Contract certainty:

risk implications of carelessly worded power contracts

Contract certainty: risk implications of carelessly worded power contracts

Introduction – the handshake seals the contract, from the contract there’s no turning back…It’s a safe bet that when negotiating financing agreements, Operational & Maintenance (O&M) contracts, long term service agreements or any of the other contracts that are among the necessary evils for the power generation business in the 21st century, insurance is not one of the first areas to which the contracting parties turn their attention.Yet most of these contracts will contain insurance or related provisions, for example:

requirements on the contracting parties to effect specified types of insurance to prescribed levels

liability and indemnification clauses which can have a material impact on the circumstances in which these insurance policies can be triggered, and insurers’ rights under them

the steps which an Insured would be wise to take to minimise the risk that insurers might be able to deny coverage in the event of a claim

Sometimes lack of care or precision, or the absence of input from an insurance specialist at the drafting stage, can create:

unnecessary cost or other burden for the Insured

contractual obligations that are impossible to comply with or may not have the effect that is intended

the need for specific disclosure to underwriters in order to protect the Insured’s position under the insurance contract

This article examines some of the commonly seen areas where better contract drafting would benefit all parties.
Absolute obligations which are dependent on the acquiescence of third partiesContracts may place an absolute obligation to do something which is beyond a party’s ultimate ability to deliver. An example is the common requirement of lenders for the borrower to procure that its insurance broker signs a broker’s letter of undertaking (‘BLU’) in the form set out in the finance agreement.Brokers will usually do their best to help their client comply with this obligation, but ultimately they are not a party to the contract and have their own interests to consider. Signing a BLU will usually expose a broker to potential liabilities that would not otherwise exist, and there might be sound business, regulatory or compliance reasons why they cannot sign the BLU in the form presented – which would put their client in breach of an absolute contractual obligation to procure that they do. While reasonable variances in the presented BLU can usually be agreed with the lenders, the possibility of the borrower being in breach can be mitigated if the obligation to procure the BLU is expressed in ‘reasonable endeavours’ (or similar) language.
Impossible obligations

Some contracts require the lenders or other contractual party to be given a prescribed period of notice (usually between 30 and 60 days) if an insurer intends to cancel. While it is usually possible to obtain insurers’ agreement to give this notice, they will usually not agree to a period of this length in the event of non-payment of premium.Non-payment should therefore be stated as an exception from the general 30/60 day notice period in the contract.Contracts often also contain provisions relating to non-renewal, for example: “Failure to renew all policies at least 30 calendar days prior to their respective renewal dates shall constitute an Event of Default.”Experience suggests that this type of provision is one of those that are more honoured in the breach than the observance. It is rare for renewals, especially for the more complex and challenging types of insurance, to be concluded this far in advance – the Insured would be giving up some of his negotiating leverage with insurers by doing so, while for their part insurers may be reluctant to bind this far ahead of renewal date.

Waivers of subrogation

Requirements under contracts for subrogation waivers to be included under insurance policies are ubiquitous, but are often superfluous. When insurers seek to subrogate against a third party they do so in the name of the Insured, and ‘step into the shoes’ of the Insured, acquiring the same rights of recovery as the Insured. So if rights of recovery have already been ceded under contract between the Insured and the culpable party, the insurer has no right of subrogation against that party to waive.If rights of recovery have not already been waived under contract, an insurer could reasonably ask why the insurance policy, rather than the liability clause in the contract, is being used to effectively determine the parties’ liabilities. Having a properly worded liability clause in the contract removes the need for awkward discussions with underwriters about waiving rights that they might be expecting to retain.Subrogation waivers and limitations of liability should also be treated with care in a couple of other aspects:

Under Long Term Service Agreements and similar contracts, the LTSA contractor is often a subsidiary or associated company of the original equipment manufacturer (‘OEM’). The wording of the kind of subrogation waiver that is usually required under an LTSA should be clear that subrogation is waived only in respect of the LTSA entity and its activities under the LTSA, not the wider company – otherwise the waiver could inadvertently prevent insurers from subrogating for losses that are covered under the OEM’s warranty.

