Carter Newell has recently been involved with issues relating to the treatment of the emerging risk to revenue of projects under construction, by way of the risk transference mechanism of DSU insurance cover.
DSU stands for Delay In Start Up. It is also sometimes known as Advance Loss of Profits [ALOP] and is a specie of business interruption insurance. It follows the same principles as an annual business interruption policy but applies to anticipated future earnings of a future business or venture.
A Global Risk Management Survey in 2013 identified business interruption as one of the top 10 risks faced by corporate insureds.(1)
That same survey ranked business interruption by industry in comparison to other top risks and found, not surprisingly, that it was most highly ranked by industries where any loss of production has an almost immediate impact on their bottom line, with very little scope to claw back the loss (e.g. manufacturing, utilities etc.).
The main source of DSU losses in the 28 years to 2008 (2) were, in percentage terms:
- Power Plants 27%;
- Building and Construction 27%; and
- Industrial Process Plants 13%.
Represented statistically, the number of policies involving DSU cover doubled over the last decade. Generally, the frequency of DSU claims is increasing. About 6.5% of all DSU risks are said to have encountered a loss. The quantum of the average DSU claim in 2008 had almost doubled from 2000.(3)
DSU is aimed at those who invest in new projects or expansion works and who wish to protect against the negative effects on the planned revenue stream caused by a delay in completion. As such it is primarily the Principal who will seek to benefit from this class of insurance. The Contractor's own revenue and the contractual penalties incurred for late completion are generally not covered by a DSU policy.
Financiers now also often insist that DSU Insurance be acquired to secure future debt servicing after business operations have commenced. This trend is likely to continue to drive the emergence of this class of insurance.
It provides financiers with the security that the borrower has the ability to meet its financial obligations and financiers will not infrequently seek to have their interests noted or require evidence that adequate cover has been arranged.
Features of DSU cover
As in traditional business interruption cover, the insurance benefit is limited to specific items and sums that were specified at the time of policy inception.
While the insurance industry offers a number of different variants, all DSU policies have certain features in common. For example, the amount idemnifiable is invariably subject to the actual loss sustained, which must be substantiated by the insured. Further coverage is determined by the agreed sum insured and by the maximum indemnity period. The author addresses these below, amongst other common features:
When fixing the sum insured, it should be kept in mind that insurers may seek a proportionate reduction in the claim settlement if the sum insured is less than the maximum loss for the relevant indemnity period. Different considerations will clearly apply with respect to losses arising on process engineering projects as opposed to say, development projects where revenue is earned through letting arrangements.
Indemnity period and maximum indemnity period
The indemnity period is the period calculated from the date of anticipated completion of the works or commencement of commercial operation, during which revenue is expected to be earned, and which could be affected by delay in completion caused by an insured incident. Often the DSU maximum probable loss will be an incident occurring immediately before completion. A maximum indemnity period, which should reflect the maximum probable loss scenario, is then agreed upon. For a large production facility or utility, the total time needed for a full recovery from a major loss can easily run to 24 months or more.
The deductible is generally time based and a common approach is to apply a single deductible to the cumulative delay period. When the deductible period is exceeded (for example, say 50 days), it may be applied to the first 50 days of the delay regardless of the amount of financial loss suffered during this period, or it may be applied on a pro rata basis where the average daily loss of the overall insured delay is calculated, and the 50 days worth of loss is then deducted from the total loss suffered.
Underlying material damage cover
There invariably needs to be a loss covered and admitted under a corresponding material damage policy for a claim to be considered under a DSU policy.
One school of thought is that there is commercial sense in making arrangements for both the material damage and business interruption insurances to be with the same underwriter. The idea behind this is to assist in striking an equitable balance between the suitability and economics of a repair, which is relevant to the material damage, and the time taken to repair, which is relevant to the business interruption.
Policies often contain exclusions in relation to defective workmanship or design. Where such a policy excludes the costs of repair to the defective item itself, but allows for the costs of rectifying resultant damage, it is only the delay referrable to the repair of the resultant damage (over and above any concurrent delay) which will be a relevant delay for purposes of the DSU calculation.
Interface with Liquidated Damages
Under the terms of the contract the Contractor may be obliged to compensate the Principal for the late delivery of the project at a specified rate over time. Although such contractor caused delays are not always the subject of indemnity under a DSU policy, where they are, any claim will be reduced by the amount of Liquidated Damages received by the Principal.
Principles of Revenue Insurance
The intention of business interruption insurance is to put an insured party back into the same financial position in which it would have been had the loss not occurred - that is to reinstate its 'bottom line' (BL) or pre tax profit (i.e. net profit before tax). BL insurances often use the term Gross Profit (which is really net revenue) being turnover (sales) less variable costs (fuel, materials etc).
In addition to the risk of reduction in revenue (and loss of profit), there are further exposures that are likely to fall within the following categories - increased costs of working, contractual commitments and liabilities and penalties. Requests are sometimes made for the provision of 'debt service only' i.e. the interest costs incurred on loans used for the business.
In the past few years, very large DSU claims have been encountered. It had become clear to interested stakeholders that parties involved often had different ideas regarding both the basic nature and scope of DSU insurance cover.
This led to the formation in 2012 of the London Market Working Party which was comprised of industry participants and its stated aim was to 'restore greater harmony to all the interest groups expectations, requirements and levels of knowledge regarding all phases of a complex construction project'.
Both The London Market Working Party and The Insurance Institute of London have produced various publications which may be of interest to stakeholders.