Tax disputes, VAT reclaims, withholding tax rec and other contingent claims can result in significant receivables sitting on a company's balance sheet for years. While businesses may be confident of eventual recovery, the timing and outcome of those claims often remain uncertain, making it difficult to access the value locked within them.
A developing market for insurance-backed financing is seeking to address that problem. By combining specialist insurance with third-party funding, companies can raise capital against contingent receivables before a final resolution is reached, effectively transforming future tax and other recoveries into an immediate source of liquidity.
In this Q&A, Gregor McMillan of insurance brokers Howden explains how insurance-backed financing works, the types of assets most suited to the structure, and why the technique is attracting interest from corporates, private equity funds and other investors.
ITR: What is insurance-backed financing?
McMillan: Insurance-backed financing is a way of accelerating the value of a contingent receivable that is expected to turn into cash in the future, but where there remains some uncertainty over either its ultimate recovery or timing.
The concept is relatively straightforward – an insurance policy is placed over the risk associated with the receivable and a lender then advances funds against that insured asset. Interest is capitalised and not paid until maturity. The amount ultimately due is repaid out of the funds recovered from the contingent receivable and/or any associated insurance payout, so that the lender is effectively purchasing the insurance-wrapped asset (although the client can retain some of the upside in exchange for a smaller amount being raised upfront).
The insurance materially changes the credit analysis for the lender: rather than relying solely on the underlying contingent receivable or the eventual outcome of a tax or similar process, the lender also has recourse to an investment-grade insurance policy if the insured risk materialises.
In effect, insurance can transform an uncertain or difficult-to-finance asset into something against which third-party capital can be raised.
ITR: What kind of receivables does the technique suit best?
McMillan: The strongest candidates are generally receivables with a clearly identifiable underlying value, but where payment may be delayed for a significant period or remains dependent upon the resolution of a particular risk.
Tax receivables are a prime candidate as they are claims on the government and so underlying credit quality is usually excellent. Examples include withholding tax and VAT reclaims, advance tax payments and other tax receivables arising from disputes or proceedings with a tax authority. However, similar structures can also be applied outside tax – Howden is currently working on financing structures involving legal or litigation receivables.
The key factor is whether insurance is available to remove the contingency and at what price – this will depend on the nature of the contingency and how far the dispute has progressed. Some receivables are very difficult to insure, for example R&D credits.
ITR: What kind of insurance can be used?
McMillan: If the underlying receivable is a tax claim, then a tax insurance policy will be used. Tax insurance is a specific risk policy which pays out if an expected tax outcome is not achieved – in this case that would generally be where the tax authority prevails in court. If the underlying receivable was related to another contingent legal risk (i.e. a litigation award) then a contingent risk policy would be used.
These policy types may be combined with a ‘time-wrap’ policy, which removes timing risk from the receivable and would pay out if there has not been a final determination in the relevant proceedings by an agreed date.
ITR: What kind of clients could this technique be of interest to?
McMillan: The technique is likely to appeal to growth companies that have high expected returns on capital and also to other companies with restricted borrowing capacity.
A corporate may have a substantial tax receivable sitting on its balance sheet which it expects ultimately to recover but which could remain outstanding for several years. Monetising that asset can improve liquidity and provide capital for other corporate purposes.
For private equity and other investment funds, the attraction can be particularly strong towards the end of a fund's life. A residual tax receivable can prevent a vehicle from being wound up and delay final distributions to investors. Financing can accelerate those distributions and potentially improve realised internal rate of return. It may also be possible to transfer the receivable into a special-purpose vehicle to separate that vehicle economically from the original group.
It can also be relevant when a business or asset is being sold, but a tax receivable is being retained by the seller.
ITR: What is the optimal time to put the structure in place?
McMillan: Earlier is generally better. Ideally, financing should be considered alongside the insurance placement rather than once the insurance has already been completed. That allows the policy to be designed with the requirements of lenders in mind.
Timing can also matter when the underlying tax position is moving through litigation or another formal process. It can be difficult to source insurance for tax disputes where the next court stage is imminent. Information emerging during a hearing can change insurers' perception of a risk – positively or negatively – and consequently affect both insurance and financing appetite.
ITR: Can the technique be used where tax or other insurance has already been put in place?
McMillan: Potentially, yes. An existing insurance policy does not prevent subsequent financing.
The key question is whether the policy works for the proposed lender. A lender will want clarity on matters such as the insured risk, exclusions, claims mechanics, policy period and its ability to benefit from the insurance proceeds.
Where financing is contemplated from the outset, these points can be addressed when negotiating the insurance. Retrofitting financing onto an existing policy may therefore require additional work and potentially amendments or endorsements from insurers.
ITR: Which counterparties provide the finance, and how do you find them?
