10 Questions with Reunion, Episode 5: Tax Credit Investor Default Insurance in IRA Tax Credit Transactions

Introduction

In episode 5 of 10 Questions with Reunion, our president, Billy Lee, sits down with David Kinzel of Marsh to discuss tax credit investor default insurance. Marsh designed this innovative and evolving insurance solution as a "credit enhancement" for buyers of transferable tax credits who are considering forward purchase commitments.

As David notes, tax credit investor default insurance has the potential to meaningfully "expand the universe of buyers well beyond what it is today and add more liquidity to the transferability market."

Listen on Spotify or Apple

10 Questions with Reunion is available as a podcast on Spotify and Apple.

Guest: David Kinzel, Structured Credit & Political Risk Insurance Consultant, Marsh

David Kinzel is a Vice President in Marsh's Structured Credit and Political Risk group. Marsh is the largest insurance broker in the world.

Takeways

• Credit insurance expands the universe of potential buyers of transferable tax credits. By providing a credit enhancement to would-be transferable tax credit buyers, credit insurance allows more companies to buy tax credits on a forward basis. According to a Marsh analysis, over 1,400 companies could be eligible.
• Credit insurance is relatively new with respect to transferability. Insurers are beginning to explore credit insurance for transferable tax credit transactions, which should expand the scope of eligible deals.
• Underwriting is evolving but relatively straightforward. Underwriters will consider the financial strength of the buyer, the experience and reputation of the developer, the duration of the commitment, and the experience of advisors involved in the transaction.
• A credit insurance policy has three parties: the developer, the buyer, and the lender. The developer would be the insured, the buyer would be the insured counter-party, and the lender would be the "loss payee," or the party who would have rights to the policy proceeds in the event of a valid claim. The lender generally provides a bridge or construction loan to the developer.
• Many privately held companies would be insurable. Companies without publicly rated debt, including privately held companies, would be eligible for tax credit insurance.
• In the event of default on the forward contract, the insurer could become the purchaser of the credits. If the tax credit buyer doesn't perform on the forward commitment, the credits haven't been transferred. Therefore, the insurer could purchase the credits as part of their recovery.
• Coverage will usually cost less if an insurer has more recovery options. Insurers look for multiple pathways to being made whole, and the more pathways they have lowers the risk of the deal.
• ‍A good starting point for the cost of credit insurance is an annualized 1% of the commitment amount. Pricing would likely go down for higher credit qualities and shorter durations. Pricing would likely go up for more challenging credits and longer durations.

Video

Video Chapters

• 0:00 - Introductions
• 2:05 - Question 1: How can credit risk insurance be applied to tax credit transfer transactions?
• 4:43 - Questions 2 and 3: How deep is the tax credit investor default insurance market today? How deep could the market become?
• 6:00 - Question 4: What would underwriting and due diligence look like for investor default insurance?
• 8:21 - Questions 5 and 6: Could any tax credit buyer be insured? Why would a tax credit buyer need a credit enhancement?
• 11:01 - Question 7: How would a tax credit investor default insurance policy be structured?
• 12:26 - Question 8: How could an insurer "step into the shoes" – that is, become the purchaser of the credits – of a buyer in the event of an insurance claim?
• 14:27 - Question 9: Theoretically, will coverage cost less if insurers have more recovery options?
• 15:06 - Question 10: How much does this insurance cost today? How much do you think this insurance will cost over time?

Transcript

Introductions

Billy Lee: Hello, and thank you for joining our webinar series, 10 Questions with Reunion. My name is Billy Lee, and I'm the President and Co-Founder of Reunion, the leading marketplace for clean energy tax credits. We work with corporate finance teams to purchase tax credits from solar, wind, battery, and other clean energy projects.

Today, we are joined by David Kinzel, Vice President of Structured Credit and Political Risk at Marsh. I'm excited to speak with you, David, because risk management – that is, the comprehensive identification and proper allocation of risk – is core to the tax credit marketplace. Innovations around risk management are critical to growing this market.

Let's get into it. David, for starters, can you tell us who you are, what you do, and where this webinar finds you today?

David Kinzel: Thanks, Billy. I appreciate you having me here today. I am part of Marsh's Credit Specialties Division. For those who don't know, Marsh is the largest insurance broker in the world but has teams who are specialized in niches within the insurance world – mine being credit and political risks. I've been working in the world of credit risk for over 15 years and have a lot of experience in political risk (but that's an interesting topic for another day).

Billy Lee: David, where are you calling in from?

David Kinzel: I'm based out of Denver, Colorado.

Billy Lee: Excellent. Insurance in the context of tax credit transferability usually focuses on tax credit insurance, where an insurer is covering the risk that a tax credit is disallowed or recaptured by the IRS. With transferable tax credits, this insurance is important because, generally, buyers bear this risk, and sellers often do not have the balance sheet wherewithal to stand behind their indemnities.

Question 1: How can credit risk insurance be applied to tax credit transfer transactions?

