Insurance is a key area of any PFI contract. Authorities need to look closely at the value they receive from their PFI insurance arrangements and whether this can be improved. There can be significant savings to be made in doing so. Here we look at the issue of payment for insurance.
How we got here
Historically, the public sector has self-insured and, in early PFIs, insurance provisions were largely the result of the funding structure. Lenders had to ensure that the senior debt would be repaid in any event, and the SPC that it could continue to pay its contractors. Insurance was priced at a level that would allow for reasonable market-lead premium increases on top of RPI. The Authority paid this as part of the Unitary Payment (UP) and got on with its business.
Even early on, however, there was the recognition that insurance premiums could change. There were a number of Benchmarking arrangements, where insurance costs would be brought back to market levels every 3 or 5 years and the UP adjusted accordingly.
The first Standard Form guidance from 1999 stated that:
How we got here
Historically, the public sector has self-insured and, in early PFIs, insurance provisions were largely the result of the funding structure. Lenders had to ensure that the senior debt would be repaid in any event, and the SPC that it could continue to pay its contractors. Insurance was priced at a level that would allow for reasonable market-lead premium increases on top of RPI. The Authority paid this as part of the Unitary Payment (UP) and got on with its business.
Even early on, however, there was the recognition that insurance premiums could change. There were a number of Benchmarking arrangements, where insurance costs would be brought back to market levels every 3 or 5 years and the UP adjusted accordingly.
The first Standard Form guidance from 1999 stated that:
The risk of increases in insurance costs should be borne by the Contractor. Whilst there may ultimately be an indirect partial pass-through (eg via indexation and benchmarking .) . . the Contract should not include any provisions which expose the Authority to direct pass-through of such extra costs . .
By the second Standard Form, in 2002, the above was repeated with the following addition:
Notwithstanding the principles stated . . . above, it does not represent best value for money if bidders price worst case scenarios for future insurance premium levels into their bids. OGC is currently considering ways in which this can be addressed and is working with consultees from the public and private sector to agree an appropriate mechanism for dealing with increases in insurance costs over the term of the Contract that are attributable to market movements. In the meantime, Authorities should contact OGC or PUK if they are facing requests from bidders for price protection in respect of insurances to be included in the Contract, and in no circumstances should the Authority introduce benchmarking of insurance provisions into the Contract.
It wasn’t increases in insurance premiums that mattered, however. There had been a general softening in the general insurance market and PFI risks, in particular, were now known and were increasingly seen as attractive. Rates were falling and would continue to fall. The private sector was also making use of portfolio insurance arrangements where groups of PFI assets under common ownership were placed together, utilising economies of scale, to deliver even lower premiums.
By 2005 the third Standard Form, advice had changed:
By 2005 the third Standard Form, advice had changed:
. . . the risk of increases in insurance costs should lie primarily with the Contractor. However it may not be value for money for the Authority to require the Contractor to take on the full risk of exceptional market wide movements in operational phase insurance costs . . . However, if the Authority takes on the risk of exceptional upward movements in market wide insurance costs, it should also receive a corresponding benefit from reductions.
Here any increases, or decreases, in costs by more than 30% were to be shared on a ratio of 85:15 in the Authority’s favour.
This guidance also addressed portfolio insurance:
This guidance also addressed portfolio insurance:
in the event that there are any insurance cost savings from portfolio placements . . . such savings should be considered in the same way as other factors causing a general market movement in insurance costs.
In practice, PFI insurance provisions generally fall into three categories:
What should Authorities do?
Total risk transfer
Here the Authority pays for insurance as part of the UP and there is no provision for changes in cost. The Authority should consider whether the amount paid under the UP represents value. The amount paid can be seen in the Financial Model. Current market rates can be ascertained by an insurance adviser. Where these two amounts differ, then the SPC and its shareholders may be making gains not envisaged at Financial Close. The Authority also needs to examine the Variation provisions of the PFI agreement to ascertain whether the insurance payment risk can be transferred. There are many complexities in such a transfer and we would recommend that expert advice is sought. P2G are able to estimate any potential gains and the Authority’s ability to transact the necessary changes, all without charge.
Benchmarking
Here the UP is adjusted periodically for changes in insurance costs. Such provisions vary and the Authority may have the right to obtain its own quote. Given the sums involved, it is often wise to seek professional help from an insurance adviser.
Gain / pain share
Here, changes in cost are shared periodically. Actual costs are compared to Base Costs and the difference apportioned. The Authority share is generally expressed as a percentage according to a number of savings bands.
Authorities should ensure that Actual Insurance Costs used in any calculation are really actual. It is not uncommon for SPCs to neglect to include rebates, often termed “low-claims rebates” or “performance bonuses”, thereby reducing any payment to the Authority. In addition, SPCs may gross up Actual Insurance Costs for the perceived benefit of using a portfolio arrangement versus a general market rate. This is made more difficult to establish by the recent practice of not including premium data on the cover notes provided.
Base Costs are generally expressed in the PFI agreement by reference to the Financial Model or to a specific table in the insurance schedule. This may be varied from time to time by variations or other contract provisions.
These calculations should be scrutinised with careful reference to the provisions in the relevant PFI agreement. P2G can help.
- total risk transfer
- benchmarking
- gain / pain share
What should Authorities do?
Total risk transfer
Here the Authority pays for insurance as part of the UP and there is no provision for changes in cost. The Authority should consider whether the amount paid under the UP represents value. The amount paid can be seen in the Financial Model. Current market rates can be ascertained by an insurance adviser. Where these two amounts differ, then the SPC and its shareholders may be making gains not envisaged at Financial Close. The Authority also needs to examine the Variation provisions of the PFI agreement to ascertain whether the insurance payment risk can be transferred. There are many complexities in such a transfer and we would recommend that expert advice is sought. P2G are able to estimate any potential gains and the Authority’s ability to transact the necessary changes, all without charge.
Benchmarking
Here the UP is adjusted periodically for changes in insurance costs. Such provisions vary and the Authority may have the right to obtain its own quote. Given the sums involved, it is often wise to seek professional help from an insurance adviser.
Gain / pain share
Here, changes in cost are shared periodically. Actual costs are compared to Base Costs and the difference apportioned. The Authority share is generally expressed as a percentage according to a number of savings bands.
Authorities should ensure that Actual Insurance Costs used in any calculation are really actual. It is not uncommon for SPCs to neglect to include rebates, often termed “low-claims rebates” or “performance bonuses”, thereby reducing any payment to the Authority. In addition, SPCs may gross up Actual Insurance Costs for the perceived benefit of using a portfolio arrangement versus a general market rate. This is made more difficult to establish by the recent practice of not including premium data on the cover notes provided.
Base Costs are generally expressed in the PFI agreement by reference to the Financial Model or to a specific table in the insurance schedule. This may be varied from time to time by variations or other contract provisions.
These calculations should be scrutinised with careful reference to the provisions in the relevant PFI agreement. P2G can help.
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