The demand for new and upgraded infrastructure in emerging markets has exploded. Over the past five years, rapid economic expansion in Latin America throughout Asia has drawn attention to serious infrastructure deficiencies that could thwart future growth. Leonard J. Battifarano reports.

In Chile, for example, less than half of the country's roads are paved and its airports are increasingly unable to handle the greater influx in passenger and cargo traffic. Infrastructure-related productivity losses in Chile are estimated at $1.5 billion annually.1

Massive infrastructure repairs and new roadways are also needed in Bangkok, where vehicle ownership has tripled in the last decade and traffic clogs the city's streets. The energy requirements of a burgeoning industrial base have outstripped power generation capacity in Vietnam, causing energy shortages and blackouts. China's energy needs are phenomenal, and similar situations abound in Brazil, India, Russia, Korea, Indonesia and the Philippines.

Transportation problems, insufficient power supply, undrinkable water and poor communications systems are just a few of the concerns facing developing countries around the world. More than just "growing pains," international infrastructure represents an estimated $5 trillion expense over the next decade.2

Lacking the necessary capital to fund infrastructure improvements on their own, many governments are tapping the private sector. Private equity infrastructure funds have proliferated because of the high demand for private capital to support a variety of projects ranging from power stations and telecommunications networks to toll roads, airports, seaports, and water supply and treatment systems.

The quest for foreign capital has prompted social and economic reforms, led to deregulation and increased privatization, and fueled the growth of joint ventures and public-private partnerships in many developing countries. Widespread changes are creating enormous opportunities for financiers, developers and contractors throughout the world. The surge in infrastructure development is also presenting global insurance brokers and insurers with an attractive, growing market.

Complex risks

Generally large-scale and long-term in nature, international infrastructure ventures are among the most complicated and inherently risky endeavors for those involved. The consortia that drive these privately financed projects include lenders, developers, design and engineering firms, contractors and equipment suppliers.

Massive undertakings, such as building a highway system or constructing a power grid in a rapidly industrializing nation, typically require a financial commitment in the hundreds of millions of dollars and may take five, 10 or even 15 years from concept to completion. Economic, legal, regulatory and political hurdles can threaten the enterprise at every juncture, and construction and other project-related risks increase exponentially with the operation's size and scope. Exposure to loss is also magnified due to the often remote locations where these projects are situated.

A formidable challenge

Complex infrastructure initiatives require comprehensive insurance and risk management programs. The responsibility of program development rests largely with the insurance advisory team made up of members of the project consortium.

Infrastructure projects generally require several types of coverage, including construction and operational property coverages, marine cargo, surety bonds, third-party liability, export credit, environmental impairment liability insurance, and political risk insurance. High limits are a must, and programs are often structured on a quota-share basis with several carriers providing an aggregate insuring capacity essential for projects of this magnitude.

The challenge for the team is to integrate these diverse coverages into one cohesive insurance and risk management program that provides effective protection against catastrophic financial loss.

At Reliance National, we have developed a Global Infrastructure Division - a single unit devoted exclusively to serving clients involved in international infrastructure projects. We realized that it was time-consuming and costly to patch together various coverages from different insurers, so we made it easier by forming one division that offers all the insurance coverages and specialized capabilities international infrastructure projects require. This division is extensively involved in structuring multi-line insurance and risk management programs for major infrastructure initiatives throughout the world.

Latin America

Democratic regimes in the Americas have stimulated free enterprise, opened the door for foreign investment and supported privately financed infrastructure projects.

Chile's telecommunications sector was privatized in the 1980s, and most of its energy sector has been privatized. The privatization of Argentina's power industry began in the early 1990s, and Brazil is just beginning power privatization. These and other countries throughout the region have taken a practical approach to infrastructure development.

Projects in Latin America tend to be smaller in scale than those in Asia and often utilize proven technology, designs and equipment. In general, Latin American infrastructure projects are more easily financed, designed and built.

An example of a typical project is a gas-fired, combined-cycle power station in Chile valued at approximately $200 million. Insurance for the construction phase of this particular project consisted of four main coverages:

* Construction all-risk (CAR). Covers losses arising from physical damage to the project during the course of construction.

* Marine cargo insurance. Provides reimbursement for construction equipment or supplies lost or damaged in transit.

* Advance loss of profits (ALOP). Indemnifies lenders for lost revenues resulting from project delays due to physical damage to the project.

* Delay in start-up (DSU). Responds to economic losses stemming from project delays due to lost or damaged equipment.

For power generation projects, it is essential that coverages be extended to provide protection through testing and commissioning, as well as construction. The testing phase is the time when the propensity for loss is greatest. When fuel or "feedstock" is added, design flaws or equipment failure can cause fire, explosion or severe damage to turbines or other major pieces of equipment. All of these events can prove catastrophic unless the project is adequately insured. This testing risk is also faced by steel mills, refineries, pulp and paper mills and most other industrial facilities.

Once the power plant goes live, a range of other coverages are needed to protect against financial loss, including: property insurance and business interruption; boiler and machinery; machinery breakdown; liability insurance; and contingent business interruption.

Coverage for this Chilean power plant was arranged on a quota-share basis with three insurers providing the necessary capacity. With respect to quota share arrangements, pricing and capacity are determined, to a certain extent, by the level of self-insured retention. Retention size, however, is quite often a point of contention among lenders and developers. Lenders seek to minimize their risk, and therefore favor lower deductibles and more first-dollar coverage. Developers, on the other hand, desire higher deductibles as a way to reduce premium costs. Balancing these concerns and determining appropriate pricing, coverage limits, terms and conditions tend to make the negotiation of insurance programs for infrastructure projects especially challenging.

