Tax insurance and representation and warranty insurance have become common in M&A deals over the past two decades, but the use of those products continues to evolve as transactions become more complex.

In this episode of The Corner Series, Jordan Tamchin of CAC Specialty joins host Geoff Cockrell to discuss tax insurance and RWI in today’s middle market M&A environment. Jordan discusses the most common uses of tax insurance in M&A deals, trends in how tax insurance and RWI claims have been processed and paid, and how these insurance products will evolve to cover more aspects of M&A deals.

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This podcast was recorded and is being made available by McGuireWoods for informational purposes only. By accessing this podcast, you acknowledge that McGuireWoods makes no warranty, guarantee, or representation as to the accuracy or sufficiency of the information featured in the podcast. The views, information, or opinions expressed during this podcast series are solely those of the individuals involved and do not necessarily reflect those of McGuireWoods. This podcast should not be used as a substitute for competent legal advice from a licensed professional attorney in your state and should not be construed as an offer to make or consider any investment or course of action.

This is The Corner Series, a McGuireWoods series exploring business and legal issues prevalent in today's private equity industry. Tune in with McGuireWoods partner Geoff Cockrell as he and specialists share real-world insight to help enhance your knowledge.

Thank you for joining another episode of The Corner Series. I'm your host, Geoff Cockrell, partner at McGuireWoods. Here at The Corner Series, we try to bring together thought leaders and deal makers at the intersection of healthcare and private equity and talk about a lot of issues that come up in the context of transactions.

Today I'm thrilled to be joined by our good friends at CAC Specialty, Jordan Tamchin, who's the executive vice president and focuses on tax insurance products. We do quite a bit with CAC, they're fantastic brokers in RWI and other kind of specialty transactional tax products. Jordan, if you could introduce yourself and CAC Specialty and then we'll jump into some deal-specific questions.

Thanks, Geoff, appreciate it, and thank you for having me on The Corner Series. As you mentioned, I'm Jordan Tamchin. I lead the Tax Insurance Practice at CAC Specialty. We're a specialty insurance brokerage and one of the things that we focus on is transactional liability risk.

And so I like to think of that as a three-leg stool. We focus on everything from rep and warranty insurance, which most of your listeners are familiar with. More than 70% of all middle market M&A transactions use that product and that's where you ensure all the unknown risks in a transaction. And then there's two sister products that we also provide tax liability insurance for. One is contingent risk and the other is tax insurance. Tax insurance is when you insure a known identified tax issue, which we'll be discussing on today's series, and the other is contingent risk, and just think of that as all other contingent issues other than tax that could potentially hold up a deal.

Way of background about myself, I'm a former M&A tax attorney. I started my career at PwC doing tax due diligence and structuring work for private equity funds. I then went over to Simpson Thacher, where I represented a lot of the same private equity funds on the tax aspects of M&A transactions. I then left private practice to enter the insurance world to help develop and shape the tax insurance product. As on the underwriter side, I placed multiple billions of dollars worth of tax insurance in the market and really helped develop out that market to where it is today. After spending numerous years on the insurer side, I then left to go over to the brokerage side to help launch CAC Specialty in the summer of 2019 and lead up its tax insurance practice.

Jordan, you mentioned the distinction between a known and unknown risk. There's a lot of tax conclusions that land on a spectrum where it's not necessarily wrong, but lots of things are not completely bulletproof. When does a risk move from an unknown to a known risk on that spectrum?

That's a great question. And when you're thinking about rep and warranty insurance, that's intended to insure the unknown risk. And typically if it's not on a disclosure schedule or it's not included as maybe a yellow or red flag on a tax due diligence report, generally the underwriter will include, or not exclude I should say, any of the tax issues that may be identified or be problematic or potentially problematic in connection with the transaction.

Anything that the underwriter in connection with the rep and warranty insurance policy deems to be an issue or potentially the buyer may think that it may be an outsized exposure compared to the amount of insurance that they'd be purchasing on a rep and warranty insurance policy, may be a good candidate for tax insurance.

So it's not always just the degree to which the conclusion was ... concern that the original conclusion was wrong, but if you're getting, let's say, 15 million of RWI coverage and you've got a relatively modest probability issue, but if it comes home it's a big dollar, is part of the solution being that you didn't really want any of your general RWI coverage to be earmarked for this particular risk? Or is it really a question of if the probability of the tax issue coming home is too hot?

