The Project Risk Advisor Balances Risk and Reward

The Project Risk Advisor Concept - Risk is not the Enemy!

Emerging Concepts in Project Risk Management:
Some Innovative Suggestions & Solutions

By Michael W Good Managing Partner - PriskA

 
SYNOPSIS. This paper describes some of the newer concepts currently emerging from the Risk Management & Insurance industry and outlines how those concepts can bring benefits to the Construction Industry. These will be of particular importance in privately financed projects, which are likely to be the norm going forward in almost every country around the world.

The goal of this paper is to encourage the concept that earlier and greater attention to Matters of Risk will produce financial benefits for project sponsors through shortening the time to financial close and by reducing the overall cost of financing.

These benefits will be delivered through the use of the Project Risk Advisory concept which has been developed by Project Risk Advisors (PriskA) in response to the demand for fresh ideas in the financing of projects and the mitigation of associated risks. PriskA is a specialist Project Risk Consulting organization.

BASIC PHILOSOPHY PROJECT RISK ADVISOR CONCEPT
The role of the Project Risk Advisor is that of Trusted Advisor on Matters of Risk. This is based on the premise that risk is not the enemy; risk is a business opportunity. The Project Risk Advisors function, therefore, is to define, package and price those opportunities in a completely seamless and transparent fashion. This will facilitate financing and help ensure completion on time, on budget.

The Project Risk Advisor concept focuses in the first instance on the risk allocation process. It develops from there into a continual ongoing
process taking a holistic view of project risk. Through earlier entry into the project development process the Project Risk Advisor
can become one of the originators of risk capital for projects.

By departing from the traditional role of the Insurance Broker or Insurance Advisor into an expanded Consulting/Advisory role, the Project Risk Advisor becomes more of an underwriter of the development process rather than being a vendor of insurance products as has been the case in the past.  This shift can only come about through closer working relationships with the project principal.

Primary Roles
Primary roles of the Project Risk Advisor are

- Risk Identification & Analysis
- Risk Allocation Consulting
- Financial Engineering
- Financial Advisory & Sourcing of Risk Capital

The challenge for the Project Risk Advisor is to strike an optimal balance between risk and reward. While born out of the insurance brokerage business, the Project Risk Advisor will focus on the broader risk issues related to projects including those risks traditionally considered uninsurable. More traditional aspects of insurance remain the purview of established construction insurance professionals.

CHANGING PRIORITIES AND CHALLENGES

In today’s changing market conditions the structure of the Construction industry continues to evolve. Today’s equivalent of the former General Contractor, now often the Engineering Procurement & Construction (EPC) Contractor in the project structure is either obliged or, in many cases, may elect to take an equity stake in the project as part of the financial engineering. Private finance requires lump sum fixed price turnkey contracts, raising many completion risk issues. Most projects are carried out by single project companies (SPC), whose financiers have limited recourse in the event of failure. Global demand for new and replacement infrastructure, combined with the desire of most Governments to exit the infrastructure business, has created enormous concession opportunities. This provides a challenging contrast to the situation which prevailed not so long ago, where Governments financed large civil engineering projects which were constructed under very traditional project structures and contractual conditions.

Risk Managers Viewpoint
From the point of view of the Insurance industry, especially brokers, the task was to respond to the Risk Manager of a successful bidder carrying out a contract, usually under FIDIC Conditions but possibly with some amendments. In general, the challenge was to go to the Global Insurance Markets and put together the most competitively priced package that could be found for a programme of insurance which matched as precisely as possible those conditions. From a professional standpoint, this was not a huge intellectual challenge but was the insurance brokers role in the project business. Meanwhile the Employer (usually a Government body) frequently remained liable for the excepted risks which are often the largest in value.

In today’s marketplace and without the backstop of a government employer the Risk Manager often finds his position somewhat different. All too often in recent times, he has found that a more adequate job description for his position would be

- Manager of those risks our commercial people took on in order to win the project and,
- Could not then pass on to anyone else but me.

This is clearly a position in which no Risk Manager should ever find himself; there needs to be continual consultation with those Risk Management & Insurance professionals whose job it will be to provide solutions to risk. This process needs to commence at the conceptual stage and is best managed through a Project Risk Advisor.

PROJECT RISK ADVISOR CONCEPT

What has emerged is the development of a new risk advisory function which goes far beyond the traditional role of the insurance broker in the project business: that of the Project Risk Advisor. His role is to guide his clients through the minefield of risk advising them how to take advantage of the business opportunities that risk presents.

The Project Risk Advisor concept can only flourish if all parties to the project have the same common agenda (as indeed they should) of:

- Completion on time
- Completion on budget

Everyone should be using their best endeavours to achieve these goals. It should be us against the work and not against each other.

