Insurance and its Role in Asset Based Finance
The purchase, trading and financing of asset based portfolios in both the equipment and real estate categories has become an increasingly competitive area for lenders and lessors. The issue we face in all of these transactions is to find a means of mitigating asset risk which is straightforward in approach, cost efficient, and offered by creditworthy entities.
Our aim is to convert an asset risk into a bondable ratable securitizable/financiable cash flow. Our second aim is to convert documentation and asset casualty risk into insured risk as market acceptable as one's homeowners insurance policy.
How does a purchaser offer a greater purchase price and not over extend exposures in certain asset classes? How does an asset exchange take place with complicated documentation and a newly minted exchange party? How does an investment banker securitize a portfolio and finance the transaction at tighter spreads, yet maintain an aggressive advance ratio? Our role is to bring insurance capital to bear on the solutions of leasing, securitization and asset based lending challenges.
The huge amount of liquidity currently available in world financial markets ensures that some competitor will manage to find an acceptable manner in which to either take or mitigate these risks. As always, the race is to the fittest. These financiers continually request solutions beyond the efficient reach of traditional banking products. The financing sources are demanding products that provide:
  • Increased Transaction Liquidity

  • Enhancement of Transaction Yields

  • Arbitrage of Tax Conventions

  • Arbitrage of Accounting Conventions

  • Create Structural Transaction Enhancements

  • Create Transaction Credit Enhancements
We identify risk opportunities in financial transactions, structure an appropriate insurance approach, market the structure to the insurance community, and coordinate the provision of cover with the closing of the financing.
The insurance industry is currently in a position similar to that in which the commercial banking industry found itself to be in some ten to fifteen years ago. Too much capital is in the hands of far too many competitors who are chasing too few opportunities in their traditional property and casualty products. The result has been rapidly declining profitability in traditional product offerings. Herein lies the opportunity, these insurers have therefore begun to seek opportunities in non-traditional types of coverage. These have included various types of guarantees which asset based financiers can use as transaction structuring tools.
This article will outline a number of the products and approaches we have adapted to your particular needs.

I. Asset Risk Protection, residual value insurance.

II. Financial Risk Insurance.

III. Structural Transaction Enhancement Insurance.

Asset Risk Protection
Residual Value Guarantee Insurance
The residual value insurance product was the original asset based finance form of coverage. Many of the issues which emerged in the development of this coverage reappear in the newer products.
Residual policies providing investment grade guarantees of asset values in both the equipment and real estate sectors are used to:
  • Support asset acquisition.

  • Enhance securitization and refinance transactions.

  • Provide liquidity for existing portfolios of investments.
To bind coverage an assessment is made by the insurer of the insurable value of an asset. The insurer issues a policy guaranteeing that value. A financing can be arranged against that residual value, as supported by the insurance. The financing may be non-recourse to either the obligor or the asset owner. The variations on this theme are limited only by specific circumstance and imagination.
General Features
Residual value insurance ("rvi") is defined as follows:
A rvi policy indemnifies the insured against a loss which might occur if the disposition proceeds of a properly maintained asset are less than the asset's insured residual value at the point specified in the policy
Several key points should be noted.
  1. The insurance is generally not structured as an unconditional put; however, puts can be structured for particular transactions. Return of the asset in suitable condition is the insured's responsibility. An unconditional obligation can be arranged by specifying inspection periods sufficiently in advance of any potential claim that any condition defects may be remedied. However, the insurer will require that he have the ability to assume the financier's rights of enforcement of maintenance and return conditions under the documents. This may be a favorable position for the financier, as any unpleasantness in negotiations will be blamed on the insurer. These controversies will therefore not impact the financier's relationship with the asset user.

  2. The policy is a contract of indemnity. Its purpose is to reimburse the insured for a covered loss, thereby returning the insured's financial position to its level prior to the loss.

  3. A sale or valuation must be obtainable by the insurer to establish the basis for a claim. Therefore a physical asset to which the insurer is able to obtain title and offer for sale must be present in the transaction. A claim may be established through an actual sale (a "Proceeds" policy), or through an appraisal procedure (a "Fair Value" policy). The mechanism for the latter involves customary appraisal procedures for establishing the arms-length value of the insured asset in the condition described in the policy; this is the quantity insured.

  4. As stated in #3 above, rvi insures an asset returned in the condition stated in the underlying financing documents. The maintenance and return conditions are as critical to the underwriting process as they are to the underlying financing. The strength or weakness of these provisions influences the level of coverage and premium.
RVI Value Added in an Asset Acquisition
The rvi policies issued by investment grade insurers can be used by the asset financier to increase the amount of debt financing used to acquire a portfolio of assets subject to leases. We suggest that leverage be increased by monetizing the back end value of the property through the use of rvi.
To establish an insured value valuations are secured which establish for our underwriters the re-rental and resale values of the property in a soft market at the termination of the proposed financing term. This guaranteed amount could then be used by the senior lender to collateralize a non-recourse balloon portion of an acquisition loan on the asset. The balloon proceeds would provide additional available funds.
From a prudent lender's perspective a insured residual loan will:
  • Not increase the primary loan to value ratio.