Billy Lee: You and I had an interesting discussion the other day about how credit risk insurance could also be applied to tax credit transfer transactions, specifically in the context of forward commitments. Can you provide some detail here?

David Kinzel: Yes, we had an interesting dialog. And, to be clear, credit insurance is different from what our talented tax credit insurance team does. Our team is focused on more of a credit enhancement for the tax credit buyer.

We can take a step back to get a little bit more context. Credit insurance covers the default of a financial obligation. The market has been around for years but has been evolving over the past decade or so. Recently, we've been looking into more complex transactions beyond short-term trade receivables. We've been looking at insuring the default of a project finance loan and we've been looking at insuring offtake agreements. (Under a power purchase agreement, there's credit risk as well.) It's a creative and evolving segment of the insurance world.  

When we look at transferability, we're thinking of credit enhancement for the tax credit buyer who makes a forward purchase commitment. We're effectively insuring the financial commitment of the tax credit buyer. From our understanding and our discussions, it seems like lenders – whether it be bridge lenders or construction lenders – have a binary view of the credit risk of the tax credit buyer. They say, "If that tax credit buyer is investment grade, we can fund the project. If they're not, then you need to find a new tax credit buyer."

So, we see credit insurance as an opportunity to open up the universe of eligible tax credit buyers.

Billy Lee: When a developer is seeking a forward commitment to sell their tax credits to a buyer – that is, they are starting construction on a project that's going to take two years, they want a buyer to be there in two years to buy the credits, but they want to contract now – the creditworthiness of that buyer is important because, typically, a developer is entering into that contract to finance that bridge loan. When we have buyers who may not be as creditworthy, then your product could come in handy.

David Kinzel: That's exactly right. Perfectly said.

Question 2: How deep is the tax credit investor default insurance market today?

Billy Lee: How deep is this market? Maybe it's not deep today, but how deep do you think it can become?

David Kinzel: As you said, Billy, it's a new market. It's evolving as we go, so it's hard to give concrete numbers. But we, Marsh, are building out this market. There's a lot of insurer interest. A lot of insurers have expressed interest in diving into this market. And, once they understand more about insuring these risks, I think there's going to be a short-term and a long-term approach.

When we say short-term, insurers are probably going to have more appetite for vanilla transactions. We're thinking ITCs because of the shorter duration of the risk that they would be taking on. We're thinking there could be anywhere up to $100 million per transaction. So, $100 million of tax credits or commitments could be insurable, which, from my understanding, should cover the majority of the transactions that are going on today or in the near future.

Question 3: How deep could the market become?

David Kinzel:  When we look to the longer term, there's going to be a lot more appetite for more complex transactions. PTCs could become eligible, given their longer term nature of credit risk.

Question 4: What would underwriting and due diligence look like for investor default insurance?

Billy Lee: What would the underwriting for a credit transaction of this type look like? What would the diligence be? I imagine it would be much different than your typical tax credit insurance.

David Kinzel: It's evolving. Initially, we think that underwriters are going to take a conservative and traditional view of the risk.They're going to dive into the credit risk of the tax credit buyer by looking at audited financials. How creditworthy are they to make this investment? Is there anything coming up that could impact their ability to make that investment when the time comes and the tax credits are available? Ultimately, that's going to be the first layer underwriters are going to look at. You have to pass that test.

Then, once they drill deeper, they're going to look at the developer. Does the developer have a good reputation? Are they reliable?

Underwriters are going to look at the duration of the forward commitment. A six-month commitment is going to be different from a 24-month commitment. So, duration – from the time the tax credit transfer agreement is signed to the time that the tax credits are transferred – will be part of the analysis.

Many people want to know, "Are insurers going to dig into the underlying contracts? Are they going to want to see all these contracts and get into the details?" The answer is no. However, they're going to want to see portions of the tax credit transfer agreement. It's important to clarify that they're insuring the default of a legally enforceable obligation. If, for some reason, there's a situation where one of the tax credit buyers says, "We found a way to back out of this commitment because of one of the clauses within the agreement," the insurers aren't looking to provide protection for a bad contract. It's important to just make that clarification and distinction.

It's also important to say the underwriters are probably going to look at what advisors are involved in these transactions. If there are advisors like you, Billy, who have a lot of experience in structuring these transactions and getting clean documents together, that's going to give them comfort as well.

Questions 5 and 6: Could any tax credit buyer be insured? Why would a tax credit buyer need a credit enhancement?

Billy Lee: You mentioned something interesting about insurers analyzing audited financials and credit. I guess the question is, could any tax credit buyer be considered an insured? And, if a potential buyer has to have some minimum level of credit, does that defeat the purpose of insurers? If you have credit already, why do you need a credit enhancement?

David Kinzel: Those are really good questions. Not every tax credit buyer would be considered insurable. But I don't believe that defeats the purpose of the insurance, and I'll explain why. In the short-term, we expect the insurer's appetite is going to be for more S&P BB risks. So, one notch below investment grade is probably where there's going to be the most appetite. This is also good for privately held companies – companies without publicly rated debt. That is something that the credit insurance market is comfortable with. Looking at financials and backing into an implied rating is something they're doing on a regular basis; that's not going to be a problem.

