Creating An Effective Security Package Using Commercial Insurance In International Projects
A key feature of infrastructure project finance is the allocation of risks among the numerous parties involved. One of the most important risk management tools for project finance, to which both project sponsors and lenders should look in order to allocate risks to a third party, is commercial insurance.
Although it is an area where the interests of both project sponsors and lenders converge to a large degree, a potential “win-win” situation, commercial insurance is a discipline with its own unique “rules of the game,” which are not always clearly understood by the main parties involved in the project negotiations.
Understanding what lies behind the inevitable insurance jargon and how successfully to incorporate insurance into a lender’s security package is critical to achieve a successful project financing.
In most project finance transactions, the main credit agreement will include detailed insurance provisions. In some cases, there will be a separate insurance agreement that will govern the insurance requirements and the parties’ interests. Although the specific scope of insurance coverage and amounts will differ in the case of individual projects, it is safe to say that in virtually all cases, these provisions will include a requirement that the project insurance policies include the lenders (acting through an agent or security trustee) as “additional insured” and name the lenders as “loss payee.” In addition, there will be a requirement that the project insurance policies include a “breach of condition” clause, also called a “non-vitiation” clause.
In the case of complex infrastructure project financing, and in the case of projects located in jurisdictions with a legal framework that mandates domestic insurance, but where the capacity and financial health of the domestic insurance industry may be an issue, insurance arrangements will require that the project’s insurance program be reinsured in the international markets with reinsurers acceptable to the lenders and with appropriate “cut through” provisions.
Another typical requirement is that the project insurance policies include a waiver by the insurer of any rights of subrogation against the lenders (a “waiver of subrogation”). Finally, there will be miscellaneous provisions regarding modifications (prohibiting the project company from modifying the insurance without lenders’ consent), notices (requiring the insurer to notify the lenders before canceling the project company’s insurance policies), and other information delivery (copies of policies, renewals, etc.).
As the term implies, an “additional insured” is any entity other than the project company which is specified as such on the insurance policy.
There has been some discussion among commentators whether to distinguish between an “additional named insured” and an “additional insured.” The former has been used to refer to an entity added to a pre-existing insurance policy, while the latter has been used to refer to an entity insured at the same time as the insurance policy is issued to the project company. However, New York courts have consistently refused to make this distinction and have ruled that the additional party’s rights are the same, regardless of whether the party was named as an additional beneficiary of the policy at the same time or later than the named insured.
As an additional insured, lenders are treated as if they were separately covered under the insurance policy. Most importantly from the lenders’ perspective, an additional insured has no obligation under the insurance policy and is not liable to the insurer to pay the premiums. Absent a “loss payee” clause (discussed below), it is important that the insurance policy state that proceeds would be payable to the named insured (the project company) and the additional insured (the lenders) “as their interests may appear.” This will enable the lenders to receive payment of insurance proceeds to the extent of their interest in the insured property ahead of the project company in the event of insured loss. Absent a provision that specifies payment “as their interest may appear,” the project company and the lenders are presumed to share the insurance proceeds equally.
A “loss payee” is entitled to receive the entire insurance proceeds, or amounts in excess of a certain threshold if so specified (but other than proceeds under third-party liability insurance which are payable to the injured third party), regardless of whether it has an interest in the insured property. Under New York law, a loss payee is deemed to have a separate contract right to be paid against the insurer and may bring a suit against the insurer in its own name.
As in the case of being named an additional insured, the loss payee has no obligations under the insurance policy and is not liable to the insurer for the payment of premiums. However, lenders should be aware that absent a “breach of condition” or “non-vitiation” clause (discussed below), being named solely as loss payee may not be sufficient from their perspective. That is because a default by the project company under, or in connection with obtaining, the insurance policy could give the insurer a defense against a claim by the insured (the project company), thus avoiding payment and in some cases entitling the insurer to void the policy, effectively barring the lenders from recovering the insurance proceeds.
