of complete new schools. 27.43 Accordingly the government developed a programme known as Building Schools for the Future (BSF). BSF creates a medium- or long-term partnering relationship between the LEA and a private sector supply chain, with the supply chain being available not just to deliver new schools but also to carry out day-to-day maintenance and perform small construction jobs. Under BSF a strategic partnering agreement is signed between the LEA and the private sector partner, which is known as a local education partnership or LEP. The LEP is then obliged to provide a complete construction and maintenance service to the secondary school estate during the life of the strategic partnering agreement. Some of the work will be funded

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externally using a PPP model, whereas other work will be paid for directly by the LEA and will be implemented using the BSF standard documentation for target cost or lump sum contracts (not dissimilar to NEC3). 27.44 Similarly, in the health sector, a programme known as LIFT has been used for a number of years now to develop primary care facilities. LIFT companies are formed in a particular geographical area and they have the responsibility to design and build primary care facilities, which are then leased to groups of doctors and other health professionals for defined periods. The LIFT companies obtain financing from the private sector and effectively have a monopoly within their geographical area to deliver primary care facilities. 27.45 The general thinking behind the creation of such programmes is that it enables private sector procurement efficiencies and the benefit of external private finance to be introduced into small- or medium-sized construction works, whereas traditional one-off PFI projects have only addressed the need for large new hospitals or secondary schools.

Insurance arrangements

Responsibility for arranging insurance

27.46 The usual arrangement on a PPP project is for Project Co to be made responsible for putting in place all the insurance policies required to cover the project. This obligation is imposed on Project Co under the project agreement, since the authority has a clear interest in seeing that the project is adequately insured, during both the construction phase and the operational phase. The lenders to the project will also be concerned to see that adequate insurance arrangements are in place at all times and their technical advisers will review the insurance arrangements to check that this is the case. In practice Project Co appoints an experienced insurance broker with expertise in the PPP market and the broker puts in place a range of insurance policies that satisfy the project agreement and lender requirements and represent value for money for Project Co. Project Co recovers the cost of the insurance through the unitary charge. 27.47 The project insurances name a number of parties as co-insured parties, including Project Co, the authority, one or more subcontractors and the lenders.

The insurance section in SoPC4

27.48 At the time of the last edition of this book the current guidance on PPP project agreements, issued by HM Treasury in March 2007, was known as “Standardisation of PFI Contracts Version 4” (usually abbreviated to “SoPC4”). SoPC4 contained a section (section 25: Insurance), which covered the insurance aspects of a PPP project. The section was a helpful discussion of various issues relating to insurance and it also contained recommended drafting for parts of the insurance clause in the project agreement. The section pointed out that the insurance arrangements under PPP are very different from those that would apply to a project directly procured by the authority. In most cases UK public authorities self-insure and do not purchase insurance on the commercial insurance market; however, in the case of

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a project procured through the PPP route, Project Co will be required to purchase insurance on the commercial market. To ensure value for money, the project agreement should incentivise Project Co at all times to:

(1) ensure full integration between the insurance programme and Project Co’s overall risk management strategy;
(2) make cost-effective trade-offs between lower deductibles and increased insurance premiums (within the constraints specified by the Authority and the lenders);
(3) procure insurance from good quality and cost-effective suppliers; and
(4) look only to the authority for cover in relation to unavailability of insurance (see below) as a last resort.

27.49 The key provisions of the SoPC4 insurance clause were the following.

Required insurances

27.50 Clause 25.2 obliged Project Co to take out and maintain the insurances described in a document known as the “standard required insurance schedule”. This document is in to this book. Part 1 of the schedule covers insurances required during the construction period and Part 2 deals with insurances required during the operational period.

Design and construction phase

27.51 The insurance clause required Project Co to procure that certain specified insurance policies were taken out prior to the commencement of the works and are maintained for the whole of the construction phase. The details of the required policies, and the key terms of those policies, were set out in a schedule to the project agreement. The policies required during the construction phase were the following:

Contractors all risks insurance. This covers all risks of physical loss or damage to the permanent and temporary works, including materials, plant and equipment.
Delay in start up insurance. This policy covers the loss of revenue of Project Co anticipated during the indemnity period arising from delays in completion as a result of physical loss or damage or other peril covered under the contractors’ all risks insurance referred to above. The purpose is to protect Project Co and the lenders in respect of the financial loss which will be suffered by Project Co as a result of delayed completion. Since under PPP contracts the authority does not start to pay the unitary charge until the facilities are completed and ready to deliver services, any delay in completion will lead to a loss of revenue for Project Co. Since Project Co is funding itself through external borrowing and has interest payments to make to the lenders, it will be seen that any delay in completion will have serious financial consequences. This is why delay in start up insurance is required.
Third party liability insurance. This policy covers the insured in respect of all sums that the insured may become legally liable to pay consequent upon

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death or personal injury to any person, loss or damage to property, or interference with property rights, arising in connection with the project.

