We have chosen to make this issue an article for discussion as we perceive there are a number of different philosophies amongst energy companies as to which costs comprising the overall construction budget should be included within the insurable value, or indeed what proportion of such costs should be included. This of course assumes that the project is not “turnkey” or lump sum, where the turnkey or lump sum cost might form the basis of the insured value.
It is a timely issue for discussion as we believe that the new draft WELCAR wording for offshore construction may be somewhat more definitive in terms of the way cover for inflation in budget costs will operate. However, this is an issue that arises for both upstream and downstream energy projects and power business, as the themes are common to all types of construction project. It is particularly appropriate in the context of very high project values that are likely to become more commonplace where offshore and onshore projects are taking place in more remote environments, or comprise more technically advanced engineering, and where insurance capacity limitation may come into play.
Insurance markets will be looking to base their limitation of liability under the CAR policy on the estimated completed value (ECV) at the scheduled completion date of the project. But no guidance is written into the policy form as to what that value should include (although some policy forms such as WELCAR will exclude recoveries for costs that were not included in the originally declared values). Clearly there is an expectation by insurers that the ECV should at the very least comprise all “hard” costs, being those relating to materials, labour and cost of physical services such as transport and installation. But a substantial proportion of the overall budget cost relates to so-called “soft costs”, that might also need to be re-incurred in the event of loss or damage. Such “soft” costs would include expenditures such as design, project management, consultancies, contingencies and even the insurance premium itself. For E. and P. energy projects a significant part of the total cost will also include the drilling of production wells.
It is conventional philosophy that non re-occurring costs do not need to be insured as part of the total value. But there are very few genuinely non re-occurring costs, especially in a catastrophic loss situation. Examples might include site preparation of facilities that can be re-used – for example access roads to a construction site or the construction of dry docks for concrete platforms. The majority of costs will need to be re-incurred, but not necessarily in full; it will depend upon the type of cost and extent of the loss.
Design cost is a case in point. The technical drawings, plans, detailed specification and models that comprise the design expenditures will still exist where the constructed and installed works are damaged. It may only be necessary to redesign the flaw that resulted in the loss, and this may only be a small element of the total design cost. However, if a loss were to occur during the later stages of the project, for example fire and explosion could occur in the testing and commissioning phase, such a loss could be catastrophic resulting in bodily injuries and fatalities amongst the workforce. An event of some magnitude involving substantial loss of life would attract media attention and the possibility of a government enquiry, that would almost certainly lead to a number of recommendations for the rebuild or repair. It is easy to envisage in such cases that the initial design cost could be eroded quickly.
The generally accepted view is that design costs should be included in the ECV but only for a stated proportion. The figure included is often between 20% and 50% of the overall design cost, but never generally higher than 50%, dependent upon the nature of the project and the Operator’s individual philosophy. In the aforementioned example of catastrophic fire and explosion during the testing phase, this could lead to significant uninsured exposure.
We feel there are some insights we can provide in the specific case of design cost, and, selectively, on some of the other “soft” costs. Most budgets will be made of conceptual design at Front End Engineering stage and detailed design. It is conceivable that a significant part of the conceptual design can be retained; it is arguably the detailed design cost that is more exposed to significant redesign work. Furthermore, this detailed design cost will be spread over the various separate components making up the contract works as they are constructed, generally in different locations. It is only in the latter stages of the project where a larger part of the total design cost will be exposed in a catastrophic situation. Potentially, therefore, a smallish proportion of the overall design project can be included in the ECV for the entire project, with the possibility of a top-up policy being purchased towards the end of the construction programme for the balance required to be insured. A phased approach of this type might be appropriate where the ECV required, taking into account insured amounts for advanced loss of profits or delayed start-up cover, is at or near to market capacity.
A slightly different approach may be taken in respect of Project Management costs. These will comprise the cost of the Operator’s dedicated project team in administering and monitoring the construction process and sequence at all construction locations. A view may be taken on a worst case delay in the project necessitating an extension of Project Management time and cost for the period of this delay, and assigning a proportion of the overall budget to such cost.
Contingencies are a different matter. It will depend upon how such contingencies are assigned within the project budget.
ontingencies may for example be divided over individual contracts and the entire project, and a view can therefore be taken as to insuring either one or both of such contingent costs or different proportions of these costs. In offshore CAR contingencies can be provided for within the escalation clause, although this is an issue that is currently being addressed by the market, and may be more restricted in the new policy form that is shortly to emerge.
Inclusion of the insurance premium often elicits diametrically opposing views between risk management of one company as compared to another. Several energy companies include the cost of insurance within the declared ECV on all projects; others exclude such cost in entirety. For those taking the latter view we must point out that the WELCAR policy excludes any claim for additional or re-incurred insurance premium for extension of the policy, where the extension is caused by delay due to insured repairs. There are however very situations where it is possible to envisage that the entire contract works would need to be replaced; if so it is likely that the insurance premium for the replacement would be very much higher than the original. The “worst case” likely scenario is an extension of the project period for repairs of catastrophic damage occurring in the latter stages of the project, which might delay the project for up to 18 months or so. However, the value of the contract works at risk at this stage of the construction programme is comparatively high and may attract a higher premium than the original. It makes sense in these situations to be insuring for at least 100% of the original premium.
In the outturn we believe a view needs to be taken on a project by project basis, taking into account the individual aspects of each development; nevertheless we hope that the foregoing comments provide some assistance, and indeed some constructive ideas in terms of purchasing capacity for very high valued projects that are approaching market capacity.