Reps and Warranties Insurance to Cost More in 2021; Areas of Underwriter Scrutiny to Expand

A portion of this article was published in ABA’s Business Law Today March 2021 Month-in-Brief

In a recent podcast posted by Liberty GTS, one of the leading insurers that offers representations and warranties insurance (RWI) policies to protect against breach of representation in acquisition agreements, Rowan Bamford, President, and Gareth Rees, Chief Underwriting Officer spoke about the factors that are likely to drive rate increases for RWI in 2021.

Claim Activity in 2020

Based on the claims data Liberty GTS had collected, generally one in five policies received claim notifications, which is in line with data previously seen in the RWI market. While the majority of those claim notifications were precautionary, 25 percent of them resulted in real claims. The interesting part was that Liberty GTS saw an increase in the number of claims coming out of smaller deals. This is likely due to the fact that more sophisticated diligence teams are employed for larger deals and more funds are spent on diligence for the larger deals, uncovering most of the skeletons in the closet. For smaller deals, typically those under $50 million in enterprise value, diligence budgets are smaller, and not as much effort is put towards looking for possible issues. These findings will likely cause insurers like Liberty GTS to refuse to take on as many smaller deals as they had in the past and to increase their minimum retention and premium requirements for the smaller deals.

Why RWI Rates are Increasing

Other interesting trends noted in the podcast and that we have generally observed in the market is the continuation in the increase of premium rates for RWI policies. Initially, the market saw increased rates in November and December of 2020 when it experienced a surge in demand for coverage. Many companies that slow-walked their deals through the COVID-19 pandemic in 2020 or waited out the November presidential election, rushed to close those deals prior to year-end, fearful of change in the political outlook. This resulted in an overload in deal volume experienced across the RWI industry among insurers, insurance brokers, and M&A deal lawyers. As a result, insurers either increased rates or declined to quote many of the deals, prompting the general RWI rates to go up by about 20 percent. This rate increase has generally been holding in the market as we head into March of 2021 and is unlikely to dissipate.

Rate Hikes in Other Insurance Markets

An interesting point made in the Liberty GTS podcast centered on the fact that insurance rates across other lines such as management liability, cyber, E&O, etc. had grown dramatically in 2020 to compensate for increased risk that was partially due to COVID-19 and partially to increased number of claims in prior years. This is indeed the case, especially in the management liability market where rates for public company D&O insurance have reached highest in years, in the D&O market for U.S. foreign filers which has virtually collapsed, the D&O market for SPACs, which has experienced significant growing pains, and in the cyber insurance market where rates went up by 30%-60% over the course of 2020. Considering that insurers need to balance their books and capacity among various insurance lines to maintain harmony with their reinsurers, in 2021 they may need to pull more capacity towards lines that are more profitable than RWI, which will, in turn, drive an additional RWI rate increase. The podcast speakers threw out 10 percent as the potential number for this additional increase but considering the ongoing competition among over 20 insurers in the current RWI market, it remains to be seen whether the actual rate increase will prove to be that drastic.

What RWI Buyers Should Focus on in Diligence

Facing a certain increase in claims from COVID-19 related matters, insurers are likely to become more conservative in their underwriting and to increase their underwriting scrutiny in the following few areas, as briefly outlined in the Liberty GTS podcast:

1. Misclassification of employees or incorrect implementation of furlough policies. Tax authorities are likely to increase their enforcement in these areas to recoup funds spent on various COVID-19 related stimulus programs, which is likely to result in additional tax claims.
2. Inventory or stock figures for manufacturing businesses. During the COVID-19 pandemic, many buyers were unable to send teams to conduct in-person due diligence on the seller’s inventory. As a result, some of the inventory figures were likely counted or recorded incorrectly. Insurers are anxious that higher numbers of claims will be brought based on the miscounts and will likely pay additional attention to how inventory is reviewed in future deals.
3. Enforcement of the misuse of software licenses. With many employees working from home, improper sharing or misuse of software licenses will likely lead to more aggressive enforcement of under-licensing by large software providers, which could, in turn, lead to more claims in this area.
4. As government aid and stimulus programs come to an end in 2021, pressure on struggling businesses will increase, causing some to become insolvent. Insurers are likely to focus on key customer insolvency problems and diligence surrounding relationships with key customers.
5. Relatedly, third-party claims from struggling businesses could increase in volume as those businesses will likely become more aggressive in their efforts to recover funds even at the expense of customer relationships.

To maximize the value of their RWI policy and to avoid broad exclusions, RWI buyers would be well advised to pay additional attention to the above five areas as they conduct their diligence of the seller’s business. And to secure competitive RWI rates, it is, of course, always advisable to speak with a knowledgeable RWI broker as early in the deal process as possible.

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