It's both. In the early days of tax insurance and rep and warranty insurance, the traditional path was is that you would separate the two known issues or two separate policies.

A good example of that is S corporation risk. During tax due diligence, I don't think I've ever found a clean S corporation, there's always some hair related to that, and that could potentially give rise to two issues. One is the historic C corporation risk. So if it wasn't taxed as a flow-through S corporation, you would have corporate level tax. And the other potential issue, which is really important to buyers, is the loss of any depreciation and amortization deductions on a going-forward basis as a result of the tax basis step-up by making a 338(h)(10) election. There are ways to restructure out of that, but certain entities you're not able to structure out of it, do like a 360 F or reorg to structure out of it.

And so historically what you would have are two separate policies, one for rep and warranty insurance and then you would have a policy for S corporation status. The insurance market feels that S corp status issues are low risk, and many a times the brokers and the insurers could get the underwriters comfortable with S corporation issues so that it's included in rep and warranty insurance policy.

But that's something that it really developed over the last, I would say, three to five years where you would generally try to get S corp risk into a rep and warranty insurance policy. But typically you would want to get two separate policies, one for the RWI and one for the S corp risk. Because as you mentioned, there is potentially outsized loss exposure related to the S corp, in comparison to the amount of limits that one would be purchasing for the RWI policy.

One topic that we often think about is if there's an issue where there is some amount of risk, we're usually, if I'm on the buy side, we're not wanting to take any of that. And so one solution to avoid risk to the buyer is to insist on standalone identification obligation in the purchase agreement. To what extent is that automatically buying you an exclusion from your RWI?

I think that's the perfect candidate and why tax insurance is such a great product to bridge the gap between buyers and sellers and an M&A transaction. Typically, what you would see is buyer do tax due diligence, identify a potential issue. And then that's going to lead, and generally it's at the 11th hour, negotiations between the buyer and seller on who's going to take responsibility for that issue.

And so potentially buyer is going to ask for an indemnity, perhaps an escrow for that issue, maybe even a purchase price reduction. None of those are going to be particularly appetizing to the seller. So tax insurance is a really neat way to transfer that risk away from the deal parties into the insurance market. And it's okay if it's an exclusion to the rep and warranty insurance policy, and it generally will be, as I mentioned, if it is a tax issue identified by the buyer and is included in under the tax due diligence report or on the disclosure schedules. And the tax insurance market is able to move and provide deal time solutions.

So it's not uncommon that we're called on a late Thursday or Friday afternoon or Friday evening and a tax issue has been identified and we speak with the advisors, and we try to come up with an insurance solution so that the deal parties could further their transaction. And so as I mentioned, it's not uncommon for us to work with an advisor to put together a memo for the insurance market potentially over the weekend, receive proposals from the insurance market by Monday, so that the deal parties are comfortable with closing or executing a transaction, knowing that insurance will be in place once the underwriters have had an opportunity to do confirmatory due diligence.

I would think that the exposure to the carrier, everyone's got to put a fence around the order of magnitude of potential exposure, but the other filter that everyone is doing is probability filter. Does that probability filter impact just mere underwriting or does the pricing take into account that probability filter?

I assume when you're talking about probability, it's the probability of success on the merits. The insurance market is really only ensuring tax risks where the advisors are at least a more likely than not level of comfort on the tax position being taken or will be taken by the taxpayer. So that means that there's over a 50% chance of success on the merits. That is just at least the standard for which the insurers to start the underwriting process. Obviously, if the advisors and the insurers are at a higher level of comfort, that's going to be reflective in both the risk appetite for the insurers, as well as pricing.

The insurance market's a lot more broader than it used to be. When I first started underwriting, there may be two or three underwriters in a total of $200 million of total capacity in the market. Now there's an excess of 25 insurers, including just standalone insurers as well as MGUs, managing general underwriters, that participate in the insurance market, and there's over $1.5 billion of total capacity for any US risk.

And so as a result of the increase in competition in the market, you're seeing an increase in risk appetite, and also pricing has come down significantly. So when you have quality risks in the market, that's going to lead to increased competition, is going to lead to reduction in pricing, and that's how one would think about when going to the market about a particular risk transfer.

