Stemming the Spiralling Cost of Delay: Delay in Start Up (DSU) or Advance Loss of Profit (ALOP) Insurance Cover
20 June, 2016-
Markus Heiss -
EMEA
Delay in Start Up (DSU) or Advance Loss of Profit (ALOP) insurance cover is an absolute necessity for large and/or complex construction or engineering projects, particularly those financed with structured debt. This insurance was designed to provide cover for the economic losses sustained by a project owner and the financing consortium as a result of insured delays in construction that results in a delay in the commencement of commercial operation. Accidents in construction may lead to slippage in the construction program, pushing back the start date of commercial operations, resulting in financial loss as expected revenues fail to materialise whilst expenses continue. For many projects cover of this this type is mandated by the project funders or lenders, to ensure that expected profits and debt repayments are protected in the event of delays to the completion of the project.
Similar to business interruption insurance, DSU or ALOP insurance will provide coverage for the financial losses that are in excess of the agreed self-insured retention, or policy deductible. For DSU and ALOP the portion of self-insurance is usually expressed as a number of days and described as the time excess deductible or waiting period. As large and/or complex projects may result in a number of insured events, the delays resulting from the individual events are aggregated and delays are indemnified once the period of self-insurance is exhausted. Time excess periods can be any number of days but we see typical cumulative waiting periods as either 30, 45, 60 or 90 days.
DSU / ALOP: Variation in Coverage
Our experience as forensic accountants in dealing with DSU or ALOP claims highlights that brokers and underwriters should closely consider the definition of gross profit utilised in the proposals they structure. We have noticed that wordings and scope of coverage widely vary and may be particularly broad or place underwriters in the position of providing coverage which could be considered more in the form of a guarantee to pay certain costs, say for example debt servicing, which include interest cost and capital repayment rather than indemnifying the insured for its true loss. This condition occurs when the wording provides for payment of a company’s fixed expenses, interest expense or debt servicing without consideration as to whether sufficient income would have been generated to pay for these costs, had no delay occurred.
We have seen many examples when projects that would have been loss-making due to industry conditions at the planned date of commencement of business are indemnified for total fixed costs, effectively over indemnifying the businesses losses. This was likely not the intent of the policy. Often we have found that objectives of simplifying the wording and simply inserting alternative definitions of gross profit covering, for example, “all estimated fixed costs of the business, calculated as a percentage of expected turnover” place underwriters in an unexpected situation at the time the loss occurs. This wording would provide for payment of the total fixed cost, even if the company would have sustained a net operating loss. Further, simple wording changes, say for example “all estimated fixed costs of the business, to the extent these costs would have been earned by the business, calculated as a percentage of expected turnover” could overcome the issue.
Definition of Gross Profit
Problems can also arise from the use of loose definitions within the definition of gross profit. Most project owners see coverage for debt servicing costs of the business as the most important element of the policy, and one of the items we see as specifically identified within the definition of gross profit. However, we have seen the term “debt servicing” have a number of different definitions depending upon the individual. Some see “debt servicing” as simply the interest cost of servicing the debt. Others see the definition more broadly to include the interest cost of servicing the debt and capital repayments.
Further, we often see policies that clearly suggest an intent to cover only fixed costs but those costs are described as “debt servicing”. If no definition is provided in the wording, the true definition of debt servicing is the full cost of servicing the debt: interest (including that which is accrued during the construction period) and capital payments. Capital repayments are not a fixed expense but rather a payment made from the profits of the business, due at fixed points in time, based on a repayment schedule. The application of the true definition of “debt servicing” results in a measurement of loss that would include fixed costs and loss of profit. Was this the intent, to indemnify a loss of profit? Without a clear definition as to what is meant by “debt servicing” material differences can arise in the valuation of the loss.
Brokers and underwriters should consider the application of the proposed definition of gross profit by running various scenarios before the policy is underwritten to ensure it reflects their intentions in the event of loss, to avoid those awkward moments when it becomes clear the policy wording does not. These are not small issues, as the projects taking out DSU / ALOP insurance are typically construction projects many times in the hundreds of millions of pounds, and differences caused by the above issues can easily amount to tens of millions of pounds. Time well spent early on in getting these points right will help minimise the level of misunderstanding later and ensure the expectations of the parties are met when a loss occurs.
Published in Insurance Day – 20 June 2016.
The statements or comments contained within this article are based on the author’s own knowledge and experience and do not necessarily represent those of the firm, other partners, our clients, or other business partners.
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