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This article explores how insurance, beyond its traditional role, serves as a powerful tool for reallocating financial risks in complex transactions. The piece delves into the strategic use of insurance in managing risks like forbearance and subordination in project finance. Key examples include the role of credit insurance in renewable energy tax equity and government-backed clean energy investments, highlighting how insurance can enable mutually beneficial agreements and drive progress.
Insurance provides financial protection that enables transactions to proceed. The simplest example is homeowners' insurance: to get a mortgage, the lender will require a home insurance policy. The same is true for auto loans, aircraft loans, and virtually every other transaction—insurance reallocates the risk of physical damage to make it possible.
There are more nuanced ways this plays out, where insurance can be used to reallocate financial risks. Insurance is also a vital tool that contractual counterparties rely on to allocate risks in commercial transactions.
In large mergers and acquisitions, representations and warranties insurance reallocates the risk that a party may breach a promise made in the contract. Errors and omissions insurance protects against the risk that a commercial counterparty makes a costly mistake during a business relationship. Credit insurance, often linked to risk mitigation, originated in early forms of trade credit insurance used post-World War II to manage recovery risks in cross-border trades.
Today, novel applications of credit insurance are emerging as risk allocation tools in complex project finance transactions. These developments create intricate intercreditor relationships, potentially leading to conflicts or disputes over seniority or forbearance. Credit insurance mitigates credit risk and reallocates forbearance requirements or subordination concerns, offering beneficiaries an alternative recovery path.
Two significant use cases for credit insurance are poised to revolutionize the energy transition.
Tax Equity Example
Tax monetization is the cheapest source of capital for renewable energy projects; projects simply do not move forward without it. It is cheap, but there are strings attached. Investors in tax equity in front-levered transactions require lenders to execute forbearance agreements. In the event of an offtaker default, lender foreclosure could be deemed a "disposition" of energy assets, triggering Section 50 recapture. Tax equity investors prefer back leverage structures, where lenders do not issue debt at the project level, eliminating the need for a forbearance agreement. While lenders may accept this, it could weaken their security position. Back leverage is not always feasible, but credit insurance can provide lenders with additional protection, offering comfort to those agreeing to forbearance by providing an alternative path to recovery in the event of default.
Government Example
Government has long been a facilitator of clean energy investment, but the Inflation Reduction Act has taken this to a whole new level. There are multiple ways that the federal government is funding projects. This capital is often cheaper, but like tax investment, there are strings attached. Government entities must always be senior and cannot be subordinate to other cash flows. Creditors working with the government can use credit insurance to strengthen their "security package." The government may accept Pari-passu or subordinate positions if insured revenue streams offer reasonable repayment assurance.
At Energetic, we take the view that insurance can be an enabler rather than a mere requirement. By reallocating risks among parties in complex transactions, insurance helps all stakeholders reach mutually agreeable terms. Insurance balance sheets are prepared to assume these risks, but market acceptance of these solutions is crucial to increasing deployment and facilitating progress. If you are encountering a roadblock in transactions due to forbearance, seniority, or credit risk in general, reach out to see if we can provide a solution.
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