Financing Costs in Construction: Unraveling the Complexity of Delay in Start-Up (DSU) and Advanced Loss of Profit (ALOP) Insurance

Large-scale construction projects, often spanning years and demanding significant capital, rely heavily on external financing from banks, private equity, and other financial institutions. For decades, a critical hurdle in securing this funding has been the inherent risk of delay. To mitigate this, a specialised insurance product—historically known as Delay in Start-Up (DSU) which provided initially coverage for debt servicing costs and standing charges (fixed costs), later evolved into insurance cover for Advanced Loss of Profit (ALOP), which also included coverage for any loss of profit generated by the project but lost due to the delay, emerged. This coverage is essential for project owners to assure lenders that loan repayments, i.e. the costs associated with the project finance, can be met even if the project’s scheduled start date is postponed due to insured perils like fires, floods, natural disasters or other covered risks.

DSU/ALOP insurance, therefore, plays a pivotal role in de-risking construction financing, making capital more accessible for complex, multi-year ventures.

The Evolution of DSU/ALOP Coverage

The initial purpose of DSU insurance was narrow: to cover the debt service—the principal, i.e. the loan amount itself, and interest payments on loans—that the project owner would incur during a delay period, as per the financing arrangements.

This concept evolved over time:

1. Initial Focus: Debt Service (Financing Costs): The policy provided coverage to ensure the project owner could meet their obligations to the lenders (banks, etc.) for the repayment of loans and interest should the scheduled start-up be delayed.
2. Expansion to Fixed Costs: Coverage was later extended to include fixed costs or ongoing operational expenses that continued to be incurred during the delayed period, even though the project wasn’t generating revenue.
3. Inclusion of Loss of Profit (ALOP): Eventually, coverage was broadened again to include the profit the project would have earned had it commenced operation on time. This comprehensive coverage is often termed Advanced Loss of Profit (ALOP).

Measuring Additional Financing Costs: The Core Challenge

A central complexity in DSU/ALOP claims lies in accurately measuring the additional financing cost incurred due to the delay. When a project is delayed, the insured is faced with debt service obligations—interest and principal repayment—without the anticipated revenue stream to cover them.

Double Indemnification Risk: Debt Service vs. Loss of Profit

When a policy covers both debt service and loss of profit, a significant risk of overlap or duplication of cover arises, particularly regarding the principal repayment component of debt service.

• Interest is a pre-profit expense and usually accounted for within the projects fixed costs and deducted in ariving at the net operating profit.
• Capital (Principal) Repayment is paid out of the net profit the project would have earned. It is not an expense to the company on the profit and loss statement, as it is a repayment of the loan amount, thereby reducing a liability on the insured’s balance sheet.

If an insurer pays the full debt service (interest and capital repayment) and the full loss of gross profit, the insured could receive a double indemnification for the capital repayment component—to the extent that the capital repayment is less than or equal to the forgone profit.

The ‘Actual Loss Sustained’ Principle

To adhere to the fundamental insurance principle of indemnity, DSU/ALOP policies typically include wording referring to the “actual loss sustained.” The goal is to ensure the insured is put back in the same financial position they would have been without the loss, not a better one.

If the insured receives payment for full debt service, including principal repayment, and this payment is greater than the profit the project would have earned, the insured is effectively put in a better position. This necessitates careful analysis to ensure that indemnification for principal repayment does not exceed the project’s lost profit (plus any actual profit that has been earned), thereby adhering to the ‘actual loss sustained’ mandate.

Further Complications in Financing Cost Calculation

Loan Conversion and Differential Interest Rates

Financing agreements often contain terms for loan conversion upon project completion. Banks typically apply different terms and interest rates for a project under construction (higher risk, higher rate) versus a project in operation (lower risk, lower rate).

A delay means the project remains in the higher-interest ‘construction phase’ for longer than anticipated. Consequently, the additional financing cost is often not simply the extended time multiplied by the initial debt service rate or simply the amount of loan repayment and interest accrued within the delay period, but rather the difference between the interest rate and payment terms that would have applied (the lower operational rate) and the terms that actually applied during the delay (the construction rate). This ‘but for’ scenario analysis is critical. This is, in practice, often overlooked, and simply the actual interest and loan repayment amounts are claimed and at times indemnified, without carefully considering the ‘but for’ scenario.

Directors’ Loans and Commerciality

Another layer of complexity stems from Directors’ Loans, where the project owners or shareholders provide financing and receive interest payments. These loans often carry much higher interest rates than commercial bank loans.

This raises two contentious issues for an insurer:

1. Commerciality: Is the agreed interest rate a commercial rate that should be covered, or should it be adjusted to a prevailing bank rate?
2. Nature of Payment: Since the payment of interest to owners can be viewed as an alternative form of profit distribution, and some DSU policies only cover debt service and fixed expenses (excluding loss of profit), a question arises as to whether indemnifying these payments constitutes covering a form of lost profit, which may not be covered under a purely DSU policy.

The ultimate decision on coverage rests with the insurer and legal advisors, but forensic analysis is essential to point out the nature of these financing arrangements and their impact on the claimed loss.

Conclusion

Project financing is a highly complex area of the construction industry, and for insurers in regard to policy cover provided for by DSU/ALOP policies. When DSU / ALOP claims arise, these demand a detailed review of sophisticated financing models and arrangements. Each claim is unique because financing agreements are inherently bespoke. For some projects, a delay simply postpones the repayment period, while for others, it means a more significant and costly delay in converting from high-interest construction financing to lower-interest operational financing. In most circumstances, only a detailed review of the underlying circumstances coupled with the specifics of the claim allows for the determination of the correct ‘but for’ scenario to calculate the actual loss to the insured.

As forensic accountants, we are uniquely positioned to delve into the minutiae of these agreements. Our role is to meticulously determine the true financial loss sustained by comparing the ‘but for’ scenario (no delay) with the ‘actual’ scenario (with delay), distinguishing between additional absolute costs and differences in financing terms. This detailed loss calculation is then referred to insurers and their legal advisors for a final determination on how these costs fit within the provided policy coverage.

By Markus Heiss.

The statements or comments contained within this article are based on the author’s own knowledge and experience and do not necessarily represent those of the firm, other partners, our clients, or other business partners.