Insurance for Projects

This article discusses a generic Project Finance transaction and exactly how insurance coverage/policies may be used to enhance the credit worthiness of the projects. We look at the basic elements of a project finance transaction, and then discuss what may or most likely may not be insured and what a potential policy will look like. (This article assumes that the insurance coverage/policy will be purchased for the benefit of the lender into the project. Various other structures are possible, but space does not permit all the permutations.)

Basic Elements

Every project finance transaction has three basic elements in common:

1. The project requires a source of relatively inexpensive supply of feedstock. The feedstock is basically the “fuel” for the project that will be converted into something more valuable. Feedstock may include sunshine (free), recyclables, organic waste, or any other items that may, through a technological process, be turned into something of value (electricity, methane, heat etc.).

2. The project requires a process of conversion, i.e., a methodology to convert the feedstock into some form of output that can be sold in the marketplace. The technology may be tried and true or it may be more experimental, wherein this may be the first project using the system on a commercial scale.

3. The project requires an off-taker for the commodity produced. In a project where electricity is produced this is referred to as the Power Purchase Agreement or “PPA.” In projects where methane or heat is sold the contract will be called something else. The contract may be merchant (sold at market at any point in time) or may be fixed-term with known pricing for a longer period of time.

Structure

As mentioned above, we will assume that the insurance policy will be purchased for the benefit of the lender into the project. Various other structures are possible. Looking at the above three basic elements of the transaction, we now discuss how each of those should be structured in order to make it most likely that such a transaction may be insured. It must always be borne in mind that insurance is a product to mitigate loss not guarantee profit.

Again dealing with the elements of the project in the sequence above:

Feedstock

Conservative investors may question as to whether will there be enough feedstock of sufficient quality to keep the project running at full capacity or at least to insure enough capacity to pay debt service in a timely manner. In the case of solar powered plants this is usually not an issue. However, in plants requiring trash, organic waste, or tires this may be an issue.

An insurer will generally require contracts with good credit-worthy suppliers (municipalities, industrial facilities, etc.) for a portion of the term of the insurance policy to be willing to take this risk. The insurer will look at the history of the supply available and the trend lines etc. to satisfy itself that it is a reasonable assumption that sufficient supply will continue to be available for the life/term of the debt service of the project. If the above conditions are met, the insurer would typically be able to guarantee that a sufficient quantity of supply will be available to produce enough product (which will able to be sold to the off-taker at a fixed price) to pay the lender on a timely basis.

Technology

An insurer will require a technology that has a good track record in commercial operation. Some technologies have been around for a good number of years. Others are still on the proving track. Insurers need to know that the technology has been used or can be used in other commercial-sized applications, or they otherwise will not be able to underwrite the transaction. Given the feedstock insurance the insurer would be willing to take the risk that the plant will be able to produce with the efficiency to produce sufficient output to pay the lender its debt service.

Off-taker

The insurer will require a long-term contract for the output of the plant generally on a take if produced basis from a credit worthy off-taker. The insurer in essence combines the two coverage types above to guarantee that enough output is produced so that the lender may be paid. It is important to note that this type of insurance is not credit insurance, i.e. , if the output is produced, but the off-taker does not pay, no claim may be filed. The credit risk of the off-taker will remain with the lender. Other types of insurance are available to cover that risk if need be.

Analysis

By combining the coverage types in 1) and 2) above, the insurer is basically guaranteeing that the project will produce the required units of output (as measured in gallons, Kilowatt hours, BTUs, etc.), which when multiplied by the contracted rate (as it appears in the relevant off-take agreement) will produce sufficient revenue to service the debt in a timely manner. The Insurance does not cover the individual parts so, e.g., if the plant runs low on feedstock but runs high on efficiency, it may still produce sufficient quantities of product to pay the debt and there will be no need to file a claim. Debt service will be met by the operation of the plant.

Most insurance coverage/policies will also require that any other revenue that the project generates (e.g., tipping fees, cash grants) be set aside as a reserve to provide a form of deductible before the beneficiary may file a claim.

As with all insurance, there will be the usual exclusions to filing a claim including property damage, manufacturers defects, etc. These events would be covered by normal property and casualty insurance or the manufacturer.

Putting this type of insurance in place can generally earn the project an investment grade rating, which will allow the developer to approach a wider group of lenders who will provide longer term sources of fixed rate funds. Policies may run as long as 12 to 15 years.

Does the one-time upfront premium cost of the insurance justify the ability to get longer term and lower priced debt? That is a decision that must be made on a project by project basis as each project has its own set of parameters. It is generally made on a present-value basis where the developer calculates the value of the more economic long-term debt as well as the ability to raise more of such debt, thus reducing the overall capital cost because less higher priced equity may be required.

Each project is different and each has various risks to be weighed. However, the coverage should certainly be considered for projects that meet the descriptions above.

Howard K. Weber is a Director with Collateral Guaranty LLC (www.collateralguaranty.com), a consultant to the leasing and insurance industries. A member of this Newsletter's Board of Editors, he may be reached at 646-824-4946 or [email protected].