Insureds should consider whether any contractual waivers of rights go beyond what would normally be expected in contracts of a similar nature, and/or would be considered material by a prudent underwriter. If so, they should be disclosed to insurers when negotiating the terms of the insurance. This illustrates the fact that it is not just the contractual insurance clauses that need to be reviewed when taking out insurance – the liability clauses can be just as relevant.

Linking liability with insurance provisions

A contract may attempt to link the extent of a party’s liability to the provisions of the other party’s insurance contract. One example is where a contractor accepts liability under an LTSA or other contract for damage that he may cause to the owner’s property, up to a limit that is intended to reflect the deductible in the owner’s Property insurance. The idea is that the owner will be indemnified for the bulk of his loss by his insurers, and the contractor will pay him the amount that the insurers dock from the claim as the deductible, thereby making the owner ‘whole’.In practice, this may not work in the way that the contractual parties intend. The owner’s policy may exclude losses to the extent that the Insured has collected, or is entitled to collect, from others. Consequently, insurers may consider that the amount for which the contractor is liable is excluded from the claim; they will therefore reduce the claim by the amount payable by the contractor, and then apply the deductible, ensuring that they, and not the owner, get the benefit of the contractual liability provision. The owner should therefore make sure that the wording of his policy is consistent with the intention of the contract, or seek to include a specific provision to this effect in
the policy.
Contradictory obligations

As noted at the start of this article, many types of contract contain insurance requirements. What happens when the requirements of one contract are not consistent with the requirements of another? If the lenders’ Facility Agreement requires a minimum insurer rating of A- but the O&M Agreement stipulates a minimum rating of A, the lowest (or in this case highest) common denominator might have to apply (unless a dispensation is obtained under the O&M Agreement), limiting the Insured’s options and probably adding to the insurance costs – even though the Facility Agreement might be considered the more important and authoritative contract.

Other contractual issuesOther examples of carelessly worded contractual conditions include:

The absence of a ‘Market Availability’ clause from lenders’ and other contracts that stipulate minimum insurance levels, which would mean that a party would not be in breach if the mandated insurance obligations are not achievable in the commercial insurance market, at least at commercially reasonable term – given that there are likely to be significant fluctuations in insurance market conditions over the term of a multi-year contract, such a provision is essential.

Obligations to buy insurance for non-existent or negligible exposures, such as professional indemnity insurance for an independent power producer, which provide no benefit to anyone except the insurer who receives a premium to cover a risk from which the chance of a claim arising is close to zero.

Clauses stipulating minimum levels of insurer or reinsurer security which only reference one rating agency; for example, a requirement to utilise carriers rated no lower than A- by S&P means that any that do not have an S&P rating would not meet this criterion, even if they carry a perfectly respectable rating from AM Best or another reputable agency, and so could not be used without obtaining specific dispensation from the lenders or other counterparty.

Circular provisions, for example liability clauses which make one party liable to indemnify the other for third party claims to the extent that he obtains indemnity under his liability policy; a liability policy generally responds insofar as the Insured is legally liable, but here his liability is to be determined by the policy, a kind of Catch-22.

Conclusion – early engagement of insurance specialists essentialThe involvement of the Insured’s risk manager and/or their insurance broker at the time these contracts are being negotiated will allow for a coordinated approach and minimises the risk of agreements being signed which contain impossible, contradictory, unnecessary or other disadvantageous insurance-related clauses with which the Insured will then be contractually obliged to comply, or for which time and effort will be needed to be spent agreeing waivers. Although many of the issues discussed arise during the operation of a power plant or other facility, many of the contracts themselves are signed before the project has even commenced construction. Early engagement from both construction and operational perspectives is therefore essential.As a general rule of thumb, the looser and less specific the contractual insurance requirements, the better it will usually be for the Insured – they will have greater flexibility over securing the best value for money coverage, and the risk of a clash between specific contract conditions will be reduced.

David Reynolds is Executive Director at Natural Resources P&C, Willis Towers Watson.