Until recently, under English law, being named as loss payee or having a loss payable endorsement served only as a direction to the insurer to pay the insurance proceeds to the lenders. Absent other language in the policy, being named as loss payee would not have entitled the lenders to enforce any rights to receive payment against the insurer. This is because under the so-called “third-party rule,” English law did not recognize rights of third-party beneficiaries, and there is no direct privity of contract between the insurer and the loss payee. That has now changed with the recent passage of the “Contracts (Rights of Third Parties) Act 1999,” which became effective on November 11, 1999. (See “Third Parties Gain Right to Enforce Project Contracts” in the December 1999 issue of the NewsWire for earlier coverage.) It remains to be seen whether being named as loss payee will be sufficient to create a third-party beneficiary right for purposes of the new law, which would allow the lenders to enforce such right directly against the insurer.
Because of the potential exposure, it is easy to see why “breach of condition” or “non-vitiation” clauses are distasteful to, and highly negotiated by, insurers. In general, mistake, misrepresentation, non-disclosure, or breach of warranty on the part of the project company may provide sufficient grounds for the insurer to void the policy. Lenders are particularly concerned about these factors because they are inherently difficult to investigate in the normal course of project appraisal and because lenders may have no effective control over the project company’s behavior in this respect.
Including a breach of condition or non-vitiation clause in the insurance policy prevents the insurer from voiding the policy or refusing payment on the basis of defenses it might otherwise have against the project company. As noted, these provisions are usually carefully negotiated, and their inclusion in a policy is in many cases a function of capacity and other general conditions which at any particular moment in time may affect the international insurance industry.
A possible alternative for lenders facing insurers that are reluctant to include breach of condition or non-vitiation clauses is to try and obtain, at the project company’s expense, so-called standard mortgage insurance. Standard mortgage insurance covers a lender/mortgagee precisely for the risk that as between the insurer and the mortgagor, the insurer may have grounds to void the policy. However, the availability of this kind of insurance is limited for much the same reasons that insurers are reluctant to include breach of condition or non-vitiation clauses in the first place, and because of the generally large amounts involved in infrastructure project finance.
In some emerging markets jurisdictions, project companies are required by law to obtain all or a portion of the commercial insurance through domestic insurers. In others, even if specific legislation pertaining to the insurance industry doesn’t exist, exchange controls may have the same effect of requiring the project company to maintain domestic insurance in local currency. Because of potential concerns regarding the legal framework and the capacity and credit quality of the domestic insurance industry, lenders in these cases will generally require that the project company’s insurance program include reinsurance of all or a substantial portion of the risk in the international markets. In addition, because of the sheer size of many infrastructure projects, reinsurance will be required directly as a result of capacity restraints on individual primary insurers, who will also, as a matter of prudent industry practice, want to pass on some of the risks to the international reinsurers.
It is important for both project sponsors and lenders to understand that a reinsurance policy is an indemnity contract between the primary insurer and the reinsurer. It is distinct and separate from the original insurance policy issued to the project company and does not generally create any privity between the reinsurer and the project company. Neither does the naming of lenders as additional insureds and loss payees on the primary insurance give the lenders any rights against the reinsurer. Because neither the project company nor the lender has any contractual relationship with the reinsurer, generally only the primary insurer may bring an action against the reinsurer to recover reinsurance proceeds, unless additional steps are taken.
What, then, can lenders do in order to overcome the lack of privity with the reinsurer and avoid the credit risks of the primary insurer in domestic emerging markets jurisdictions?
If the project’s finance documents and insurance policies are subject to New York law, lenders should require that the project company’s insurance program include reinsurance with “cut-through” provisions. A number of different cut-through endorsements are in use in the reinsurance industry, each with different legal effect. A pure cut-through changes the direction of payment of the reinsurance proceeds from the primary insurer to a designated beneficiary. A cut-through guarantee endorsement also changes the direction of payment, but guarantees not only the reinsured loss but also any exposure that may have been retained by the primary insurer. A cut-through endorsement can also constitute a novation, placing the reinsurer in the position of the primary insurer for full payment to the designated beneficiary, including all claims handling. New York law specifically recognizes “other loss payees,” which may be the lenders, as the beneficiaries of a cut-through endorsement.