I do want to come back to pricing, but before we leave underwriting, you mentioned a pretty technical legal conclusion of more likely than not having success on the merits. Is an opinion to that effect the table stakes for getting a policy underwritten?

It used to be, but that's no longer the case. The insurance market has become quite sophisticated. Each of the underwriters are former tax attorneys or CPAs, and they also use outside counsel to help assist them in their underwriting process. And so they're able to wrap their own head around the issue and form their own opinion with respect to the underlying issue.

And so an opinion is not always needed, but it is helpful for the underwriters so that they don't have to recreate the wheel or start from the ground level. It's just a way for them to fully understand the underlying facts, what the underlying law is and analysis, so that they could quickly form their own opinion and get to a level of comfort to provide a proposal and finalize its underwriting.

That being said, if an opinion is not available, a mere memo that summarizes the underlying issue is generally sufficient to get insurers to provide proposals. Because an opinion is not going to be provided in such circumstances, you could expect that the underwriting fee to be slightly more expensive because the underwriter and their counsel are really going to have to basically form their own opinion with respect to the under underlying issue.

So base RWI is priced as a percentage of per dollar of coverage, and that's for unknown risks. Obviously underwriting for known risks is going to be more expensive. What's the pricing look like both in absolute terms and relative to base RWI coverage?

Yeah, it varies depending on the jurisdiction as well as the underlying risk transfer itself, but generally what we say is that the all-in cost of insurance generally ranges between two to 4% of the limits being purchased, but that could vary.

For example, if an issue is under audit, it's going to trade at a lot higher than that two to 4% rate. If you're insuring a tax position in a jurisdiction like India for example, it's going to be more expensive than in the US. And we're also seeing an increased appetite of insuring tax positions now in South America, where you would expect pricing to even be higher than that. So we've placed insurance policies in Brazil where the cost would be in the double digits, around somewhere between 12 to 16%.

A general RWI policy I would expect to have a retention of somewhere between let's call it a half a percent of enterprise value, moving up to maybe one, one and a half if you're in a highly regulated industry. I'm assuming this is going to have a similar retention ideal, albeit framed differently. How do the carriers think about the retention?

Yeah, so the retention has really moved over the last years and in result of the competitive market. You generally do not see a retention other than for contest costs, and that's the cost to defend the taxing authority's challenge. And that generally ranges depending on the underlying risk as well as the size of the risk, but it's generally somewhere around 100,000 to $250,000. And again, that's for contest costs only.

That being said, in certain types of risk transfers where you're dealing with not just insuring the law or the facts but potentially insuring the numbers, for example, like a valuation risk, it is possible that you see a higher retention that takes into account any additional taxes, interests, and penalties.

While this is a growing market, it's still relatively young, certainly compared to broader RWI. What has the claims history look like and has there been areas where the claims have been thicker, and does that also translate to different pricing?

Yeah. Similar to the rep and warranty insurance market, the tax insurance market has a great claims handling and great claims paying history so far. It's less mature I would say than the rep and warranty insurance market, given the long tail contingent exposure of these risk transfers. Think about a typical tax issue that we may insure. The tax position occurs in year one, and then it's not filed until year two. And then you have a three-year statute of limitations, and then you also have the audit process, which could take years. So even going back to the early years, there are tax issues where there's claims have been made, they are being audited or going through the audit process, and so it just takes time to handle.

That being said, tax claims had been paid out, which is great. There also had been a situation where there had been tax claims and losses had been paid due to settlements. And so I think it just shows that the tax insurance market is strong. The underwriters and their underwriting counsel work cooperatively with the insurers to make sure that there's a great resolution to make sure that losses are paid.

Jordan, in the context of middle market M&A deals, what's the most common use of tax insurance?

I like to think about tax insurance in the M&A context being used in three different buckets. The first, as we've been discussing, is buyer does tax due diligence of the target entity, and there may be tax positions taken by the target entity on seller's watch that causes the buyer some concern. And so those could be any issues related to sales and use tax issues, employee versus independent contractor issues, if that entity did any type of historic reorganizations or restructurings that could have resulted in any type of tax leakage, transfer pricing issues, accounting methodology issues, those are all the issues that arise on seller's watch that the buyer could be concerned about inheriting as part of the transaction.

