Posted in News on 06 Dec 2019

Over the last decade, Original Equipment Manufacturers (OEMs), particularly of gas turbines, have been under commercial pressure to enhance the efficiency and flexibility of existing technology resulting in unproven machines entering commercial operation with no or limited operating performance history.

As the Power Generation insurance market’s conditions harden, we are anticipating (re)insurers will be increasingly looking to avoid any potential issues that a new and unproven unit might experience shortly after testing and commissioning, or in the early commercial operational phases.

It is common practice for (re)insurers to categorise new turbines entering the market into the following generally accepted categories to protect themselves from manufacturer’s design issues:

  • Prototypical – Before the first 3 lead units have run issue free until first combustion inspection (previously around the 8000 hour mark, but now increasingly commonly prolonged until 10,000 – 12,000 hours).

  • Unproven – lead 3 units having run issue free and successfully completed first combustion inspection (previously around the 8000 hour mark, but now increasingly commonly prolonged until 10,000 – 12,000 hours).
  • Proven – lead 3 units having run issue free and successfully completed Hot Gas Path Inspection (previously around the 24,000 hour mark, but increasingly commonly prolonged until 32,000) hours. Any modification to the lead unit will usually dictate that said unit will need to be reclassified, and satisfy once again the required inspections at the stipulated achieved hour milestones.


Instances of losses caused by manufacturing defects on new models entering the market, and the subsequent downtime loss being elongated due to the need for OEMs to correct design issues, are forcing (re)insurers to adopt a tougher stance on these issues and require a much more detailed understanding of the small print with their OEM issued warranties.

Reinsurers have several ways in which they can look to provide themselves with protection against having to bear the manufacturing cost. Most commonly, through the application of a Defects Clause, they will look to usually exclude the cost of replacing a defective part, but cover Resultant & Consequential Damages. In some cases, where there is limited cover under the OEM’s warranty provisions and known technological concerns with a specific unit, then there might be further tightening of said Defects Clause to perhaps exclude consequential / resultant damages in the event of loss. In increasing circumstances, (re)insurers are increasingly adopting a stance of being reluctant to provide cover within the first twelve months of operations.

Whilst principally it is the early stages of a unit’s operational life that reinsurers are most cautious about, it is also throughout the running lifetime of some units where defect and design issues come to light. Tom Clifton, Head of Power EMEA for Liberty Specialty Markets states, ’Industry loss data tells us that a significant proportion of machinery breakdown events are a result of defects in material, design or workmanship caused by the original equipment manufacturer (OEM). These events are occurring at various stages of the equipment’s lifecycle, not only in the first few years of operation.’ Tom continues to state, ‘In more recent years insurers have discovered that many OEM warranties or Long Term Service Agreements (LTSA) are extremely limited in their scope for rectifying defects. Typically insurers only discover this during the claims adjustment process. This trend suggests that, due to commercial pressures, OEMs are pushing the balance of liability for defects towards the owner or customer and as a result the insurance market has suffered.’[1]

As an alternative to the standard market defects clauses, the LEG (London Engineering Group) defects clauses, more specifically aimed at construction projects, are also commonly used in operational policies:

  • LEG 1 – Most restrictive form. Outright exclusion for all loss / damage due to defects of material workmanship design plan or specification.

  • LEG 2 – ‘Consequences Model’ – Most similar to standard Defects Clause - Exclusion for the defective component part or individual item and access costs, but coverage for resultant damage provided there is damage to the defective portion.

  • LEG 3 – Full Coverage for both defective parts and resultant damage to property, but excluding the costs of improvement to original design, plan, specification, workmanship of materials.

Despite the fact that the LEG clauses are regularly used in Operational Power wordings, we urge our clients and clients’ advisors to be cautious with their inclusion. LEG 2, being most similar to a market standard defects clause, is more restrictive in a couple of key ways, most notably LEG 2 does not cover standard opening and closing costs -  which in the event of an event to a gas turbine, can very quickly escalate.

A correctly drafted policy should have a full Defects cover granted if the result of the defect is a Machinery Breakdown or Boiler Explosion. In such circumstances, we would expect the policy to respond to both the cost to rectify the consequential damage as well as the cost to rectify the defect itself following an insurable loss, something which is catered for in the Alesco Operational Risk Wording. The important point to flag here is the fact that this could not only affect the Property Damage (PD) cover but can have a commensurate effect on the Business Interruption (BI) Time Element cover too.

Whilst insurers can provide solutions for damages, clients should pursue warranties for defects. In a situation where defects have caused damages, wordings must be clear on which parties will respond. In some instances, (re)insurers will settle said claim, and then look to recover from the manufacturers’ warranty for the defects portion, depending on level of cover provided in the clause. In other situations, reinsurers will be very clear in the fact that Manufacturers warranties are to operate primary to any insurance, and will not respond in a situation where there is a loss which caused by defect / design error, regardless of whether they are able to subrogate against OEM or note.

Alesco’s expertise in the construction and operational phases of Power Generation projects will ensure that we are always able to provide our partners with valuable advice given our collective years of experience in advising clients and transacting on their behalf. If you have any questions or would like to discuss any of the topics raised in the article above, then please do not hesitate but to get in contact with anyone in our dedicated Power Generation team.


FOR MORE INFORMATION, PLEASE CONTACT

Matthew Savitt | Partner


T +44 (0)20 72 04 85 40 | E. Matthew_savitt@alescorms.com



[1] https://www.alescorms.com/news/alesco-news-power-market-update-october-2019

[2] Comments recorded in interview with insurer, October 2019.




 
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