There is a common misperception that political risk, fire or other catastrophic events wreak the greatest havoc on infrastructure projects. In fact, project failure is due more often to the inability of lenders and developers to agree on critical contractual issues related to each participant's risk and reward contribution to the project.

Asia

Financial crisis in Asia has had a marked slowdown on infrastructure development. In the wake of weakening local currencies (won, baht, rupiah), foreign investors are holding back on commitments in this region.

The need for new and upgraded transportation systems, power plants and water treatment facilities still exists, so many projects that have been approved and are already in the works are continuing. Those projects on the drawing board, though, are being reassessed.

Asian infrastructure projects have tended to be two to three times larger than projects in Latin America and other parts of the world. With huge sums of foreign capital pouring in, there had been few funding concerns. Now Asian projects are being scaled back and downsized, and consortia are looking for practical approaches that work given the current financial situation.

Because of their size, Asian infrastructure initiatives have had somewhat different insurance requirements than projects in Latin America. The coverages are generally the same (CAR, cargo, ALOP, DSU, operational property coverages, liability, etc), but the limits are substantially higher and there tends to be more layering.

In the Philippines, which has fared significantly better than other Pacific Rim countries in recent months, this layering worked especially well for a $1.2 billion gas-fired power station. Prior to construction, lenders require projects to be insured for their full value. To attract enough carriers to secure sufficient capacity and still maintain competitive pricing, a three-tiered insurance program was structured for the power station, consisting of:

* a primary layer of $10 million in coverage;

* a layer of excess insurance with quota-share participation providing $250 million in coverage; and

* a second excess layer up to $950 million.

With approximately 40% of premiums paying for primary coverage, 45% paying for the first layer of excess and 15% for the second layer of excess, this arrangement proved to be substantially more cost-effective than if the entire program was placed on a quota-share basis.

Other projects of varying sizes have opted to use captive or rent-a-captive insurance facilities to assume liability for the first layer of coverage above the project deductible. Multi-year, multi-line blended programs with a single retention and an aggregate limit can also be used as a means to promote cost-savings and better balance sheet management.

Financial reinsurance, however, tends not to be a viable option because in the eyes of the lender, the finite risk program becomes just another exposure on a developer's balance sheet.

Within the property/casualty insurance industry, CAT bonds and various capital market strategies have been discussed as ways to provide additional capacity for flood, earthquake and other severe exposures. While there has been some interest in these approaches, they have yet to be utilized in the infrastructure arena.

It is unclear how long it will take for Asian economies to stabilize. Going forward, however, hedging against foreign exchange rate fluctuations may become a more integral and indispensable part of Asian infrastructure risk management.

Trends

In light of the situation in Asia, Latin America has for now become the new infrastructure hot spot. Foreign investors are also gravitating to Eastern Europe, the former Soviet Union and Southern Africa. While Asian markets struggle to get back on track, we expect to see increased infrastructure development in these and other parts of the world.

Clearly, each region has its own unique coverage concerns. For instance, a project in Siberia involving the construction of a $190 million gas compressor station faced inherent climate risks, as well as significant exposure to in-transit equipment losses due to the high crime rate in Russia. An in-depth understanding of local risks is essential for effective project risk management.

Another serious matter is environmental impact. In response to public pressure, governments are instituting and enforcing strict environmental regulations that can affect the cost and feasibility of infrastructure projects. Without proper protection, the unanticipated cost of site remediation and damages, involving people and property, could be a severe drain on project finances. As a result, environmental impairment liability insurance is quickly becoming a necessary coverage.

Conclusion

Having briefly toured the world of infrastructure, there are several items to consider when selecting carriers for international infrastructure projects.

Financial stability is important and the insurer's experience should be looked at closely. Has the carrier arranged programs for infrastructure projects before? Can the insurer provide coverage over the life of the project? For continuity, lenders prefer the same carriers insure both the construction and operation of a project.

Does the carrier have the right combination of global resources and local expertise? Skill in negotiating with local insurers is essential to the issuance of locally admitted policies, which are required by many countries and jurisdictions. Knowledge of the local political, economic and regulatory environment is critical as well.

Similarly, an insurer needs to have adjusters and other professionals who can be on site immediately when a loss occurs. A carrier's in-country claims service capabilities should include the ability to make payment in the local currency.

Since political risk insurance is often required by lenders, it is also important for the insurer to have relationships with such entities as the Overseas Private Investment Corp. (OPIC), various OPIC-like agencies, the Import-Export Bank and the Multilateral Investment Guarantee Agency (part of the World Bank).

Many of the most successful infrastructure projects involve insurer(s) taking a proactive approach to help owners and developers avoid delays and help prevent costly losses from occurring. From detailed risk analysis to on-site surveys, safety programs, regular monitoring and other measures, insurers with loss control engineers and consultants can supply services that substantially reduce the frequency and severity of claims.

With the right approach, insurance can become more than a necessary precaution, it can become a financial tool that can promote the efficient use of capital, improve access to financing and help optimize the project's rate of return.

Leonard J. Battifarano is senior vice president and managing director of the Global Infrastructure Division of Reliance National, a principal unit of Reliance Group Holdings, Inc., New York.

Footnotes:

1. Source: Chile's Ministry of Public Works, as reported in Infrastructure Finance, July/August 1997 issue.

2. Based on World Bank estimates.