Speed and Savings
The dilemma of limited public sector budgets and crumbling infrastructure may have found a cure. The state of Pennsylvania took advantage of recent developments by surety bond underwriters to help secure an aggressive program to replace bridges around the state.
Surety bonds are required for work done by government entities, but this is a public-private partnership, so letters of credit were an option. But the sponsor, the state Department of Transportation (PennDOT), decided to use a surety bond program using new elements that included a fixed claims-determination process, and also liquidity provisions to ensure that work could continue during a claim.
The Rapid Bridge Replacement Project (RBR) is addressing 558 structurally deficient bridges across the commonwealth under a design-build-finance-maintain public-private partnership (P3) arrangement between PennDOT and Plenary Walsh Keystone Partners — the joint venture concessionaire, owned 80 percent by Plenary Group USA and 20 percent by Walsh Investors.
“This feature, which is more seen with contractor performance bonds in Europe, reduces the period of uncertainty in relation to a claim from a surety and for that reason it is assessed in a positive way from rating agencies and lenders.” — Michael R. Bonini, director, Public-Private Transportation Partnership Office, PennDOT.
Plenary Walsh is responsible for demolishing the existing bridges, maintaining traffic during construction, and then maintaining the new bridges for 25 years following construction. PennDOT will retain ownership of the bridges throughout.
It is the largest road project in Pennsylvania history.
Most of the bridges included in the program range from 40 to 75 feet in length and are located in rural regions on the state highway system.
The RBR is the first project to be completed under Pennsylvania’s 2012 P3-enabling legislation.
PennDOT said it chose the P3 structure to accelerate the replacement of the bridges and facilitate efficiencies in design and the construction of bridge components. This has resulted in a 20 percent cost savings over the life of the concession period, compared to PennDOT’s replacing the bridges itself, according to the agency.
Substantial completion of the project is expected on Dec. 31, 2017. Total cost is $1.119 billion; the design-build contract is for $899 million.
PennDOT said the batching of the projects will allow the bridges to be replaced and maintained at an average cost of $1.6 million each versus $2 million each if completed by PennDOT.
Commercial close occurred on Jan. 9, financial was March 18. Construction on the first bridges began this summer, and the bridges will be completed in batches. Substantial completion of the project is expected on Dec. 31, 2017. Total cost is $1.119 billion; the design-build contract is for $899 million.
“The key feature of the performance bond used for the Rapid Bridge Replacement project that is different from more traditional ones is that it spells out a specific process about accepting claims, dispute resolution and how long such a process can take,” said Michael R. Bonini, director of the Public-Private Transportation Partnership Office at PennDOT.
“This feature, which is more seen with contractor performance bonds in Europe, reduces the period of uncertainty in relation to a claim from a surety and for that reason it is assessed in a positive way from rating agencies and lenders.
“For PennDOT, this means a more streamlined process in relation to timely completion of the project and access to this mechanism if the contract is terminated and the design-build contract is assigned to PennDOT.”
New Delivery Method
Surety bonding is “in a state of rapid development,” said Michael Bond, head of surety for Zurich, which was a participating surety in the RBR. “This is a new delivery method in the U.S.
“The enabling legislation for P3 programs does not necessarily specify surety as opposed to letters of credit or other forms of performance security. Letters of credit have been used worldwide to provide liquidity to a project, but they don’t protect subcontractors.
“Performance bonds also cover payments for labor and materials. That ensures workers and suppliers are covered.”
“The Pennsylvania program is a very creative example of how the public works and surety industries are responding to current needs.” Michael Bond, head of surety, Zurich
Bond said that the innovations in the RBR program address some of the prevailing concerns about surety, namely the uncertainty of the claims process, and the possibility of untimely payments, that could cause a liquidity problem for the project.
“The Pennsylvania program is a very creative example of how the public works and surety industries are responding to current needs,” said Bond.
To be clear, the surety bonds are different from the public-works bonds or funding bonds that are issued by the state authority and actually pay for the project.
The surety bonds provide performance security that the concessionaire, Plenary Walsh in this case, will complete the project satisfactorily. If there is a default, there would be a call on the bond and the surety would step in to work with the authority and the contractors to complete the project.
“What is new and different is that in a traditional public-works project the government is the owner and counterparty to the contractor,” said Bond. “In the P3 model, the counterparty is a private entity created to execute the project.”
He added that while such a special-purpose entity has some advantages over traditional public-works operations, it also has some proscriptions. Notably, the project is funded on a limited-recourse basis, so if there are cost escalations or unforeseen expenses, the concessionaire cannot dip into the government pockets to cover. There is some contingency, but it is limited.
