Proving the Pre-tax Plight

Property and casualty insurance is a barometer reflecting developments in the broader economy, especially in the commercial arena. Losses or litigation in one sector irrevocably result in underwriting discipline and rate increases while new technology or entertainment trends will elicit the creation of unique products to provide coverage and transfer risks.

One interesting phenomenon affecting conventional corporations that currently remains a mere blip just below most p&c insurers radar’s is the tendency to convert to income trusts. From energy companies to media outlets or real estate firms, trusts are beginning to rise to big player economic status, in the economy – especially in the energy field. This trend – paired with interest from financial services companies and reward plans such as Aeroplan – is poised for nominal growth.

While complex features distinguishing conventional corporations from income trusts (and among trusts) do exist, however the biggest difference is a simple one – where corporations pay corporate income tax, trusts do not. A business income trust will instead distribute its income to its unit holders on a pre-tax basis. These distributions are considered income in the hands of the unit holders, who then pay tax at their own personal rates. This structure differs from corporations that must first pay corporate income tax before distributing their net after-tax income to investors in the form of dividends – establishing it as a popular option for many conventional corporations. Currently, there are 201 income trusts listed on the TSX and TSX Venture exchanges, with a total market value of more than $130 billion.

With this huge growth, the question emerges – have p&c underwriters clearly defined and differentiated the exposures that income trust’s face compared to conventional corporations? In addition, do the directors and officers of income trusts have a different, and even lower, risk profile than directors of corporate entities?

There is compelling evidence supporting the notion that the structure of income trusts does reduce the overall risks facing trusts and the trustees. Several factors limit the exposures of income trusts, including the business model, operational risk profile, sponsors’ retained interest, disciplined management, regulatory environment and the costs of capital.

THE BUSINESS MODEL

Income trusts exist in various areas of the economy but they all share common fundamental characteristics including: stable cash flow; strong balance sheet; experienced and stable management; attractive industry profile; and, a track record of sustainable distributions. The same cannot be said for corporations that, for example, show volatile performance related to commodity price fluctuations or share prices movement and director and officer bonuses pegged to shorter-term results. Trusts strive for sustainable distributions and generally tend to favour long-term incentive programs for trustees.

This is exemplified in the lack of D&O litigation in the trust sector, especially relative to the corporate sector. Of the roughly 200 public offerings for trusts since 1999, only two have been the source of D&O litigation. Corporate IPOs have more commonly generated litigation during this period.

One of the reasons is the differing operational risk profile of an income trust. To deliver on the business model, trusts must have a tight operational scope and definite parameters of growth. They must also provide sustainable and stable cash flows that will attract low-cost lenders and unit holders. The risk profile is reduced when one considers that trusts are mature businesses, which focus on core operations or “single purpose entities.” Most trusts are also domestic and, in the case of energy trusts, are unlikely to operate offshore.

BUILDING TRUST

Trusts have evolved in the last few years, growing from a mere exit strategy for private equity owners into a model where sellers have a retained interest (up to 20%) in the trust. Typically, this also results in a board of director’s seat for that interest. Retained interest reflects continuity in the trust conversion. It also shows a likelihood that unit holders can anticipate future stability of sustained business operations, distribution and governance.

Disciplined management is perhaps the least understood although the most important aspect of a trust’s structure. Typically, most trust mangers are associated with the corporate entity before it converts to a trust, thereby ensuring a smooth transition. An experienced management team will approach business decisions with the long-term sustainability and the core business of the trust in mind.

The trustees add another layer to the management discipline. In order to successfully implement this business strategy, it is the trustees who take on the onus of strategic planning and management hiring. The role of the trustee board is to provide support or ask important questions and challenge or disagree with the tactical plans of management.

BY THE BOOK

The Ontario Securities Commission recently introduced guidelines for income trusts by defining a set of governance obligations. Today, credit rating agencies and insurance underwriters are watching the degree to which trusts embrace and use governance guidelines. There is an opportunity for trusts to differentiate themselves by consistently embracing and openly adopting good governance practices.

In fact, the stable business model of income trusts has garnered strong interest from credit rating agencies and lenders. The lower operational risk profile coupled with superior returns and advantageous tax structures have made income trusts attractive to lenders and subsequently, most income trusts have better-than-average credit risk ratings.

In many ways, this lower cost of capital demonstrates better quality risks for directors and officer’s liability insurance – a market that, over the past five years, has seen its share of turbulence in the corporate world. One of the dangers of D&O litigation is that all entities are tarred with the same brush of exposure and risk.

Underwriters have to differentiate risks on a case-by-case basis and therefore some insurance companies are responding to the trust sector with targeted product and lower premiums. This is a welcome development vitally important to the personal liability protection of trustees/directors and officers of trusts. Greater differentiation is needed to reflect the unique exposures of trusts and deliver a lower total cost of risk.

Insurance companies that closely monitor developments in the broader economy can sense opportunities and have a reputation for providing creative solutions. Income trusts are a rapidly growing part of the economic landscape that requires precisely this kind of innovative thinking.