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Project risk management

Risks of international project insurance from a German perspective

Roland Gerds

Project risk management: Risks of international project insurance from a German perspective

The growing globalization with more than 200 countries worldwide and the steadily increasing participation of small and medium-sized enterprises requires that laws, guidelines and jurisdictions must be followed and complied with in the context of international business activities - i.e. to be "compliant". However, only some of the medium-sized companies are set up to perform this complex task.

In projects, the focus is on completion or handover on schedule, as delays can have major financial consequences for all parties involved. They may lead to unforeseeable losses in the planned operating result for a client, to payments of contractual penalties for companies, or even bad debt losses for financers. Centralized, comprehensive risk management across all risk areas can contribute preventively to risk mitigation or risk avoidance, but the avoidance.

Description of material risks

Natural hazards

They have a large share in project risks, are hardly controllable or predictable in detail. If they occur, the effects are usually devastating. A rising trend in number and degree can be noted worldwide. The global climate change, with the dangers varying geographically and changing within a year (hurricane season, monsoon), is often the trigger. For this reason, the project duration must be taken into account when assessing the risk.

Vulnerability helps to quantify possible risks. It describes the potential loss due to a possible occurrence of injury within a certain area and time period with the help of object- and process-specific vulnerability factors by establishing a functional relationship between the forces acting in a certain natural process and the resulting effect on affected objects. Further dependencies are the kind of object (consideration of various parameters such as condition, protective measures or building materials and construction method/technology etc.) as well as factors for the intensity of the event (pressure, speed etc.) and the resulting effect on the object (e.g. degree of destruction or damage).

In addition to direct damage, indirect damage (consequential damage) must also be included when assessing the overall loss. Evaluating the latter presents a major challenge due to its often delayed and long-term effects.

Losses and their negative impacts depend on a large number of influences which are, however, experienced subjectively in different ways. The assessment of negative effects depends on the human system of values and is therefore complex.

There is no objective, quantifiable determination of risk. In consideration of vulnerability factors, the risk can be described correctly with the following formula:

Rso = f(pso, AOo, POo,ss, VOo,ss)

This formula demonstrates that the possible reduction of the risk can be carried out both on the acting side of natural hazards as well as on the side of potentially affected and damage-sensitive objects. Project Management should determine as early as possible who will carry out this examination and verification of a possible reduction amongst the project participants.

Further loss reduction can be achieved through insurance solutions, if the insurer can act as partner and provide preventive support with appropriate know-how, e.g. in the area of risk engineering.

Furthermore, existing local databases should be used prior to project planning to support risk assessment (in Germany, for example, the "Kompass Naturgefahren / ZÜRS - Zoning system for flooding, backwater and heavy rain"). Country-specific information can be obtained from the relevant local authorities. In addition reinsurers have the relevant information to record possible accumulation risks. This allows a significant risk minimization.

Geological risks

A not negligible risk factor with potentially catastrophic consequences, in particular in greenfield projects, lies in incorrect, underestimated or misinterpreted research results. Geology includes areas such as stratigraphy, geophysics, plate tectonics, structural geology and geomorphology. Consequently, the results of such studies should always be valued in relation to the project in question and its duration. Already documented or existing experiences are indispensable in order to provide reliable assessments and to derive preventive measures for risk reduction.

Particularly with new technologies - such as geothermal energy generation or fracking - special safety measures must be taken to prevent or minimize negative effects and damage. In geothermal energy production projects, for instance, extreme damage occurred as a result of uplift caused by the swelling of claystone or by mineral transformations in anhydrite- and pyrite-bearing rocks.

Corresponding databases are available at the responsible authorities in Germany. Supplemented by own sampling, risks can be assessed proficiently. To what extent such information is available in other countries and the qualitative significance associated with those can only be assessed with the appropriate expertise. Therefore, expenses for preventive measures in this area are significantly higher. Insurers can also be consulted preventively in order to discuss mutual measures and risk protection possibilities.

Communication risks

With large projects in plant construction (e.g. power plants or chemical plants), linguistic challenges are commonplace. During project implementation, well over 2,000 people could work at once on a construction site at peak times. In addition to general challenges such as accommodation and catering, the linguistic component is one of the biggest sources of error for all parties involved. The different measurement systems commonly used by employees (metric/Anglo-American system) also entail extreme risks.

Furthermore, the different understanding and knowledge of local occupational health & safety regulations should not be regarded as negligible; these regulations and instructions should be provided in other languages as well as the respective national language. This applies as well to trainings or instructions in order to reduce language and communication risks.

As there is no international standard for required qualifications in the industrial sector, one is dependent on country-specific training and regulations.