The basic function of a cut-through endorsement is to provide that in the event of insolvency of the primary insurer, the reinsurance proceeds are paid by the reinsurer directly to the lender rather than to the primary insurer or its liquidator, thereby eliminating the insolvency risk at the primary insurer level. Without a cut-through endorsement, in the event of insolvency of the primary insurer, the reinsurer will make payment to the insolvent insurer’s liquidator and the reinsurance proceeds will go to increase the size of the funds available for distribution to all of the insurer’s creditors, or as otherwise specifically provided by the domestic insurance and bankruptcy laws of the insurer’s jurisdiction of incorporation.
By way of illustration, under New York law, in that scenario, the project company and the lenders would have no right to any preference over other policy holders or general creditors of the primary insurer and would share ratably with other policy holders in the distribution of the primary insurer’s assets. In other words, without a cut-through endorsement, the lenders are taking on, in addition to project company and project risk, credit risk of the primary insurer. This is unlikely to be acceptable to lenders where the primary insurer is itself weak or is subject to the financial and business vagaries of emerging markets.
As previously noted, English law until recently did not recognize the rights of third-party beneficiaries, with the result that cut-through endorsements were unenforceable under English law because of the lack of privity between the project company and the lenders on the one hand, and the reinsurer on the other. Thus, if a project’s finance documents and insurance policies were subject to English law, in order to have had an enforceable cut-through, lenders would have needed to have required that the project company, primary insurer, and reinsurer enter into a tripartite agreement to that effect.
According to one commentator, although such an agreement would have addressed the lack of enforceability issue, there was a concern that it created a possible problem as a voidable preference under the UK “Insolvency Act of 1986.” However, under the new “Contract (Rights of Third Parties) Act,” the need for such an agreement has been obviated, and it can be expected that a properly worded cut-through endorsement should suffice to give the lenders enforceable rights.
The best protection for lenders is clearly a cut-through endorsement from the reinsurer that guarantees the full amount of the insurance (not just the excess reinsured) and which also acts as a novation, allowing the project company and the lenders to deal directly with the reinsurer in all matters relating to insurance under the policies.
Ultimately, the type of cut-through endorsement which reinsurers will be willing to provide will be a matter for negotiation and may depend upon, among other things, whether the reinsurance is facultative reinsurance (i.e., reinsurance of part or all of the insurance provided by a single policy, with separate negotiation for each unit of insurance passed — or ceded — to the reinsurer) or treaty reinsurance (i.e., reinsurance provided pursuant to a standing agreement between the reinsurer and the primary insurer for the —usually automatic — cession and assumption of certain risks).
A “waiver of subrogation” is usually required by lenders to protect themselves from the possibility of any action by an insurer, who, upon payment to an insured project company would become subrogated to any and all of the project company’s rights against third parties. However, if the lenders are named as an additional insured, this protection is probably not necessary, both under New York law and English law, since it is well established in both jurisdictions that an insurer does not have any right of subrogation against its own insured for any claim arising from the very risk for which the insurer contracted to provide insurance coverage. As previously noted, by being named additional insured the lenders would automatically enjoy this protection.
In addition to naming the lenders as an additional insured, specifying the lenders as loss payee, and obtaining reinsurance with a cut-through endorsement, it has become customary in most project finance transactions to have the project company assign all of its rights, title and interest in and to all insurance proceeds and the insurance policies to the lenders, either as part of the general security agreement governing project intangibles or under a separate insurance assignment agreement.
A typical formulation of the granting provisions would read as follows:
“As security for the prompt and complete payment of the secured obligations, the project company hereby assigns, charges, conveys, sets over and transfers unto the lenders and hereby grants to the lenders a continuing first priority security interest in all of the right, title and interest of the project company in, to and under all of the following, whether now existing or hereafter acquired, [...] and all insurance proceeds and insurance contracts.”
While such a security agreement does not, as between the lenders and the insurer, add anything to that which the lenders will have by virtue of being named as additional insureds and designated as loss payees, it would seem to be good protection for lenders, enhancing their position as secured creditors vis-a-vis the project company and its other potential creditors in case of bankruptcy of the project company. However, if the project’s finance and security documents are subject to New York law, lenders should be aware of several issues regarding the creation and perfection of a security interest as it relates to insurance under article 9 of the Uniform Commercial Code, which is the statutory scheme in the US governing secured transactions where personal property is provided as collateral.
