Cost, Who Pays, What About Claims? Top 7 Questions and Answers about Reps and Warranties Insurance

Reps and Warranties insurance has gone from being an occasionally used, slightly mysterious product, to an everyday component of many mergers and acquisitions. Despite this uptick, a lot of people involved in a transaction may still be using it for the first time. Even advisors who have heard of it may not be involved in the details of a placement. The following are questions I am most commonly asked about reps and warranties.

1. How much does it cost?

There are two numbers to think about with regards to reps and warranties, and indeed, any insurance policy. The deductible/retention, and the premium.

Deductible/Retention

This is the amount of “loss” someone has to suffer before the insurance begins to pay out. In reps and warranties insurance, the deductible is expressed as a percentage of the overall transaction size. Currently minimum deductibles are at 1%. So in a $100 million transaction, the minimum deductible is 1%. This amount can be borne by either the buyer or the seller or a combination of the two.

Premium

This is also expressed as a percentage. This time it is a limit of the coverage bought. IT HAS NO RELATIONSHIP TO TRANSACTION SIZE. Sorry to shout, but it’s one of the most common causes of confusion for people new to the product. Premiums are currently 2.5%-4%. Therefore, $10 million of cover would cost $250-$400,000 for six years of cover.

2. Who pays the premium?

There is no specific requirement for this. There is no relationship between who pays the premium and who the insured is. This is a matter for negotiation between the buyer and the seller.

3. What’s the smallest amount we can buy?

Minimum premiums are currently running about $150,000, so unless someone is looking for at least $3 million of coverage, it doesn’t make sense.

This question is often expressed as, “What’s the minimum size of a transaction we can cover?” As I stated above, the limit is NOT linked to the transaction size. Therefore, the smallest amount you can buy is a function of how much coverage makes sense for minimum premiums, and is not a function of overall transaction size.

As a rule of thumb, we are generally seeing average limits being set between 10%-12% of the transaction size.

4. How long does it take?

Unfortunately, the answer to this one can be frustrating because essentially, “it depends.” There are two phases to the underwriting process:

Phase 1 – We can start this with just a copy of the current draft of the transaction agreement and target financials. We start by sending a submission out to market. Then, about one week later we can produce a report showing the underwriter’s initial thoughts and competing bids.

Phase 2 – This happens concurrently with the deal; however, depending on what stage the deal is in, the underwriting process can take another seven to ten days. As this part of the process takes as long as it takes the deal and diligence to solidify, we end up with the “it depends” answer.

5. Does a shorter time period, or only covering some warranties, affect the premium?

No, shorter periods of cover do not really affect premium. Most claims are brought in the first 18 months, so the difference in price between two years of coverage and four years is minimal.

Fewer warranties may make the process smoother but won’t affect the price unless we are talking about only covering fundamental warranties.

6. What are the exclusions?

• Forward-looking warranties (you can sell “x” units at “x” price in the next year)
• Availability of net operating losses
• Wage and hour claims
• Underfunding of pensions
• All other exclusions will be dependent on the deal terms and conditions and the quality of the due diligence.

7. Are there claims and do they get paid?

Yes, we’ve looked at recent claims data in a previous blog post. You can take a look at that post for interesting information on claims trends and severity.

Hopefully that has answered some questions and given you a flavor of the kinds of concerns people have with this coverage. However, if there is a question I haven’t covered I would love to hear from you. Feel free to reach out at emaier@woodruffsawyer.com.