PROGRESSION OF WHO BUYS INSURANCE

Over recent years one of the fundamental changes in the insurance market is buyer progression in terms of which party contracts the insurance programmes.

Contractor Controlled Insurance Programme (CCIP)
In previous times most forms of contract required the contractor to arrange a series of specified insurances under a Contractor (Purchased or) Controlled Insurance Programme (CCIP). The prime constraint was that the insurances should be placed with an acceptable insurance market.

Owner Controlled Insurance Programmes (OCIP)
Thirty years or so ago there started to emerge a concept that it might be better if The Owner of the works, or in those days The Employer, purchased the insurance programme under an Owner Controlled Insurance Programme (OCIP). This change was to a great extent fuelled by the experience on the Tarbela Project in Pakistan and the difficulties there in securing the recovery, from differing insurers under differing contracts, for some of the losses that arose on that project.

The OCIP has gained considerable following in recent years, not least because of the private finance initiative. The theory, at least, is that if the lenders interest is to be fully protected by some form of Advance Loss of Profits (ALOP) or Revenue Stream Protection Insurance (RSP), that insurance must be placed in conjunction with the Physical Damage (Contractors All Risks/Builders Risk) Cover. This makes the Owner a more appropriate policyholder than the Contractor.

While splitting up the placing of these covers remains undesirable due to potential conflict of interest issues, it is not impossible to structure this differently today.

Lender Controlled Insurance Programme (LCIP)
The question arises in today's market as to who is The Owner. In the case of a well known bridge project a special project company with paid-up capital of 1,000 was the vehicle through which this 350m project was developed.

The providers of the main financing package in this and many other cases may feel that they have greater entitlement to the sobriquet Owner than the holders of the rather modest equity in the SPC. This has resulted in lenders taking a much greater interest in the insurance programme. They, to a degree, are now flexing their muscles saying that they wish to have a much more direct involvement in the insurance programme, even to the extent of promoting Lender Controlled Insurance Programmes.

Combined Financial Advisory & Risk Management
There is indeed a strong case to argue that money and risk go hand in hand. Why not, therefore, move a step ahead even beyond the Lender Controlled Insurance Programme and combine Financial Advisory and Risk Management services into a single discipline at one overall fee. The concept is sound and the benefits may be considerable.

Construction Industry Reaction
In the meantime in USA at least, possibly elsewhere as well, a debate currently rages over who should control the Risk Management and Insurance function in major projects.

A section of the Construction Industry holds the view that the insurance broking fraternity have deserted their traditional client base the general contractor and run off with project owners. As a result, brokers regularly now find themselves in conflicts of interest; caught between their owner client base and their contractor client base. The contractors also feel that owners are failing to take advantage of the contractors often vast experience of Insurance and Risk Management problems on many similar projects, experience which could in the event of problems be key to the success of the venture.

Now with the emergence of the Lender Controlled Insurance Programme, the general contractor is finding himself even further removed from the process. The fact remains that there is only going to be one insurance programme for the project and that all participants, be they Owner, Contractor or Lender are going to have to rely on that single programme for their protection.

Who should manage the insurance programme? It seems clear that, in the same way that risks must be borne by the party best able to manage and absorb the risk, the insurance programme should be managed by the project participant best able, and most experienced, at handling such matters on a day to day basis. That, in the vast majority of cases, will be the EPC Contractor. So, what is the solution to this conflict? What can be done to get all parties to sign up on the common risk agenda? One possible solution is to have a Project Risk Advisor.

PROJECT RISK ADVISOR CONCEPT
As stated above, the concept of the Project Risk Advisor (PRA) is that he works as the Trusted Advisor on Matters of Risk.

He works for the project and NOT for the individual participants. The role is to ensure complete transparency in the management of risk and, as mentioned earlier, the concept relies on the parties having no hidden agenda from each other in this area.

Project Risk Advisor Benefits
The benefits that the Project Risk Advisor will bring are essentially

- To reduce time to financial close
- To reduce long term cost of money

Through transparency, the Project Risk Advisor will reduce confrontation and will ensure that internal conflicts are carefully managed. Time and money will be saved.

At a typical risk allocation meeting on a privately financed project, each project participant is regularly accompanied by his attorney and his insurance broker. What usually develops first is a legal exercise in passing risks between each of the attorneys clients without reference to practicalities or capabilities for efficient management of risks. The second scenario is that the lenders insurance consultant imposes suites of insurances on the project as a condition of financing. Both of these add cost and confrontation setting the wrong initial atmosphere for project success.