Recruiting trained specialists can also be a challenge if similar major projects are implemented at the same time. This may lead to delays in the project progression or excessive post-qualifications with a deliberately accepted reduction in quality. This can have a lasting effect on the contractual parameters. Therefore, each worker is required to complete a "qualified test work" in such projects to verify his or her qualifications and minimize risks in this area.

Intercultural risks

Major international projects demand a lot from managers. The gradual generation of a sense of cultural competence among all those involved presupposes knowledge of the causes, mechanisms and consequences of intercultural conflicts in working life, but requires also personal qualities such as openness and an appreciative attitude towards all cultures. Important areas such as rituals, values and procedures should not be underestimated. Intercultural conflicts are considered particularly complex and difficult.

Often they are not recognized as such and conclusions are drawn about personality and character, or perceived as intended provocation against one´s counterpart. Therefore, inappropriate treatment of others can be destructive and affect the interpersonal relationships of the project participants, culminating in ethnic bullying. In turn, this can lead to discontent amongst the workforce and result in an additional strain. The fact that discontent in the workplace leads to a decline in performance is not new knowledge. In particular ethnic bullying in the workplace is often ignored for too long, and the resolving and settlement of conflicts ignored. Often, intervention takes only place when the situation has escalated, and thus too late. Concrete consequences from a human resources perspective are suboptimal use of human resources, decline in motivation, innovation and productivity of the bullied group of people, increased absence, illness and error rates, as well as the rise of conflicts. This risk can only be reduced through targeted training and sensitization.

Political risks

The term "political risks" refers to all exposures to a project abroad which originate in the political circumstances of the investment country or government intervention in its economic life. These can include considerable delays in the transfer of loan instalments, profits and interest or even complete conversion and payment bans. Other political risks include sovereign measures such as nationalization and expropriation, or violent conflicts such as war or revolution. The political changes brought about by the "Arab Spring" in some countries have illustrated it. Simple legal changes, such as a change in the feed-in tariff for renewable energy projects, can cause projects being no longer financially viable.

German companies invest to a considerable degree abroad in order to generate location advantages or are temporarily / project-related active there. However, the general conditions may differ considerably from those known in Germany. This applies to cultural and economic aspects as well as legal and political factors. Foreign activities require special attention in order to avoid existential risks altogether. In particular political risks that are difficult to predict pose an extremely great challenge to the risk management of many companies. Therefore, internal risk management has become an integral part of corporate strategy for many companies. Based on a clearly formulated risk strategy, potential risks are systematically identified, evaluated, controlled and monitored.

Despite an excellently positioned risk management, companies often reach their limits in international activities. Political and legal developments that are quantifiable and calculable in their effects based on experience in the domestic market can become imponderables abroad that are difficult to evaluate. Challenges in dealing with local partners, e.g. due to differences in culture and mentality, can create additional problems in an engagement abroad.

Whilst economic risks are usually better assessable, it is difficult to predict the consequences of political risks in long-term overseas projects / foreign activities of companies. Not least due to demands of legislators (e.g. laid down in the Law on Control and Transparency in the Corporate Sector "KonTraG"), many companies have become aware of the question of how to deal with political risks. The KonTraG is intended to ensure that companies create structures which point out potential risks to decision-makers in a preventive manner, so they can be quantified at the earliest possible stage and appropriate measures can be initiated. In the event of concrete challenges, this should allow a timely and appropriate response in order to limit or prevent possible losses.

Effective and systematic structures for dealing with political risks are currently non-existent as integral part of the risk management process in many internationally active companies. Corresponding identification/evaluation as well as reporting and control are therefore very difficult to implement.

Consequently, the management of political risks should play a more prominent role in current risk management systems, as they can have a disastrous impact on the company's results. To manage these means to avoid or to minimize negative financial surprises. For this purpose, the insurance industry offers international solutions.

Contractual, legal and regulatory risks

During the project phase, unpredictable risks may arise due to changes in the legal basis (both locally and abroad). Examples include changes in regulatory requirements or the reinterpretation of existing laws. Unforeseeable risks arise in particular in case of longer project durations for the project or its financing. There is never a hundred percent protection, and total losses are possible.

A corresponding dynamic in sanctions law (e.g. embargoes, dual use goods) due to globalization can be observed and requires constant monitoring.

Contracts for work and services or General Terms and Conditions (GTC) may also entail such risks. Therefore it is possible for international construction projects, to rely on alternative and standardized contractual regulations such as those of the umbrella organization of consulting engineers, the "Fédération Internationale des Ingénieurs Conseils (FiDIC)". Finally, contracts should be drawn up in a universal language and the applicable law and place of jurisdiction should be specified in a binding manner. In addition, the subject matter of the contract, terms of payment/delivery and warranty provisions are to define clearly.

