A Project Owner's Primer On Delay In Start-Up Insurance

by King & Spalding

Project owners and financiers are increasingly turning to delay in startup insurance to protect themselves from the financial consequences of delays in completion of large new construction projects, particularly for projects that are financed on a nonrecourse or limited recourse basis. DSU insurance can provide risk transfer for power generation, onshore and offshore oil and gas, renewable energy, heavy industry and a wide variety of other complex construction projects featuring large anticipated operational revenue streams. One recent representative example is the 160-megawatt Noor 1 concentrated solar power project in Morocco.[1]

DSU insurance is typically purchased together with an erection all risks or construction all risks policy covering physical loss or damage to the project and is triggered by a delay of project completion due to physical damage from a risk insured under the counterpart EAR policy. DSU insurance is a complex product, particularly given that it resides within a larger framework of project-related contracts, and the interplay presents a number of potential pitfalls for the project owner. Asking the following four questions in advance and securing clear answers will help circumvent costly disputes and shortfalls in the project owner's expected recovery.

Who Is Responsible for Purchasing DSU Insurance?

The project owner should think twice before delegating responsibility for purchasing DSU insurance to the contractor. Although DSU insurance often is purchased together with an EAR policy that covers both the contractor and the project owner, DSU insurance is designed to cover only the project owner (and in some cases project financiers, such as in the nonrecourse or limited recourse project finance setting). DSU coverage does not benefit the contractor because the contractor has no insurable interest in revenue derived from post-completion business operations.

If the contractor controls the insurance relationship, it will be the contractor and the contractor's insurance broker negotiating policy provisions and conveying information to and from the underwriters. The project owner will be two steps removed from the process, and will be beholden to the contractor to ask the right questions, convey accurate information to the underwriters about the project owner's business and obtain the most favorable terms for protection of the revenue stream. In addition, the information conveyed to the insurer to support DSU coverage is likely confidential and project owners typically do not want to share this confidential information with the contractor.

Does the DSU Buildup Accurately Depict the Anticipated Costs of the Project Owner's Business?

The total sum insured (i.e., limit of liability) under a DSU policy typically is determined by preparing a schedule of fixed costs and debt service payments (along with anticipated revenues for a policy covering gross profits — the "DSU buildup") that the project owner anticipates incurring during the policy's indemnity period. The sum insured should represent the greatest financial loss that the project owner can incur during the indemnity period, but if key items are neglected and do not make it onto the DSU buildup, there will be a shortfall.

Importantly, the DSU buildup should reflect an understanding that fixed costs and debt service obligations often evolve over the life of a project. For example, annual debt service may be limited to interest payments in the first few years of a project, with a transition to principal payments down the road. If the DSU buildup accounts only for the interest payments, the project owner may find itself underinsured.

The project owner also should determine in advance whether the DSU buildup is to be incorporated into the terms of the policy. In other words, is the DSU buildup intended merely as an estimate to help calculate the appropriate payable policy limit or is it an itemized "declaration" of the specific costs to be covered? If the latter, the DSU buildup effectively may serve as an exclusion or limitation on coverage. This will amplify the project owner's need for diligence in preparing the DSU buildup.

Does the Waiver of Subrogation Provision in the Policy Adequately Protect the Project Owner?

The project owner should carefully review waiver of subrogation language in the DSU policy to determine: (1) whether the terms satisfy the project owner's contractual commitments to secure waivers for third-party contractors; and (2) whether the waiver extends to the project owner's contractual indemnitees. In particular, the project owner should recognize that a general waiver of subrogation against "any insured party" may not afford sufficient protection. The DSU policy's additional insured provisions may not capture certain entities at all and may only confer insured status to others on a very limited basis.

If the waiver language is not sufficiently broad, the DSU insurer could push forward with a subrogation claim that is damaging to the project owner's interests, even one against a party that has a contractual right to indemnity from the project owner. Thus, the project owner could face the risk of having to reimburse the DSU insurer out of payments just made to the project owner. The project owner also could face the Faustian choice between complying with the insurer's requests for assistance in prosecuting the subrogation claim or refusing to comply and risking a damages claim for breach of the insurance policy's cooperation provision.

Does the Policy Specify Whether the Insurer May Take an Offset for Liquidated Damages?

Timely completion of the project may be encouraged by liquidated damages provisions in the construction contract. DSU policy wordings, however, often do not address the interplay between LDs and collection of DSU proceeds. Is the DSU insurer entitled to a credit or offset to account for LDs collected by the project owner? If the DSU insurer expects to benefit from LD provisions in the construction contract, this should be negotiated in advance and delineated in the policy. The project owner then can make a more informed decision about the scope of the LD provisions and the price to be paid for them in the construction contract.

If it is determined that the DSU insurer will benefit from LD provisions in the construction contract, the policy wording also should address who pays first. If the policy is silent on this issue, the insurer may take the position that the project owner must exhaust the LD route before collecting DSU proceeds. This can be very problematic because entitlement to LDs is not always clear cut for a variety of reasons, and a contractor typically will not admit fault. It could be years before entitlement to LDs is conclusively determined. Ideally, DSU proceeds should be paid without regard to the potential recovery of LDs, with the insurer retaining only a right to reimbursement if and when LD payments are made.

All too frequently, the policyholder does not discover unfavorable policy provisions until after a claim has been submitted. Policy wordings may be amended to adapt to the project owner's needs and to clarify how the parties expect the policy to respond, but this will happen only if the project owner communicates actively and effectively with its broker and insurer prior to issuance of the DSU policy.

This article was originally published as a Law360 guest column on February 3, 2015.
[1] Alternative Energy Projects Covered, Lloyd's News and Insight, Oct. 23, 2013.

John H. Fontham
Washington, D.C.
+1 202 626 5543

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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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