Following on from guidance issued in December 2005, HM Treasury issued its fourth edition of the ‘Standardisation of PFI Contracts’, commonly known as “SoPC4”, back in March 2007. As with its predecessors, SoPC4 contained standard wording and guidance to be used by a public sector party (termed under SoPC4 as “the Authority”) when drafting PFI Contracts.
Between the issue of HM Treasury’s guidance in December 2005 and the Government’s withdrawal of PFI/PF2 as its preferred model of large-scale PPP investment in October 2018, close to 300 PFI agreements were let in respect of various civil infrastructure projects - ultimately leading to the construction of dozens of new hospitals, schools, roads, prisons, waste management facilities, military barracks, and housing developments, up and down the UK. The majority of such projects will have utilised SoPC4 standard drafting in their PFI Project Agreements.
Insurance premium risk sharing under SoPC4
Under SoPC4 standard drafting, responsibility for insuring a PFI project lies with the private sector contracting party - known under SoPC4 as “the Contractor”. With the operational phase of a PFI project often spanning decades, it is not usually practicable for the Contractor to place an insurance policy covering the full term. Rather, policies are typically placed by Contractors on an annual basis. The Contractor will then seek payment of premiums for insuring the project as part of the Unitary Charge charged to the Authority for the services.
SoPC4 provides for an optional contractual mechanism whereby the effect of market wide changes on the costs of maintaining operational phase insurance under a PFI contract are shared between the parties. Under such an insurance premium risk sharing regime, in circumstances where premiums increase above a specified threshold due to market movement (as opposed to say, an Authority Change in Service) both parties bear the cost of such an increase in defined proportions. Similarly, where market forces (as opposed to say, the introduction of an active risk mitigation measure by the Contractor) drive down the cost of premiums then savings are to be shared between the parties in the same proportions.
In principle, such a mechanism can reduce costs and improve value for money. Consider an alternative for a moment: in long term contracts (and, as above, a PFI Project Agreement may run for up to 30 years), a prudent contractor will often look for protection from the risk of an exceptional rise in insurance premiums during the course of the contract by building in contingencies within its price. An appropriately drafted insurance cost/gain share mechanism can obviate the need for this. Setting the trigger for the sharing mechanism at the right threshold – under SoPC4, the Contractor takes the first 30% of any relevant change in insurance cost as well as 15% of any relevant change in excess of 30% - then ensures the Contractor remains incentivised when it comes to reducing premiums at the renewal stage.
Market conditions and actual insurance costs
Under SoPC4, changes in insurance costs are assessed against Base Case, being an amount set out in the contractual financial model and representing the projected costs of insuring the project over the operational period. SoPC4 notes that Base Case “should be set at a long run median level, such that the probabilities of the outturn costs being higher or lower in the future (after adjusting for inflation) are the same.” [1] In practice, most Base Cases were modelled assuming a steady increase in insurance premiums throughout the operational period to account for assumed future market fluctuations.
Putting aside forecasts, projections and assumptions, which are necessarily inherent within any future looking financial model - how has the PFI insurance market, as a matter of fact, fared in recent years? Well, it is generally accepted that the insurance market has significantly softened since the mid-2000s, with project insurance premiums either holding steady or, in some sectors, significantly decreasing.
Is the public sector receiving its share of savings?
Given such favourable market conditions, in many cases, the actual costs of insuring a PFI project have been significantly lower than that assumed in the project Base Case. In theory, therefore, in such cases, the operation of the insurance premium risk sharing regime (where utilised) should have resulted in a sizeable, and potentially recurring (depending on future conditions), rebate to the Authority.
However, the experience of Burges Salmon’s Construction & Engineering team suggests that this may not always be the case.
Having acted in a successful adjudication on behalf of one public sector client, we are aware that some Contractors (or, perhaps more accurately in some cases, their appointed insurance brokers) are wrongly attributing reductions in premiums to factors other than market conditions – erroneously alleging, for example, that cost savings are due to positive (but unspecified) actions attributable to the Contractor. In some instances, the effect of this is to artificially reduce the Authority’s due share of insurance savings by hundreds of thousands of pounds each year.
The need to act fast
Given the potential sums at stake, it is important that parties familiarise themselves with the insurance cost/gain share mechanism in their PFI Project Agreement and, where relevant, seek advice as to whether these have been properly applied. If the relevant contractual provisions have not been duly followed, then a challenge to the basis of assessment, alongside a claim for repayment, may well be warranted. Be warned, however; many of the insurance premium risk sharing regimes prescribe a tight deadline by which the Authority must challenge the Contractor’s assessment of sums due. Therefore, it is imperative that Authorities – be that central government, local authorities or NHS trusts - be alive to these tight timetables and act promptly.
For the private sector, it is vital that the insurance sharing assessment reports prepared by their insurance brokers are properly scrutinised before submission. In circumstances where it is concluded that the introduction of specific measures have reduced project risk, and thereby reduced premiums, then it is vital to ensure that such specific measures can be identified and quantified – otherwise Contractor’s may face an adverse re-application of the sharing mechanism, resulting in repayment of significant sums to the Authority. In such circumstances, Contractor’s may well be considering the adequacy of the advice received from their brokers.
Getting the right support
Assessing, pursuing and (where necessary) prosecuting due entitlement under such PFI insurance cost/gain share mechanisms will often require highly specialist legal expertise. Burges Salmon’s market leading Construction & Engineering dispute lawyers have together acted on dozens of PPP/ PFI disputes and have direct experience of advising clients in respect of the proper application of their contractual insurance premium risk sharing mechanism, having worked with leading insurance experts to successfully adjudicate claims within this complex and developing area of law.
If you would like any advice in relation to your PFI insurance premium risk sharing mechanism, or in respect of issues arising under your PPP/ PFI agreements more generally, please contact Jessica Evans or Tom Weld.
[1] SoPC4, paragraph 25.8.1