Operational phase

27.52 The policies required during the operational phase (Part 2 of the Standard Required Insurance Schedule) were the following:

Property damage insurance. This covers all risks of physical loss or damage to any property of Project Co or property for which Project Co is responsible under the project agreement.
Business interruption insurance. This provides an indemnity to Project Co in respect of the loss of revenue anticipated during the indemnity period arising from an interruption or interference in the operation of the project as a result of loss or damage covered under the property damage insurance referred to above.
Third party public and products liability insurance. This provides an indemnity in respect of all sums that the insured may become legally liable to pay, consequent upon death, personal injury or disease, loss or damage to property or interference with property rights, arising in connection with the project.

27.53 For full details of these different types of policy, including cover features and exclusions, the reader is referred to the standard required insurance schedule in to this book. 27.54 Clause 25.4 of the SoPC4 drafting required that the insurances referred to in clause 25 were taken out with insurers approved by the authority, such approval not to be unreasonably withheld or delayed. In practice the lenders would check that the insurance policies were arranged by brokers and placed with insurers approved by the lenders.

Other insurance policies

27.55 The previous section described the required insurances - namely, those policies that Project Co is obliged to maintain pursuant to the terms of the project agreement. In addition, there are various statutory insurance requirements, such as the requirement on a business to maintain employer’s liability insurance. Clause 25.2 of the SoPC4 drafting required Project Co to maintain these statutory insurances as well as the required insurances, and they are treated in a similar manner for the purposes of “uninsurability” (see below). Project Co could take out additional policies that it (or the lenders) consider to be desirable, but these were not covered by the “uninsurability” provisions referred to below.

Reinstatement of project assets

27.56 One area that has frequently been the subject of debate is the question of Project Co’s obligations to reinstate the project assets if there is an event that

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destroys part or all of the facility. Clearly the Authority would generally expect that Project Co would use the proceeds of insurance policies to rebuild and reinstate the project assets, to enable the project to continue. A typical PPP project agreement therefore imposes an obligation on Project Co to apply all insurance proceeds received under physical damage policies (but not third party liability, employers’ liability, business interruption and advance loss of profits insurance policies) to repair, reinstate and replace the project assets in respect of which the claim was made. The clause requires that all insurance proceeds received under such physical damage policies should be paid into the joint insurance account (sometimes called the insurance proceeds account). 27.57 Clause 25.5 of the SoPC4 drafting provided that if a claim is made or proceeds of insurance are received under a physical damage policy (for an amount in excess of a specified threshold) Project Co is required to prepare a plan for the carrying out of the reinstatement works. This plan is discussed and approved by the authority and Project Co is then permitted to withdraw amounts from the joint insurance account to carry out the reinstatement works as specified in the reinstatement plan. 27.58 The lenders may wish to exert a degree of control over the use of insurance proceeds. In some cases they may prefer to take the proceeds of an insurance claim and use the funds to repay the outstanding debt of Project Co, as opposed to having Project Co use the funds to reinstate the project. In some projects a “project economic test” has been agreed with the authority. Broadly, this provides that if the project assets are destroyed or substantially destroyed in a single event and the insurance proceeds are equal to or greater than the amount required to repair or reinstate the assets, Project Co is required to calculate the senior debt loan life cover ratio on the assumption that the assets are repaired or reinstated as required by the project agreement. If the calculation shows that the senior debt loan life cover ratio is greater than or equal to a specified level (this is normally the threshold below which Project Co is in default under its financing agreements), then Project Co is required to use the insurance proceeds in reinstatement of the assets. If, on the other hand, the calculation shows that the senior debt loan life cover ratio is lower than the specified threshold (i.e. the lenders’ risk has increased) then an amount equal to the lower of the insurance proceeds received and the base senior debt termination amount is released from the joint insurance account to Project Co. In the latter case, the banks will exercise their security rights over the amount received and will apply the amount received as a pre-payment against the senior debt. 27.59 If, following the application of the project economic test, the senior lenders take the insurance proceeds in repayment of outstanding senior debt, Project Co will be unable to comply with its reinstatement obligations under the project agreement (because it has no funding). The authority is likely to terminate the project agreement for contractor default, in which case the authority can then choose to rebuild the facility with a new contractor (not necessarily on a PPP basis). 27.60 SoPC4 made it clear that a project economic test should not be conceded by the authority where there is a low risk of total destruction of the asset (for example where the project is a road or rail project and it is unlikely that any one event would destroy the complete road or rail line; or a project that has a number of geographically diverse sites, such as a grouped schools PPP project where there may

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be schools on seven or eight sites over a wide geographical area). A project economic test should only be conceded in limited cases, where there is a single site project and there is a risk that the whole facility could be destroyed in one incident.