  • Will create a highly rated loan asset for NAIC or bank rating purposes; i.e., lower capital charges.
The insured asset loan will be:
  • Against a guarantee from an investment grade insurer.

  • From a source other than the asset itself.
A situation is therefore created whereby:
  • There is a third party source of repayment versus the value of the assets itself.

  • Carrying an investment grade guarantee.
RVI Value Added in a Portfolio Refinancing
Rvi can guarantee an increase in residual value of an existing portfolio of assets, allowing the sale or discounting of notes to raise earnings or cash without a sale of the underlying assets. A property owner approached us recently with a project for drawing cash from his interest in a partnership. The partnership owns a building subject to a lease with a strong credit tenant. The lease has six years to run. Our appraisals indicated that a $14mm guarantee would be appropriate, for a premium of 5% of the amount insured. We joined the investor in negotiating a $14mm, zero-coupon loan priced at 200 basis points over the six year Treasury rate. The loan is, of course, recourse only to the value of his interest in the partnership.
RVI Value Added for Accounting Purposes
In numerous accounting jurisdictions, rvi guarantees can be used as a lessor and manufacturer's earnings and balance sheet management tool. In these accounting jurisdiction leases are categorized as either an Operating Lease or a Direct Finance Lease. An Operating Lease has numerous definitions. It can be either a true Operating Lease (a short term rental), a non-full payout lease, or an Operating Lease for US Financial Accounting Standard 13 (FAS 13) purposes.
For a lessor or manufacturer the Operating Lease is the least preferred accounting treatment, yet the most preferred accounting treatment for a lessee. Residual insurance will allow both parties to obtain their preferred result.
II. Financial Risk Insurance
Financial Insurance involves the transfer of risk from the insured to the insurer. Risk distribution is accomplished by spreading risk over time rather than pooling it with other risk over an annual period as is the case with conventional property and casualty coverage. The key idea is that financial insurance is a "finite product," which means that the minimum loss payable by the insurer is predetermined and aggregated over the term of the policy. But even though the insurance industry is a "CYA" industry, much of the benefit in insurance related to leasing accrues to the insureds.
Look at the benefits. Financial risk insurance is flexible in that products may be tailored to meet the specific needs of a client. Products are structured as multiyear contracts, which makes them a strategic risk financing tool. There is some profit sharing involved; if loss experience is better than actually forecast, the insurer shares the reward with the insured. Risk financing is stabilized over time, coverage can be secured for traditionally "uninsurable" exposures, earnings and/or cash flow can be stabilized, and the variable impact of insurance market forces can be minimized.
Financial risk insurance is structured to create the maximum benefits from already existing transaction mitigants or from exposures that are undertaken by the lessor, lessee or lender yet are undertaken in a tax inefficient manner. FASB 113 outlines the elements of risk insurance programs which may allow for credit reserves, residual value reserves, defeasance accounts etc. to be treated in a tax efficient manner. A reserve can be transformed into a tax deductible experience rated insurance program versus being "held" as non-tax efficient reserves. Defeasance accounts can be transformed into insured risks that will treat the "build-up" of the defeased amount in a tax deferred manner and mitigate the "soft income" issues of defeased contracts.
Tax Opinion and
Representation & Warranty Insurance
Tax Opinion and Representation & Warranty Insurance are issued on a multiyear, non-cancelable basis, using a clearly written policy form. The insurance term is coextensive with the applicable statute of limitations or term of indemnification, and the insurance normally will not require a deductible.
Basically, a Tax Opinion Insurance policy simply guarantees an insured that if it does not obtain the particular tax benefits described in a tax opinion, or in the tax years specified the insurer will indemnify the insured for the full amount of the tax loss sustained, plus any ancillary expenses. Conversely, Tax Opinion Insurance can be used to guarantee to an insured the specified adverse tax consequences will not occur in the future.
Tax Opinion Insurance is designed to provide a business with economic certainty as to the tax implications of a transaction or investment, while allowing it to forego the expense and delay inherent in attempting to obtain a private letter ruling from the Internal Revenue Service (assuming that the Service would rule in the area involved). Consequently, Tax Opinion Insurance may facilitate a business' ability to make, and effectuate, commercial decisions in a timely fashion and in a guaranteed manner.
Once issued, Tax Opinion and Representation & Warranty Insurance guarantees the insured that the enumerated tax benefits, in a dollar denominated schedule contained in the policy, will be obtained by the insured in the tax years indicated in the underlying tax opinion and/or policy. If the insured does not receive those benefits, and all other terms and conditions of the Insurance are satisfied, the Tax Opinion Insurance will pay the insured.
While there are no preconceived restrictions on the situations to which Tax Opinion and Representation & Warranty Insurance could apply, all proposals must involve specific, identified, business decisions. Hence, the insurance could address corporate sales, purchases, spin-offs, restructurings, derivatives, etc., as well as issues pertaining to such items as hybrid securities, compensation, and foreign transactions. Conversely, Tax Opinion and Representation & Warranty Insurance would be inapplicable to amorphous or hypothetical plans, and to blind pool type of investments.