A key issue to be aware of is that UCC article 9, by its terms, does not apply to “a transfer of an interest or a claim in or under any policy of insurance . . . except as provided with respect to proceeds and priorities in proceeds.” Article 9 does provide that “[I]nsurance payable by reason of loss or damage to the collateral is proceeds, except to the extent that it is payable to a person other than a party to the security agreement” (sections 9-104 and 9-306). Thus, by purporting to convey and transfer all insurance contracts, the broad language of a typical security agreement may create a problem for lenders, inasmuch as the creation and perfection of that security interest will no longer be governed by a filing under UCC article 9. Instead, it will be governed by other, non-UCC provisions applicable in the jurisdiction.
New York courts have held that creation and perfection of a security interest in an insurance policy itself is governed by the common law of pledge. Although a pledge of an insurance policy as collateral is valid absent a prohibition in the policy, to perfect the security interest in this case will require the project company to physically deliver the insurance policies to the lenders.
Another concern is that by purporting to convey and transfer all insurance contracts, the broad language of the typical security agreement may create a practical problem for lenders, since they may find themselves primarily responsible for the insured’s obligations under the insurance policies, including the obligation to pay the premiums.
Other Lender Issues
One particularly troublesome issue for lenders that has arisen under UCC article 9 provisions relates to delay-in-start-up insurance (insurance which covers a project company from the financial consequences of a delay in project completion) and business interruption insurance (insurance which covers a project company from the financial consequences of an interruption in commercial operations, post project completion).
Do proceeds of delayed start-up or business interruption constitute “insurance payable by reason of loss or damage to collateral?”
The argument in favor is clear enough. There is a direct cause and effect between a loss or damage to collateral, i.e., to the physical plant and property given as security to the lenders, and the payment of delayed start-up or business interruption insurance. Unfortunately, New York courts have not provided such a clear answer.
While no case directly on point exists, the federal district court for the eastern district of New York in Peacock Holdings, Inc. v. Mass. Mutual Life Ins. Co. cited with disapproval and criticized the decision of the federal district court for the eastern district of Pennsylvania in in re Bell Fuel Corp., which held that proceeds from business interruption insurance constituted “insurance payable by reason of loss or damage to collateral.” The New York court cited with approval a decision of the bankruptcy court in the western district of Pennsylvania, Premium Fin. Specialists, Inc. v. Remcor, Inc., in which that court found the in re Bell Fuel Corp. decision to be both “dictum and incorrect.” The New York court went on to also cite with approval a decision of the bankruptcy court in the district of Minnesota, in re Investment & Tax Servs., Inc., in which that court held that the reasoning in in re Bell Fuel Corp. is flawed because, among other things, business interruption does not insure any of the creditor’s collateral, but simply insures the debtor against interruption of its business and the proceeds of business interruption are not proceeds of the creditor’s collateral.
Accordingly, there is a possibility that New York courts will reject an attempt to have UCC article 9 govern the creation and perfection of lenders’ security interest in proceeds of delayed start-up and business interruption insurance.
Finally, it is worth noting that an assignment of insurance proceeds under a security agreement, in and of itself without the additional protections of being specified as additional insured and loss payee and having a non-vitiation clause in the policy, may not be sufficient protection for lenders. One reason for this is that as assignees, lenders’ rights cannot exceed those held by the assignor (the project company) at the time of assignment. Hence, an assignment in and of itself, absent a non-vitiation clause contained in the insurance policy, will not protect the lenders in situations where the insurer can successfully raise a defense against the project company.
If the project company would not be entitled to insurance proceeds, neither would the lenders as assignees.
Another reason is the issue of notice. New York courts, as well as courts in several other US jurisdictions, have held that in order for an insurer to pay directly to a secured party, it must have sufficient notice of the secured party’s security interest over insurance proceeds. These courts have refused to recognize constructive notice on the part of the insurer on the basis of a UCC filing. Thus, absent designation as loss payees, lenders should take the necessary precaution, in addition to filing UCC financing statements, to provide specific notice to the insurer and even obtain an express acknowledgment from the insurer of their security interest.