“This is the next level in construction [risk management],” said Doug Wheeler, regional managing director for construction services at Aon Infrastructure Solutions. Aon was the broker for the contractor.
A European Model
“This alternative project delivery model came out of Europe and into Canada, then into the U.S. There is more legwork up-front, but there are dozens of projects already on board. Pennsylvania is a big proponent, New Jersey is almost there [with enabling legislation], but Governor Christie vetoed the most recent proposal. In New York, there has been a push.”
This is a very exciting time in public works and surety, said Aon’s Grace Drinker, senior analyst of infrastructure.
She stressed that even though the P3 process is different than the traditional design-bid-build approach, “there are still checks and balances aplenty in P3. There have been P3 contracts cancelled because of oversight and scrutiny.
“There is no risk to public safety or the public purse in the P3 process,” Drinker said. “What it does is bring operating efficiency to infrastructure.”
With the P3 approach, she said, “it is possible to have a higher initial cost, but the operating efficiency over the 30-year lifecycle of a project is a net savings. There is a real value for money in this.”
Drinker added that “contractors prefer to use surety capacity to letters of credit capacity to meet lender requirements on projects.”
Wheeler concurred that contractor preference is a big piece of the puzzle. “Surety is more efficient for the construction industry.” He added that capacity in surety is finite, but not a concern.
“Bundling the bridges allows them to be replaced faster and cheaper,” said Steve T. Park, senior associate with Ballard Spahr in Philadelphia, the bond counsel to PennDOT.
“The typical design-bid-build process would have taken longer. They selected bridges that could be easily bundled, designs that were similar, so they could fix the most in one program.”
There was equal diligence on the other side of the table.
“We spent a lot of time de-risking the program,” said Sarah Roberts, president of Intech Risk Management, insurance advisers to the concessionaire.
“We spent a lot of time de-risking the program.” — Sarah Roberts, president, Intech Risk Management
“When people hear 558 bridges, the initial perception is that they were not certain it could succeed. But the project is actually easier to manage with a lot of bridges than it would be for a single project of the same size.
“With a single project, if there is a delay, the whole timeline is thrown off. With so many bridges, it is possible to swap out one for another and work around delays to keep the whole project on schedule.”
She is sanguine about the growth potential for P3 projects in the U.S., at least in the long term.
“I don’t think we are there yet in P3 in the U.S.; there is still a lot of coming of age to do. In this case, the P3 model had a direct benefit to the owner, PennDOT, and indirectly to the taxpayers of the state.”
Lynn Schubert, president of the Surety & Fidelity Association of America, confirmed that P3s, and most public construction in Europe are protected by letters of credit.
“In the U.S., our public construction prefers performance bonds for completion and payment. But the concern of the ratings agencies is the speed with which surety bonds are called upon.
“In the Pennsylvania [project], the contracts include a quick-resolution process. It is a little extra piece, but it is very exciting.”
A Possible New Market
Government regulation is often portrayed as the bane of free markets, but in the case of new rules governing electrical power generation in the Northeast and Midwest, regulation is actually creating a new and specialized insurance market.
After a series of electricity shortfalls over the past few years, two regional power wholesale organizations in the eastern U.S. now have federal approval to institute a system under which generators that fail to provide the power they have promised at peak times will pay for the cost of replacement power. In one interesting twist, it is not so much the risk that is emerging, but rather the risk-transfer market itself.
Last year, ISO-New England (ISO-NE) got approval from the Federal Energy Regulatory Commission (FERC) to institute a system of charges and payments. In July of this year, PJM, the regional transmission operator for a wide swath of the Middle Atlantic and eastern Midwest, also got FERC approval for a similar system.
The United States and Canada are divided into regional independent system operators (ISOs) and regional transmission organizations (RTOs), which differ only in a few legal senses.
It is straight cost of replacement for non-delivered goods, in this case, electricity.” — Matthew White, chief economist at ISO-NE
At present, ISO-NE and PJM are mandatory markets, where all power providers must participate and mandatory charges are in place. Others are voluntary.
Utility industry organizations note that pending federal legislation could recognize the preferability of mandatory participation and payment systems, but that is a long way from being passed and signed into law.
Even though the ISO-NE and PJM regimes were approved at different times, they both go into effect with the delivery contracts starting in June 2018. Those contracts have already been bid and accepted, and in most cases power generators have already figured the costs into their rates.
The purpose for the new rules is to ensure sufficient power at peak demand, especially during hot summer days and winter storms. The charge-and-payment system is a double-settlement contract, standard in commodity markets.