In summary, particular attention must be paid to legal risks due to their diversity and a possible total loss, in particular in the international sphere, as well as to the high requirements for updating, and would have to be classified in risk management accordingly.

Tax risks

Close attention is paid to fiscal requirements. Like legal risks, these are subject to a dynamic in the manifestation of their impact. A worldwide intensification of legal frameworks and an increase in investigative measures on the part of the authorities can be noted. Levying of insurance tax is common in many countries. An important criterion with regards to the latter is where the risk is located and its definition, based on the legislation of the respective countries. Particularly in case of international projects, the risks which are covered inter alia by construction and erection insurance, are manifold. Solutions include local covers, fronting policies, Freedom of Service (FoS), master programs, difference in conditions/difference in limits (DIC/DIL), non-admitted covers and financial interest cover (FInC) solutions.

The biggest challenge is to identify risks in order to reduce or avoid "blind spots" as far as possible. One of the core elements is the procedural design of a comprehensive "tax risk management system" with definition of a risk strategy and implementation of an analogous "risk policy" and monitoring function.
In general, the policyholder is responsible for the correct payment of the insurance tax. In order to be compliant, one characteristic of fiscal evaluation in project business is the location of risk or the territorial principle. The appropriate state legislation must be noted. Judgment II R 53/11 of 11.12.2013 of the German Federal Fiscal Court serves as an example. In summary, it was ruled that in the case of project insurance, the tax consideration of the maintenance/guarantee cover module is given in the country in which the device/plant is located and is finally operated. The consequences of this in the field of project insurance are manifold and pose enormous challenges for all parties involved.

Risks from compulsory insurance

National legislation require local compulsory or monopoly insurance for certain covers, e.g. cover against natural hazards and terrorism, whereby direct insurance and reinsurance exclusions (inter alia for war and nuclear energy) are not considered. As these are subject to certain dynamics, the following examples are merely a current review and neither comprehensive nor complete. Project-related verification is required.
Examples Belgium & France: terrorism or third-party liability claims, additionally in France Catastrophes Naturelles; Denmark: storm surge; Great Britain: terrorism; Norway: natural hazards; Spain: Consorcio and (outside the EU) South Africa/Namibia: political riot or USA: terrorism etc.

In addition to the country-specific requirements implemented to date, other special local requirements exist (e.g. "Cash Before Cover" in Mexico or India). This can also result in errors or risks respectively.

Risks from exported policy extensions

In Germany, project insurance often covers the client as well as all companies involved in the construction. This makes sense from a German perspective due to the corresponding legal framework (BGB, VOB) in order to minimize the challenges posed by possible demarcations. However, this understanding can lead to problems in other countries. In France, the "Assurance Décennale" (building contractors, engineers, architects, surveyors, suppliers of building materials) and "Assurance Dommages-Ouvrages" (client) should be mentioned as example for compulsory insurances.

Within the framework of the European freedom of services, local idiosyncracies and different regulations must be noted, which have extreme legal consequences and may therefore have a strong impact on the company. Reputation losses are also conceivable.

In addition, the coverage extension "Surrounding Property" can be found in the majority of project-related insurance policies. As this is a kind of third party liability cover for local goods, this part of the cover is to be regarded as a local risk. Hence, the resulting legal and tax aspects must be verified in each individual case. The extent to which other extensions of cover have to be considered in the respective legal area requires a comprehensive examination.

Human risk factor

More than 90% of the causes for losses in international project insurance business are attributable to human error. The impact can be graded from minor to catastrophic. Financial security via insurance solutions is common. Personal injury or poor project quality can also lead to delays which cannot at all or only be partially insured and, in extreme cases, may also lead to reputational damage that cannot be compensated. Therefore, measures must be taken in order to minimize risk factors emanating from human beings. In projects with special climatic conditions, for example, it can make sense to adapt working hours or simply provide water for the workers free of charge.

Summary

To summarize, risks in international projects are manifold and their possible impacts can be catastrophic. Complete risk avoidance is not possible, but minimization through comprehensive and company-wide risk management. Due to their complexity, conventional concepts available in the market must be fundamentally validated and adapted in order to achieve a corresponding minimization of risk. Particularly in the case of project-related working groups, uniform assessments must be performed. It is therefore recommended to install a project-related comprehensive risk management system.

Author:

Roland Gerds

[The text is based on a thesis of the author in the education program "Enterprise Risk Manager (Univ.)", which is offered by the Research Center Risk Management of the Faculty of Economics of the University of Würzburg]
 

[ Source of images: Adobe Stock ]


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