McMillan: There is no single lender market. Depending upon the transaction, potential capital providers include banks, hedge funds and private credit funds.
The exercise is therefore partly one of matching the asset to the appropriate capital. Some institutions are comfortable underwriting insured receivables but others may be constrained by mandate, jurisdiction, tenor or their approach to the underlying tax or litigation risk, particularly as it pertains to reputational risk.
It is therefore important to understand the target market and tailor the approach accordingly.
ITR: How are deals typically structured?
McMillan: The precise structure depends upon the asset and the client's objectives, but typically the lender advances an agreed percentage of the expected receivable.
The receivable and the insurance policy then form an important part of the lender's security package, with arrangements governing how eventual proceeds are applied. The documentation also needs to deal with scenarios such as early repayment, a successful recovery from the tax authority, or a claim under the insurance policy. In addition, safeguards need to be put in place to guard against the insolvency of the entity which owns the claim.
Depending upon the circumstances, it may also be possible to isolate the receivable in a separate vehicle, which can be particularly useful in a corporate disposal or fund wind-down.
ITR: What effective interest rate are clients likely to be offered, and what advance rate does this translate into?
McMillan: There is not yet a single market-clearing price for insurance-backed tax receivable financing. Pricing depends upon the quality and tenor of the receivable, jurisdiction, insurance structure, lender and wider credit environment.
As a rough guide, spreads above risk-free rates tend to range from 250 to 700 basis points, but they are very transaction- and risk-specific.
The amount that can be raised is a function of:
The interest rate,
The duration of the loan, which is in turn dependent on how long the underlying claim process is likely to take; and
The cost of putting the insurance in place.
Lenders will consider the expected receivable, the amount and quality of insurance protection, the expected timing of repayment and any residual risks that remain outside the policy. Stronger insurance protection should, all else being equal, support a higher advance rate and/or lower cost of capital.
As a very rough rule of thumb, financing of around 50% of the value of the underlying receivable can be raised for five years.
ITR: What risks do lenders continue to assume?
McMillan: The insurance policy does not eliminate every risk. A lender therefore needs to understand precisely what the policy covers and, equally importantly, what it excludes. Particular attention is paid to policy exclusions, compliance with insured obligations, claims procedures and circumstances in which insurers could legitimately decline a claim. Exclusions which will normally be in scope include fraud, misrepresentation and, importantly, failure of the insured to follow the conduct requirements of the policy.
There can also be timing risk. Even if the ultimate receivable is highly protected, the date on which either the tax authority or insurer pays may remain uncertain. Lenders are generally unwilling to assume timing extension risk, so they may look to also take out a time-wrap insurance policy as described above.
Note that the time-wrap policy is normally separate from the insurance policy covering the underlying risk (although in principle they could be combined in one policy). If the time-wrap policy pays out (because the claim is not finally determined within the expected timeframe), the time-wrap insurer will then recover its funds when the tax amount is repaid (if the case is won) or when the tax insurance pays out.
This is why the insurance and financing workstreams need to interact closely. The objective is not simply to obtain a tax insurance policy; it is to obtain a policy that creates a sufficiently robust collateral package for the financing.
ITR: What kind of complexities arise during the transaction process?
McMillan: The principal complexity is that three separate disciplines have to come together: the underlying tax analysis, the insurance contract and the financing documentation.
Lenders and their advisers will review the policy in detail and may ask questions which would not ordinarily arise in a standalone tax insurance placement. Insurers, in turn, may need to accommodate lender requirements around assignments, loss-payee provisions, information rights and claims proceeds.
There are also practical questions around prepayment and break costs if the receivable pays earlier than anticipated. These issues are manageable, but coordinating the parties is an important part of the process.
ITR: How long does a transaction take to close?
McMillan: There is no fixed timetable, but clients should allow sufficient time for both insurance underwriting and lender diligence.
A relatively straightforward financing where the tax analysis and insurance are already well advanced can move comparatively quickly. A more novel structure – particularly one involving litigation, multiple jurisdictions or bespoke security arrangements – will take longer.
Ultimately, insurance-backed financing is less a new asset class than a new way of looking at existing assets. Tax receivables, which have traditionally been regarded as illiquid balance sheet items, can, in the right circumstances, become financeable assets. As insurers, lenders and advisers become more familiar with the structures, we expect the range of situations in which that approach can be used to continue to expand.
Key takeaways
As the insurance and lending markets become familiar with these structures, the range of receivables that can be financed is continuing to grow. For tax advisers and in-house tax teams, the practical takeaway is that where there is a significant contingent receivable that may take years to resolve, it is worth considering early whether an insurance-backed financing structure could accelerate that value. The earlier the conversation begins, the greater the flexibility will be to design the insurance programme and financing in tandem.