If a supplier fails to provide the commodity — grain, oil, power — in the agreed amount at the agreed time, the supplier has to pay a set compensation, which the buyer then uses to fill the gap on the spot market. It is a straight transfer to ensure delivery.
“These are fully insurable risks,” said Matthew White, chief economist at ISO-NE.
“It is straight cost of replacement for non-delivered goods, in this case, electricity. Insurance is a critical part of our ability to deliver power, and we considered the insurability of the risk in market design whenever we make significant changes.”
It is also important to note that the core purpose of the new regimes is to encourage generators to invest in their infrastructure, operations and reliability.
Seeking a Just System
Both ISO-NE and PJM have said that they would much prefer that all their generators provide every watt they have contracted to supply. But realistically that won’t happen, so the new arrangement, they hope, will enable timely, transparent and fair replacement power.
“There are no penalties in our design,” White said. “This is a true two-settlement obligation, just like any other commodity contract.
“We know that penalties are not insurable, so we were careful not to structure the market that way. This is covering a short position where every party knows the terms.
“The risk can be indexed to a transparent development outside the control of the insured, so there is no moral hazard. Insurers can model the system.”
Insurers are doing exactly that. Manfred Schneider, head of engineering in North America for Allianz, confirmed that fines or penalties would not be covered under standard business interruption (BI) coverage.
“We are working with our alternative risk transfer group looking for financial solutions to this non-typical exposure. We have to find the framework, the limits, the exposures. This is not just something you can lift out of the drawer.”
Schneider said that it could take another six to 12 months for Allianz and other carriers to work through the full underwriting, including assessing the needs, costs and potential size of the market.
A History of Coverage Ambivalence
One important concern for underwriters is that owners may choose not to buy policies after they invest time and effort into developing coverage for generators’ exposure under the new rules.
That would not be unprecedented.
One carrier recalled that BI coverage was not triggered when an ash cloud from a volcano in Iceland essentially locked down all transport in Europe for more than a week in 2010 because there was no physical damage.
Raw materials, inventory and parts could not be delivered, and many operations were halted. Insurers developed new policies, but owners deemed them too expensive and did not buy them.
“This is very new and we are being very careful.” — anonymous electricity industry source.
The same thing happened after Hurricane Ike swept over the Gulf Coast in 2008.
Cities were evacuated and refineries and chemical plants had to close for lack of workers. The storm did relatively little damage, but plants incurred the costs of shutdown, idleness and restart.
Again, at least one carrier developed “spin-down” insurance to cover such non-damage costs, but owners did not buy it.
“Swiss Re has seen a sharp increase from risk managers, CFOs and the heads of power trading inquiring about coverage options for generators participating in binding capacity performance markets,” said Brian Beebe, head of origination in North America for environmental and commodity markets with SwissRe Corporate Solutions.
“Since the magnitude of potential penalties for generator non-performance is extraordinary — millions of dollars an hour for a 500 Mw plant — the risk mitigation topic has been elevated within generation company senior management, including boards of directors.
“In response, generator risk managers and insurance brokers are seeking a variety of forward starting coverage options for key generation capacity.
“Clearly, the evolution of increased transparency and client knowledge of generator capacity prices is underway in deregulated markets. However, in traditional regulated utility markets, I do not see evidence that these areas are adopting any type of market-based mechanism to encourage generator availability.”
The high penalty charges have indeed caught the attention of corporate boards at generators, and they are pressing their risk managers for answers.
None that Risk & Insurance® contacted were willing to speak publicly, given that the situation is in flux and that they have to report first to their boards.
A significant concern among risk managers is not the availability of risk-transfer options, but the price, terms and conditions.
Several large generating companies serve both ISO-NE and PJM. Those contacted did not reply or declined to comment citing “competitive issues.”
One official observed, “This is very new and we are being very careful.”
It is expected that some of the larger corporations will retain the risk posed by the charges. That expectation in turn is making some risk managers anxious that lack of demand will limit participation by carriers and keep rates high.
Only time will tell how broad and deep this risk-transfer market becomes, and where capacity and rates settle. But one other concern raised about the new charge-and-payment scheme can be addressed. There has been a thought that small generators, especially those in renewable power, are essentially shut out, because they cannot commit to large delivery contracts.
That is not the case, said ISO-NE’s White.
“We know the status of every generator, updated every few seconds. If a wind generator cannot make a commitment to deliver, they don’t get the up-front payment, but they can be on standby.
“If the wind is blowing and they can supply during a delivery event, we will pay them the rate same as anyone else.”
Lower Investment Income Impacting Carrier Appetite
The impact of investment income on carrier financial performance is changing the insurance industry and the availability of coverage, according to a presentation at the Brokerslink annual conference held in New York on Oct. 16.
