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New products aid corporate finance: Several forms of insurance have been developed to help companies get financing for a transaction or protect themselves from loss. (Insurance).

In the past five years, new insurance products have been developed to facilitate mergers, acquisitions and other forms of corporate transactions by translating future contingencies into current premium dollars. These products also can help a corporation obtain financing based on future income through a policy that guarantees a future revenue stream. Thus insurance is no longer a last step - an afterthought - in a corporate deal. It can now affect the structure of the transaction, and an insurance professional may be present along with the investment bankers during the initial strategy sessions.

Corporate policyholders should welcome these new sources of financing and the flexibility that these insurance products provide. However, policyholders should also be aware of the potential pitfalls that use of these products may bring. Three categories of new products are particularly noteworthy as tools for corporate deal-making, though with a few caveats; these categories of insurance - M&A, finite risk and credit enhancement - are not all-inclusive, as new products constantly are being developed and the policies actually sold generally are modified to meet specific needs.

M&A Insurance

Perhaps the fastest-growing area for creative use of insurance is mergers and acquisitions. These involve numerous future contingencies that the parties need to either value as of the closing date and work into the price of the deal; or provide for in a reserve, indemnification or an escrow fund, In response, many commercial insurance companies have M&A practice groups ready to design and sell a product to help players finalize a deal.

For instance, the representations and warranties section of the purchase and sale agreement often is the subject of contentious negotiations. Frequently, the representations and warranties are backed by an indemnification or escrow fund. To help resolve these disputes, and in lieu of tying up capital in the escrow fund, many insurance companies sell representations and warranties insurance. This insurance provides indemnification for loss in the event that there is a breach of the representations in the purchase and sale agreement.

Although the scope of the coverage is defined by the actual policy wording, the policies generally are marketed as indemnification for losses arising out of a breach of a representation of fact, and not as indemnification for losses arising out of a breach of a covenant or a projection. Thus, a representations and warranties insurance policy may not insure the calculation of a purchase price based on a multiple of projected earnings.

Similarly, the tax consequences of a merger or acquisition, or any corporate transaction, may be uncertain. An opinion letter from tax counsel provides comfort, but no guarantee, that the transaction will be treated in a certain way by the Internal Revenue Service. The insurance industry now offers tax opinion guarantee insurance to indemnify for losses resulting from an IRS disagreement with the tax opinion. There also is aborted bid cost insurance to cover the costs of transactions that fail,

Representations and warranties insurance and tax opinion guarantee insurance may give the parties more options for structuring a deal. Moreover, the policies may allow the parties to walk at the closing, without ongoing financial entanglements tied to any future contingency.

Leading insurance companies selling this M&A insurance include American International Group Inc., The Hartford and Chubb Corp. Each tends to underwrite a particular type or size of transaction. As a result, there is little competition for a particular piece of business and, thus, little price competition. Premiums generally are between 3 and 9 percent of the policy limits, depending on the specific transaction insured.

Each insurer has standard policy language adapted to the particular terms of the deal, Indeed, one of the mistakes that some policyholders have made with M&A insurance is not ensuring that the terms of the insurance policy mirror the terms in the transaction documents. For instance, in determining whether a seller has breached a representation or warranty, a key issue is the definition of the control group whose knowledge is relevant. If the representation is that there is no known pollution on a particular piece of property, the definition of whose knowledge is determinative should be clearly defined in the purchase and sale agreement. It is important that, for purposes of triggering the insurer's obligation to pay in the event of a breach, the definition of whose knowledge is relevant is identical in the policy.

Insurance can provide finality, but it should be expressly provided for in the documents. If possible, the purchase and sale agreement should limit the sole recourse of the aggrieved party to the insurance policy. In turn, the insurance company should waive its subrogation rights against the party in error, at least for any misrepresentation that is not willful.

Other principal concerns of M&A insurance policyholders are the delays that the underwriting may cause in closing the deal and the insurance company's claims-handling practices, which may jeopardize recovery. The delay problem can best be addressed by bringing the insurance company into the transaction at the earliest possible date and providing it with copies of key documents, including a draft purchase and sale agreement.

With respect to claims-handling concerns, there is simply not enough experience with this type of coverage to form an opinion as to what type of problems, if any, policyholders will face when a claim is submitted. The New York office of Marsh & McClennan Cos., one of the largest brokers of this type of coverage, reported that out of 80 to 100 representations and warranties insurance policies sold, they have submitted only three claims, and all have been paid. Given that M&A insurance is a potential growth area for the insurance industry -- and is competing with alternative, non-insurance financing tools -- insurers have an incentive to employ fair claims-handling procedures. It will be important for potential policyholders to monitor carefully how the industry, in fact, handles these M&A claims.

Moreover, Linden Reid, senior vice president of Marsh & McClennan's Private Equity and M&A Services Department, argues that alternatives to insurance, such as enforcing rights against an escrow or indemnity fund, can add costs and delays. Reid suggests that certain claims-handling provisions be inserted into the policy, such as requiring payment by the insurer within a short fixed period after submission of the claim.