The Project Risk Advisor concept avoids, through its transparent approach, the need for everyone to have their own insurance advisor. This will undoubtedly reduce cost, conflict and the time involved.

The fundamental key is that the Project Risk Advisor displays in a transparent template all the risks facing the project. It clarifies who bears those risks, what mitigation plan should be adopted, what insurance is available and most importantly, what risks can which project participant sensibly and readily assume. This enables project participants to view this as a business opportunity and not simply an exercise in insurance procurement.

BALANCING RISK AND REWARD

Thus the Project Risk Advisor has the task of assisting the parties in balancing risk and reward. As mentioned earlier, Risk is a business opportunity. Risk is often wrongly confused with uncertainty. Uncertainty is simply undefined risk. If the Project Risk Advisor can assist in successfully defining the risk the result will be the successful financing of the project.

The Basic Process
The process which enables the Project Risk Advisor to produce the solutions involves considering and advising on Risk Identification, Risk Analysis, Risk Allocation and Financial Engineering.

The goal of the Project Risk Advisor will be to make your project more attractive to lenders and equity investors by reducing the downside financial risk and improving the overall viability of the project.

SELECTING A PROJECT RISK ADVISOR

As with the emergence of any new concept there are no precise guidelines or parameters which fully define the role of the PRA or the skills he/she needs to possess. The individual or company selected certainly needs good commercial judgement backed up with significant practical experience, diplomatic and communication skills are essential, engineering, legal and insurance knowledge are also necessary as is a willingness to think outside the box when it comes to matters of risk.

NEW MITIGATION PRODUCTS AND CONCEPTS

The secondary purpose of this paper is to highlight some of the new risk mitigation products and concepts which are becoming available both from the insurance markets and from the capital markets. These are all still in the development phase and most are relatively untried but several have been used in various types of power project.

Blended Risk Solutions
There is a move towards more integrated or blended risk solutions. These will result in a more comprehensive package of protection than the traditional variety pack of different policies providing limited but specific cover addressing different areas of risk.

The convergence between the banking industry and the insurance business is progressing quite rapidly. Much greater consolidation between these previously separate financial activities can be anticipated in the coming decade. The linking of capital market investors with traditional insurance underwriters produces a potent new force with a considerable appetite for risk provided it is properly defined and adequately priced.

This new breed of player and the emergence of the alternative risk transfer (ART) market will provide risk solutions previously unknown in either industry. The value of these products lies largely in their ability to enhance the credit-worthiness of the project and/or the SPC and which will lead directly to the Project Risk Advisors goals of lowering the cost and of speeding up the financing.

There are available a wide range of creatively devised financial products which can be applied to formerly uninsurable risks. Ultimately, the scope of and the extent to which these products can be used will become more fully defined; but as they emerge, their availability and application is limited only by the imagination of the parties involved. Here, just a very modest selection are mentioned which have particular relevance to power generation projects including hydropower.

Cost Overrun Protection
Of the new products coming from the marketplace, probably the single most important product as far as the hydropower industry is concerned, is the development of cost over-run insurance for tunnelling and foundation work.

This is by no means an off-the-shelf product, nor is it readily available, but it is possible to cap the tunnelling cost risk through the insurance market. Of the uncertainties facing hydropower projects, the risk of encountering something unforeseen in the tunnels remains the greatest concern of lenders. Anything which can be done to assuage this concern and guarantee costs within certain parameters is certain to be hugely welcomed.

Regulatory Risk
Another new product recently to emerge from the market is a wide ranging Political or Regulatory Risks form of cover. This is designed to provide an indemnity in the event that any changes occur to the level playing field perceived at the conception of the project during construction and into commercial operations.

Revenue Stream Stabilisation
Numerous new mechanisms have been developed for the protection of project revenue. These vary from Loss Stabilisation Programmes to sophisticated Capital Equity Puts (Cat-E-Puts) or Contingent Equity Plans, the detailed description of which is beyond the scope of this particular paper. These products can be used in the hydropower business to deal with the hydrology risk and might also have application in the merchant power market, which is now developing in many countries. Again, the function of all these products is to make the project more attractive to lenders.


CONCLUSION
A role has been defined in which the residual risks inherent in many capital projects, be they geotechnical, hydrological, market or construction management, can be transparently allocated into financial vehicles with the objective of making projects more economically viable.


Michael W Good
Managing Partner
Project Risk Advisors Ltd. (PriskA)

Tel: +44 1883 623589
Fax: +44 1883 623383
Mobile: +44 7836 614684
US Mobile: (917) 371 9999

Web:  www.projectriskadvisors.com

E-Mail: mike.good@projectriskadvisors.com