Robert S. Schimek, president and chief executive officer of the Americas for AIG, said there is a bifurcation among carriers as a result of the continuing low interest rates prevailing in many industrialized countries.
There are only two sources of income for insurers: underwriting profit and investment, Schimek said.
“Investment income depends upon the yield curve. When it is low, as it is now, then getting the underwriting part correct is all the more important.”
Schimek said that insurance companies view coverage differently when interest rates are low.
“Returns on excess workers’ comp are the worst because they stretch over 16 years. So our appetite for that type of coverage is less today than it was when interest rates were higher.” — Robert S. Schimek, president and CEO of the Americas, AIG
“Returns on excess workers’ comp are the worst because they stretch over 16 years. So our appetite for that type of coverage is less today than it was when interest rates were higher,” he said.
Expanding on that theme, Schimek said that “people ask me, ‘What happened to the old AIG?’ They say, ‘Give me that swagger and take that risk.’ I reply that you give me investment income and I will take that risk. But we cannot do it at current interest returns.”
Careful to draw a distinction but not make a value judgment, Schimek said that as a result of the underwriting-investment situation of the last few years, insurance companies have tended to reconfigure themselves into two different types.
“The environment in our industry is changing because of the macroeconomic factors,” he said.
One carrier type is capital heavy, and focused on policies. They are typically non-primary insurers, but high risk takers, and very efficient, he said.
“Today, there are 10 to 20 billion things connected to the Internet,” he said. “By 2020, there will be 40 to 50 billion things in the Internet of Things. That is changing the landscape of risk.” — Robert S. Schimek, president and CEO of the Americas, AIG
The other type, that includes AIG, according to Schimek, is focused on loss control, claims handling and science. They tend to be primary insurers, with the focus on underwriting and science; less efficient in a pure profitability sense.
The global environment is also impacting insurers, he said.
The yield curves vary not just in time and with type of coverage, but in different economies. One useful normalized comparison is combined ratio, he said, noting that a combined ratio of 100 in the U.S. is equivalent to 94 in Japan, a country with low inflation, and 111 in Argentina, a country with high inflation.
He also noted that the 100 in the U.S. was comparable to just 80 in Greece, which he suggested should decouple its currency from the euro — although that now seems less likely than it did earlier in the year.
“In the U.S., AIG now has more engineers than underwriters,” said Schimek.
He noted that the day before the conference, AIG appointed Madhu Tadikonda, who had been commercial chief science officer, as commercial chief underwriting officer.
Tadikonda now oversees chief underwriting officers in the commercial insurance group’s global lines. He will define global underwriting standards. Drawing on his science background, he will also oversee development and deployment of underwriting tools to make use of the company’s considerable data set and capabilities, Schimek said.
“The focus is on differentiation, our ability to control and reduce risk. The battleground used to be premium — who can charge the lowest. We are now moving on to total cost of risk so the competition is no longer commoditized in a battle for premium.”
AIG chooses to be among those differentiating themselves on risk management, he said, because risk is changing so quickly, citing the examples of drones, railroads and driverless cars.
“Today, there are 10 to 20 billion things connected to the Internet,” he said. “By 2020, there will be 40 to 50 billion things in the Internet of Things. That is changing the landscape of risk.
“There are 40,000 drones flying today, and by 2025, there are expected to be 160,000. That will create huge new risks, but could also help manage risk. What if we could have flown drones over the area hit by Hurricane Katrina immediately after the storm, and made adjustment decisions, literally on the fly?”
As for driverless cars, he suggested that their appearance on the roadways are expected to reduce the many accidents caused by driver error.
“There will still be accidents, but the responsibility will be not on the occupants, but on the corporation that built or directed the car. That is how the nature of risk changes,” he said.
What if we could have flown drones over the area hit by Hurricane Katrina immediately after the storm, and made adjustment decisions, literally on the fly?” — Robert S. Schimek, president and CEO of the Americas, AIG
But risks remain among older industries as well. While dispatching systems for railroads are high tech, the sector remains an elemental heavy industry, relying on steel wheels on steel rails.
And there have been several high-profile accidents involving trains carrying crude oil.
“Our rails are not the most modern things you have ever seen,” he said.
So far all of the railroad accidents in the U.S. involving crude oil have occurred in areas with low or no population, unlike the tragedy in Lac-Megantic, Quebec, in July 2013, where a runaway crude train incinerated the center of that small town, killing 47 people.
New techniques in oil and gas production have enabled the U.S. to reclaim a top spot as a global producer, but if there is an accident in or near a major city, Schimek said flatly, “that will require an insurance response.”