Finite Risk Insurance

Corporate finance insurance is not confined to the world of mergers and acquisitions. Ongoing business operations can be crippled by an existing liability, where the extent or timing of payment is uncertain. These liabilities can be owed to the IRS or to other third parties, and often involve claims made in existing or threatened litigation. Litigation liabilities can involve a single existing liability (e.g., clean-up costs at a large environmental site, worker's compensation exposure) or a continuing series of similar lawsuits, such as repeated claims related to asbestos or product liability. Instead of tying up funds in a reserve to pay for these losses, a company can purchase a finite risk insurance policy, release the funds in the reserve and take the liability off its books. Thus, the future liabilities are transferred to an insurer in exchange for a fixed premium.

Finite risk insurance originally was marketed as a way to substitute tax-deductible premium dollars for a reserve fund. The insurance companies have backed off this claim. Whether or not the premium is deductible will depend on the degree of risk that is actually transferred. For instance, if the present value of the policy limit is close to the premium amount, the parties are basically in agreement on the amount of the known loss and are providing a mechanism for payment over time through the transfer of current premium dollars by the policyholder to the insurer. The close proximity of the premium to the limit is evidence that little, if any, risk is being transferred, In such an event, the policy will be viewed merely as a way to reserve for a known loss, without a transfer of risk, and the premium will not be tax-deductible. On the other hand, if the premium is significantly less than the policy limit, that is evidence that significant risk is being transferred -- and the premium may be deductible.

Credit Enhancement Insurance

The use of insurance to guarantee earnings is perhaps the most innovative product to come out of insurance's expansion into the world of corporate finance. The extent of future earnings is a contingency, and insurance policies can be purchased which pay in the event that earnings projections are not met. In effect, the insurance guarantees a minimum income stream. Backed by this insurance, a financial institution is more likely to lend present dollars. The security for the loan is the projected earnings, backed by the insurance policy.

An example of such a policy can be found in the film industry, and it demonstrates the benefits and drawbacks of this type of insurance. Films were traditionally financed in significant part through presales to distributors. In the early 1990s, however, distributors cut back on their investments and gaps arose between the amount the producers were able to raise through presales and a film's production costs. Investors or lending institutions were not willing to supply the funds to bridge this gap when there was no collateral except the film's projected profits.

The insurance industry responded by creating policies that make the financing, and thus the film, possible. The production company buys an insurance policy that names the investors or lending institution as the beneficiary. If the film fails to generate revenues to pay back the investors by a specific date, the insurer agrees to indemnify the investors or bank for the shortfall. Although this insurance originally was written on an individual film basis, the industry soon found it easier to assess risk and set premiums on a slate of multiple pictures.

Underwriting insurance that guarantees a future income stream requires a far more detailed understanding of the policyholder's business than is required by more traditional kinds of insurance. Credit enhancement insurance depends on the overall profitability of the enterprise, not just the losses that may result from particular risk.

Perhaps surprisingly, the insurers' underwriting often has been inadequate. In the film industry, insurers have focused primarily on what distributors had committed to the film -- not the many other factors that can affect profitability, such as the directors or the stars, or the likelihood of a production delay. Christine Hazen of American Re Capital Markets recently remarked on the underwriting of these types of policies: "We're not interested in scripts or talent, but we are concerned about distribution. A lot of movies get made, but no one ever sees them."

By 2000, it was estimated that $3 billion worth of movies had been financed using insurance-backed financing. For example, American Re Capital Markets put together a program worth $540 million to guarantee the revenue of a slate of movies produced by Dreamworks SKG. The production loans were arranged through Chase Manhattan Bank (now J.P. Morgan Chase). Dreamworks will repay the bank with revenues from the films it produces, with repayment backed by the American Re policy.

In summary, the insurance industry can add real value by providing ways for corporations to access capital and to creatively structure deals through products that put a present value on future contingencies. Insurers appear anxious to enter the world of corporate finance. However, they will be competing with non-insurance alternatives, not just other insurers. It is interesting to speculate whether insurance claims-handling practices, and some of the more arcane aspects of the law and insurance industry practices, particularly in the London insurance market, will survive as insurance becomes more broadly used in corporate finance.

Two things are clear. First, corporate lawyers and financial officers owe it to themselves and their employers to consider insurance as a possible solution to a financing problem that involves the value of a future contingency. It is worth a call to a knowledgeable broker to see if there is an insurance solution to a particular problem. Second, insurance comes with its own law and lore, and it behooves the corporate insider to be aware of insurance pitfalls when seeking to use these products.

Randy Paar is a partner in New York with the law firm of Dickstein Shapiro Morin & Oshin-sky LLP. Her practice focuses on commercial litigation in federal and state courts and on counseling clients nationwide on insurance coverage and related matters.
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Author:Paar, Randy
Publication:Financial Executive
Geographic Code:1USA
Date:Jan 1, 2002
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