Risk Mitigation Mechanisms (including guarantees and political risk insurance)
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This section looks at the different mechanisms products that are available in the market for project sponsors, lenders and governments to mitigate some of the project risks.
Some financial risks can be shared through financial instruments known as derivatives, futures contracts or hedging. For example, exposure to foreign exchange risk can be mitigated by swapping currency requirements with another market participant. Equally other risks such as interest rate risk can be managed through the use of derivatives. These arrangements are usually managed under the common terms set out in the International Swaps and Derivatives Association (ISDA) master agreement. Hedging arrangements will influence the cost of debt, and the breakage costs to be included in termination compensation. Hedge counterparties, or possibly a hedging bank, will be a party to the intercreditor agreement to formalize the sharing of security and arrangements on default. To the extent that hedge counterparties benefit from project security, in theory their hedges should also be limited recourse. Similarly, if hedge counterparties get paid out if they suffer a loss when they close out their hedge, then lenders will argue that they should share any windfall profits. These issues will be addressed in the intercreditor arrangements. Derivatives are used in many functions in project finance transactions, including The offtake purchaser may agree to bear interest rate risk, by indexing part of its tariff to cost of debt. However, such tariff adjustments to account for interest rate fluctuations are unlikely to be applied at the speed at which interest rate fluctuations can arise, creating a mismatch risk. Guarantees and other credit enhancement mechanisms can be used to mobilize fixed rate debt. Although the project participants may each provide insurance for the project, it is generally more efficient for the project company to provide or ensure provision of comprehensive insurance coverage for the entire project. In this way the interfaces between different insurance packages, the coverage provided by different insurance providers and the overlapping of the tasks performed by the various project participants will not result in overlapping insurance or gaps in insurance coverage. The lenders may require that insurance proceeds received by the project company, in certain circumstances or over certain amounts and at their discretion, must be paid to the lenders for repayment of debt. The grantor and the project company will want insurance proceeds always to be used for reinstatement of the works. This is contrary to the interests of the lenders and will be a heavily negotiated issue. Restrictions imposed by insurers and at law will need to be considered in this context. Required insurance may become too costly or unavailable. The project company will be required to have in place certain insurances, under the concession agreement and the financing agreement. The parties will need to agree how to manage risks that become "uninsurable", and the definition of this term. For certain risks, and in certain markets, the grantor may agree to be the insurer of last resort, effectively stepping in to insure risk in exchange for the payment of the premium last paid when the insurance was "insurable" or some other agreed rate. However, the grantor will want to be sure that the increased cost is not due to project company failure or actions. Applicable law may require insurance to be obtained locally, in which case the project company will seek to reinsure those risks internationally in order to obtain the higher-quality insurance protection. Local law may limit the extent to which reinsurance can be used. Lenders will likely seek cut through arrangements with reinsurers, to allow direct payment from reinsurers to the project company and or to the lenders. Get a snap shot below or click here to view the complete section.Hedging and Futures Contracts
Use of Insurance
Guarantee and Risk Insurance Products Provided by IFIs
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Visit the section on Risk Mitigation Mechanisms for general information on the topic.
Links to Guarantee and Risk Insurance Products
World Bank Group
Asian Development Bank
Inter-American Development Bank
African Development Bank
A number of regional development banks and development finance institutions (DFIs) also offer guarantee and risk insurance products.
Further Reading
- World Bank Group Guarantee Products Guidance Note by the PPP Resource Center, a product of the World Bank PPP Group. Edited by Victoria Delmon and Susanne Foerster, 2016. This publication summarizes key features of the guarantee products offered by each World Bank Group institution and highlights main similarities and differences among them, looking in particular to how these guarantee products may be used in support of public-private partnership (PPP) transactions for infrastructure projects in emerging markets. It is also available in Spanish - Productos de Garantía del Grupo Banco Mundial Nota de Orientación and French - Produits de Garantie du Groupe de la Banque Mondiale
- Review of Risk Mitigation Instruments for Infrastructure Financing and Recent Trends and Developments by Tomoko Matsukawa and Odo Habeck, Trends and Policy Options No. 4, Public-Private Infrastructure Advisory Facility (PPIAF) 2007.
Related Content
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Sources of Financing and Intercreditor Agreement
Project Finance – Key Concepts
Key Issues in Developing Project Financed Transactions
Risk Allocation Bankability and Mitigation in Project Financed Transactions
Government Support in Financing PPPs
Government Risk Management
Further Readings on Financing and Risk Mitigation
Additional Resources
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Type of ResourceAvailability and Terms of Insurance
Type of ResourcePolitical Risk Insurance
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