III. Structural Transaction Enhancements
A. Policies Directed Toward Real Estate Financings
Certain risks apply specifically to real estate based transactions as well as portfolios. The objective is to apply as many insurance mitigants as possible to upgrade a less than triple-net lease to a bondable status for securitization and for NAIC rating purposes. These coverages are used in both the specific property, private market mortgage financings and in the new mortgage securitization markets.

I. Condemnation and Casualty Coverage

This coverage protects holders of lease-backed loans against a tenant's exercise of early termination rights in the event of a condemnation or substantial casualty. In the event a tenant exercises this right, the policy will pay the unamortized balance of the lease-backed loan. If the lender prefers yield maintenance, the policy can be designed so that the regularly scheduled debt payments are maintained for the remainder of the loan. Policy terms of up to 25 years are available on a non-cancelable basis.

II. Inflation Escalations

This coverage is available for rental agreements containing inflation escalators. The policy enables property owners to finance against total rentals including CPI increases, while the tenants' obligations under the lease remain contingent on the actual changes in the inflation index.

III. Pollution Insurance

Determination of the presence of pollution in a property has become a major concern in the financing of real estate in the USA. The current approach is to secure a "Phase I" report. This engineering analysis determines whether standard tests have established that levels of pollution are or are not present. If pollution is present the Phase I Report will outline what measures are needed to remediate the pollution.
When an insured applies for Environmental Protection Coverage (EPC) the underwriting will determine if pollution is present. If pollution is not present the insurer will insure against pollution over the term of the financing.
If pollution is present the underwriter will determine the costs of remediation and insure that the remediation cost will not exceed a contracted amount. Once a site is remediated the insurer will insure against pollution over the term of the financing.
B. Credit Enhancement Coverage
Credit enhancement insurance provides that, if the obligor in a financing fails to meet its payment obligations, the insurer will maintain the timeliness of the transaction's cash flows. The chief use has been to upgrade lower ranked investment grade securities, those rated BBB or above to an A, AA or AA credit status. The insurer charges an annual premium, calculated on the opening principle amount of the financing enhanced. The coverage enables the obligor to sell his debt obligations at the enhanced credit rated interest cost. This coverage has been widely used where the credits are unfamiliar to funding sources (i.e., foreign borrowers), or where funding sources have difficulty analyzing the borrower's financial status (i.e., US municipal governments).
Credit enhancement policies in the asset based finance market have the same objectives as in the unsecured credit case above. However, if the insurer pays a claim, it will look to recover its outlay from the asset financed as well as the obligor. Therefore the same considerations as to asset maintenance and return conditions as detailed in the description of residual value insurance above apply. The creditworthiness of an obligation will be based in part on the quality of the asset being financed and the tightness of the maintenance and return conditions in the transaction documents.
I. Individual Transaction Upgrades
This insurance has been used in financings where the obligor, and possibly a guarantor, are not well known in the financing market. The form taken has been to provide a reaffirmation of a guarantee of the periodic cash flows due to the equity investor in a leveraged lease. The insurer may elect not to pay off the lease balance outstanding and sell the asset at the moment of default, but rather may elect to continue the transaction in place. This would have a favorable tax consequence for the equity investor in certain jurisdictions. In the event of a claim, the insurer will step into the position of the investor and receive an assignment of all his rights in the asset. If the insurer elected to continue the financing, then at the termination of the transaction, the insurer would have a first claim on any proceeds from the sale of the asset.
II. Portfolio Credit Upgrades
A financial institution might wish to sell or refinance a portfolio of assets subject to lease. If some of the obligors under the leases are investment grade, and if the assets are of high value and the documentation is strong, the portfolio as a whole can be "wrapped" in an investment grade guarantee. This will have the effect of increasing proceeds of the transaction. A wrap of the portfolio could also lower institutional capital charges, as the credit is now a AAA rated financial institution instead of the original lease obligors.
In conclusion, to properly effectuate these coverages there should be close working relationships between insureds, their representative and insurer's as each party has to understand the other's needs. Insurers do not yet understand the asset based leasing and lending business in the same way you understand your business. Consequently, we both have to ask questions of one another to see how we can mutually benefit. After all, most of our best ideas regarding insurance programs are generated by client demand to find a means of mitigating asset risk which is straightforward in approach, cost efficient, and offered by creditworthy entities.
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Thomas A. Orofino is a Managing Partner of Collateral Guaranty LLC Westport Ct (203.227.7080). He is responsible for the marketing and product design of residual value insurance products and services worldwide
Mr. Orofino is a graduate of Villanova University where he earned his BA in Economics.