In a three-post series, Jonathan Legge, a Senior Vice President at RT Pro Exec, is taking a look at the key insurance issues relating to Private Capital Investment. In the first of the three articles in the series (here), Jon examined the issues involved with getting the insurance for private equity-backed portfolio companies right. In today’s post, the second in the three-part series, Jon discusses transactional risk insurance, and in particular, contingent liability insurance. I would like to thank Jon for allowing me to publish his series of articles as guest posts on this site. I welcome guest post submissions from responsible authors on topics of interest to this site’s readers. Please contact me directly if you would like to submit a guest post. Here is Jon’s article.
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My prior post on Private Capital (here) discussed the importance of ensuring that portfolio companies had appropriate coverage to protect the private capital investor’s (PCI) financial interest, investment vehicle, and management team. In this post, I am going to discuss how PCI’s can use insurance at the time of a merger or acquisition to improve their bids and manage risks that could materially impair their investment post-closing.
Representations and Warranties insurance (R&W) is by far the best known and most widely used “transactional risk” product. R&W insurance reduces or eliminates the Seller’s need to indemnify the Buyer, backed by an escrow or holdback, against breaches of the Seller’s representations and warranties. This mechanism generally improves the Buyer’s bid in two ways. First, it allows the Seller to receive all or most of the proceeds more quickly than would be the case without the R&W insurance. Second, R&W insurance significantly reduces the risk that the Buyer will pursue the Seller for indemnification for a breach of a representation. In this way, R&W insurance provides an enhancement to the traditional methods of protecting against a breach.
While R&W insurance provides clear benefits, the absence of the coverage is not typically a “deal killer,” meaning that the two sides can usually come to a compromise on deal terms even without the R&W insurance. In contrast, contingent liability insurance (tax, litigation, successor liability, etc.) can help bridge a gap and close a deal that would have otherwise fallen apart. To demonstrate the point (and keep this discussion to a reasonable length) this post will focus on tax liability insurance, but the concepts are generally applicable to all insurable types of contingent liability coverages.
Tax issues are well suited for insurance as there is a low probability of loss, but when there is a loss, it is often catastrophic in nature. In the context of a transaction, neither the Buyer nor the Seller wants to take on the financial responsibility for this potentially catastrophic risk. The Seller wants to take their proceeds from the sale and move on without worrying about a significant exposure extending years in the future. The Buyer has a model that justifies the price they are paying for the business, which doesn’t include the cost of a material tax loss. For a PCI the issue is often more acute than for a strategic investor. As a Buyer, the PCI typically plans to hold the business for three or four years. A material tax loss will dramatically impact their ability to make a successful exit on their planned timeline. As a Seller, the PCI wants to return the proceeds from a sale to its investors as quickly as possible. If they have to hold substantial capital post close to address a potential tax liability, this will diminish their internal rate of return and subsequently may impair their ability to attract investors in the future.
Suppose the Buyer and Seller are negotiating who will end up “owning” a $10,000,000 tax risk. This negotiation could derail the entire deal (depending on the significance of the tax risk to the size of the deal.) As an alternative, if the risk can be insured for a premium of approximately $400,000, the two sides have gone from a $10,000,000 deal killer to a $400,000 allocation of cost issue, which is much easier to negotiate.
Tax insurance is not more widely distributed because most insurance brokers are not familiar with the language of tax and therefore are not comfortable discussing it with their clients. This is unfortunate because the opportunities in tax and other contingent liability are potentially larger than the rapidly growing R&W market. These are the basic parameters of a typical tax insurance program:
| Cost: | 3% to 6% of the limit purchased, which is a onetime premium. |
| Policy Period: | 6 years. |
| Retention: | Will depend on the transaction details. If underwriters are comfortable with the transaction the retention will be relatively low. Otherwise it will get set at a level where the underwriter is sitting excess of the amount for which they think the tax authority would be willing to settle. |
| Underwriting Fee: | The underwriters will provide a Non-Binding Indication (NBIL). If the client wants to go forward they will pay a fee of $25,000 to $50,000 which covers the insurer’s cost to complete underwriting and draft the policy. |
| Submission: | The best way to get prompt feedback on the viability of a tax risk is to provide a concise memo that outlines the facts underlying the transaction, the relevant tax law and a description of the overall transaction. Providing a thorough description up front dramatically increases the speed of the underwriting process and reduces the risk of miscommunication down the line. |
For a greater understanding of tax liability insurance I recommend RT ProExec’s Primer on Tax Insurance (here) and the 2017 article by the Davis Polk law firm entitled “Insuring M&A Tax Risk” (here).
Contingent liabilities in general and tax liability represent an opportunity for brokers to add substantial value for their clients by introducing a suite of products that can dramatically increase their client’s ability to overcome obstacles and close transactions.
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Jonathan Legge
RT ProExec
330 West Newbury Road
Bloomfield, CT 06002
(D): (212) 314-9629
(C): (203) 522-8880
jonathan.legge@rtspecialty.com