Where we get excited is we've done some analysis of S&P data and looked at the universe of all the rated entities in the United States. If you look at who is investment grade, there's approximately 1,200 investment grade issuers in the United States. That says the potential universe of companies that can invest in tax credits on a forward commitment is around 1,200 – a big number. But what could we do differently? If we go down the credit curve and say BB entities are eligible, maybe even B entities, that adds another estimated 1,400 entities.

On top of that, if we look at privately held entities that don't have public debt, or if we look at U.S. subsidiaries of a foreign parent where the parent may be investment grade but doesn't want to give a parental guarantee – there are many situations where this could come into play. We see credit insurance as an opportunity to expand the universe of potential buyers well beyond what it is today and add more liquidity into the market.

Billy Lee: Those are interesting numbers. Right off the bat, we're doubling the potential universe of buyers. That's great. We need more of that type of thinking and creativity.

Question 7: How would a tax credit investor default insurance policy be structured?

Billy Lee: How would a policy like this be structured, from a mechanical standpoint?

David Kinzel: I'll keep it simple. There will be three parties involved. First, you would have the developer, and they would be the insured on the policy. They're going to be who purchases the policy.

The second party would be the insured counter-party, or the tax credit buyer. That's the party that could trigger a claim by defaulting on the legally enforceable obligation that we talked about.

Third would be the lender. The lender would be what's called a "lost payee." They'd be named on the policy and, if there was a claim paid, they would have rights to the proceeds, giving them that comfort of why the policy is there in the first place. The claim could be triggered by a number of different things – for example, you could have a 12-month forward commitment and the tax credit buyer files insolvency on month six. A second scenario could be where the tax credits are transferred and there's some agreement to pay after the transfer event; if there are payment terms like that, that would trigger a claim as well. Really, any situation in which the tax credit buyer defaults on the contract that we're wrapping in insurance, that's where claims would be triggered, and that's how it would be structured from a general level.

Question 8: How could an insurer "step into the shoes" – that is, become the purchaser of the credits – of a buyer in the event of an insurance claim?

Billy Lee: We also spent some time talking about how an insurer could step into the shoes of a buyer in the event of a claim, which I think is really interesting. Could you explain this arrangement? Also, would an insurer need to have privity to the purchase and sale agreement? Would it become a three-way tax transfer agreement?

David Kinzel: It's interesting. We've talked a lot about the underwriting process and how it works based on credit quality. But another important factor that the insurance market takes into account is the potential for recoveries. Once an insurance company pays a claim, it's not like they sit there and say, "We made a bad decision. Let's move on to the next one." They are going to be going back and looking for recoveries in any way that they can to minimize their loss. That's part of their process, and there are three ways they can go through it. First, they would go after the tax credit buyer under their breach of that legally enforceable obligation to commit the capital.

If the insurer isn't successful there, they'd have the expectation that the developer would help them find a new buyer for the tax credits. The third step is the interesting thing that we talked about: there could be a situation where the insurer may say, "We paid a claim, but our recoveries could be in the form of a tax credit" – that is, finding a way to say the tax credits have not been transferred to the original tax credit buyer. Since there's not a buyer anymore because they defaulted on that contract, could the insurance company step in take those tax credits for themselves? This is something we're exploring and talking about, and it seems possible.

Question 9: Theoretically, will coverage cost less if insurers have more recovery options?

Billy Lee: Right. If you give insurers more backup options to ultimately recover, the more willing they will be to extend that coverage, and perhaps the coverage will cost less theoretically, correct?

David Kinzel: Exactly. That could impact the cost and how far down the credit curve we can go. There's a lot of implications as the market develops. If the insurers get good experience and get comfortable, it could really open up the universe of who would be eligible to be insured as a tax credit buyer.

Question 10: How much does this insurance cost today? How much do you think this insurance will cost over time?

Billy Lee: Great. The immediate follow-up question and my last question is the million dollar question: How much does this insurance cost today? Obviously, there's probably been very few data points, but how much do you think this coverage will cost over time? Will it go down as more of these policies are written?

David Kinzel: The market's developing. I think there is going to be quite a bit of variation based on the risk with all those underwriting factors that we talked about. But we know the market really well. We've been in this market for a long time. I think a good starting point is around an annualized 1% on the commitment amount that's going to be insured. And that could go down as we see better credit quality, more comfort from insurers. I would expect that to go down for the higher credit qualities and the shorter duration risk. Whereas if we look at going down the credit curve to more challenging credits and longer durations, then it could be above that 1% annualized threshold. But that's a good base estimate if people are looking to explore this at a high level.

Billy Lee: David, this has been a great conversation. I love connecting with thought leaders and innovators, particularly around risk management. Thank you for your time. Thank you for tuning into 10 Questions. We'll see you next time.