Risks that become uninsurable

27.61 Since the project agreement places a contractual obligation on Project Co to maintain certain insurance policies, provisions need to be included that deal with a situation where Project Co is unable to comply. PPP project agreements, therefore, generally include a provision dealing with uninsurability. In this context, “uninsurable” means in relation to a risk, either that insurance is not available in the worldwide insurance market in respect of that risk or the insurance premium payable for insuring that risk is at such a level that the risk is not generally being insured against in the worldwide insurance market by contractors in the United Kingdom (see the full definition in SoPC4). A risk for these purposes is an insured peril that is the proximate cause for a loss. For example, lightning causes a fire in school premises and this results in material damage to the school. In this example, the lightning is the proximate cause, not the fire. 27.62 The contract will contain a provision confirming that Project Co is not required to take out insurance in respect of a risk that is uninsurable (unless the main reason for the risk being uninsurable is the act or omission of Project Co or its subcontractors). 27.63 If a risk becomes uninsurable for reasons outside the control of Project Co, then the parties are required to consider alternative approaches to the risk to see if a means can be found for the risk to be managed or shared. If no agreement is reached, then the authority will effectively take over as the underwriter in respect of that particular risk. The amount of the insurance premium which was previously paid by Project Co for insuring that particular risk is deducted from the unitary charge because the authority is now acting as the insurer and should receive the premium. 27.64 If at some future point the risk occurs and causes Project Co loss, the authority can choose to pay an amount equal to the insurance proceeds that would have been payable, had the required insurance policy been in place (in which case the project agreement continues in force) or alternatively the authority may choose to terminate the project agreement and pay compensation to Project Co calculated as if the project agreement had been terminated following an event of force majeure. 27.65 Where a risk has become uninsurable, and the authority has assumed responsibility for that risk, Project Co is required to test the insurance market at regular intervals so that commercial insurance coverage can be restored as soon as capacity becomes available in the insurance market. 27.66 The uninsurability provisions apply to both required insurances and statutory insurances.

Cost sharing of insurance premiums

27.67 As explained above, it is Project Co that is responsible for arranging and paying for the insurance policies covering the project. The policies include as insured

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parties all the entities that need insurance cover in connection with the project, so the policies are in the nature of “project policies”. Project Co recovers the cost of insurance through the unitary charge payable by the authority. However, there is a difficulty in relation to insurance premiums, namely that it is difficult to forecast what the cost of insurance will be over the life of the project. Accordingly, there needs to be a basis for determining how future changes in insurance premium costs are allocated between the parties. 27.68 The normal arrangement is for Project Co to include a fixed price for insurance costs for an initial period. This period runs from signature of the project agreement through to a first review date, which might be one year after the date of full service commencement. (Project Co is always required to fix its insurance costs for the design and construction period and in practice the relevant policies are taken out for the duration of the construction period, and not on an annual basis.) If we assume that the construction period is four years, that means that Project Co is fixing its cost recovery in relation to insurance for a five-year period. 27.69 The base costs relating to insurance that have been assumed by Project Co and included in the project’s financial model as part of the bidding process are set out in a schedule to the project agreement. For periods after the review date, a comparison is made between the actual insurance costs that are payable by Project Co and the base costs set out in the project agreement. To the extent that there is a substantial variation between Project Co’s actual insurance costs and the base costs, there is a sharing. SoPC4 contains an insurance premium risk sharing schedule that sets out the sharing mechanism. For example, if the actual insurance costs exceed the base costs by no more than 30%, Project Co is responsible for meeting the full amount of the excess cost. 27.70 If the actual insurance cost is more than 30% in excess of the base cost, then the extra premium cost is shared between Project Co and the authority, with the authority paying 85% and Project Co 15%. Conversely, if there are exceptional savings (i.e. the actual insurance costs are lower than the base costs by more than 30%) these will be shared between Project Co and the authority, with the authority receiving 85% of the cost saving. There are subsequent insurance review dates, usually at intervals of two years, throughout the operational period. 27.71 The insurance cost-sharing arrangements summarised above are meant to reflect marketwide movements in insurance costs, so movements in premiums caused by changes in insurance premium tax or in insurance intermediaries’ fees, or caused by changes that are related to the specific project, are excluded from consideration.

Guidance PF2

27.72 Since the introduction of SpPC4, the election of a new (coalition) UK government led to the introduction of a replacement guidance document, PF2. of PF 2 covers the same territory as section 25 of SoPC4. We would suggest that there is no significant change of concept in respect of where the obligation to insure such risks as are insurable lies.

1 Directive 2004/18/EC.

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