The second bucket of risks that we typically see in connection with the M&A transaction are tax issues that result from the underlying transaction itself. For example, it could be tax issues as related to whether or not the transaction would be respected as a tax-free reorganization or a taxable transaction. If you're doing any type of pre-closing restructuring, so for example if you're distributing out any unwanted assets, that could cause tax leakage at the target level and the buyer will be inheriting the risk that the IRS could come back and challenge the valuation of those distributed assets or the basis in those distributed assets. We also see partnership issues frequently arise, whether it's anti-churning rule issues or tax issues related to disguised sale rules.

And the third bucket of risks are issues relating to the target entity and its classification itself. The most common tax issue that I think underwriters see over the last 10 years are related to S corporation issues. As I mentioned before, there's no such thing as a clean S corporation. And so if the taxpayer does not qualify for the S corporation, as I mentioned, you would have that historic C corporation tax risk as well as potentially losing that step up and amortization and depreciation deductions in the future. We also see tax issues related to real estate investment trusts, as well as MLPs. So those are the three areas where tax insurance is commonly used in M&A transactions.

In traditional RWI context, right now, given that M&A activity has been choppier, the insurers have been much hungrier to push out insurance products and that has had impact in both reducing pricing, reducing retentions. How has the choppier M&A market impacted underwriting decisions and pricing in this corner of the market?

The tax insurance market, in my opinion, has remained very disciplined despite the choppiness in the M&A market. I don't think insurers are taking on risks that they otherwise may not have otherwise taken on in a robust M&A market.

That being said, the insurers are just looking to deploy capital in other ways. In addition to insuring tax positions in the M&A context, the tax insurance market is much broader where we use tax insurance to help facilitate tax equity transactions, we're insuring any loss or reductions to a tax credit, particularly in the renewable energy industry, which has really taken off in light of the Inflation Reduction Act. So a lot of capital is being deployed there.

We also ensure tax positions being used in the ordinary course of business where there's no M&A or third-party transaction at all, and it's just a way for companies to protect its balance sheet given the uncertainty in the tax law. And so despite maybe a slowness in the M&A market, the tax insurance market has been really taking off and being used quite frequently in those other two spaces.

Given the continued evolution of some of these products, what are some areas that are maybe on the horizon that you would like to see this product moving into but maybe isn't quite fully developed in?

Yeah, so recently I think the insurers are taking a more interest in ensuring what I call the numbers. That's either transfer pricing issues, valuation issues, and so we're seeing a lot more interest in those areas historically. And as your viewers or listeners will know, in the context of rep and warranty insurance, any transfer pricing issue is generally excluded, and now we're able to provide a risk mitigation tool to allay that risk with the use of tax insurance. So I think that's quite exciting.

The other area where we're seeing an interest by the insurance market is ensuring tax positions that are currently under audit or potentially in active litigation. Again, those are items that would be excluded from coverage under RWI, that could now potentially be insured by a tax insurance product. The level of comfort will need to be much stronger than just at a more likely and not level of comfort, but tax insurance would be a great tool to allay that risk and potentially get a deal done that may not otherwise go through because of those tax issues, particularly tax issues that are under audit or in active litigation, which the buyer would not want to incur.

I think the evolution of these products has been a welcome development for M&A practitioners because in the context of a deal, low or lowish probability but high magnitude problems, are very, very difficult to resolve. They often won't resolve for a long time, and putting away a lot of money in escrow for a long period of time is not a viable solution. A material purchase price adjustment that's trying to balance the probability of a problem and the magnitude of that problem, it's very difficult to distill that to a workable answer. Some of these products can really be a bridge to getting a deal done, so they're certainly very welcome.

And Jordan, I think we'll probably end it there. This is super interesting discussion and really value CAC's contribution both to the market and the context of many deals. But thanks again for joining.

Thank you for having me.

Thank you for joining us on this installment of The Corner Series. To learn more about today's discussion, please email host Geoff Cockrell at gcockrell@mcguirewoods.com. We look forward to hearing from you.

This series was recorded and is being made available by McGuireWoods for informational purposes only. By accessing this series, you acknowledge that McGuireWoods makes no warranty, guarantee, or representation as to the accuracy or sufficiency of the information featured in this installment. The views, information, or opinions expressed are solely those of the individuals involved and do not necessarily reflect those of McGuireWoods. This series should not be used as a substitute for competent legal advice from a licensed professional attorney in your state, and should not be construed as an offer to make or consider any investment or course of action.