As representations and warranties (R&W) insurance becomes increasingly mainstream, Woodruff Sawyer’s M&A insurance team presents this comprehensive look at this facet of coverage—a growing concern in today’s corporate climate.
Download our Guide to R&W Insurance:
8 Reasons to Use Representations & Warranties Insurance
These days, you can obtain broader R&W coverage with better pricing, and the process is more streamlined. Here are eight reasons why R&W insurance appeals more than ever to today’s M&A transactions market. In the full Guide learn more about how R&W insurance helps you:
- Close the Transaction More Quickly
- Achieve a Smooth Transition
- Mitigate Concern Surrounding Solvency of Seller
- Negotiate Your Terms
- Vet the Transaction
- Choose Your Protection
- Gain Peace of Mind
- Present Competitively in an Auction
What is Representations & Warranties Insurance?
R&W insurance is essentially a breach of contract coverage designed to enhance or replace the indemnification given by the seller to the buyer. In short, once the ink has dried on the merger or acquisition deal, R&W covers some of the unforeseen costs caused by any breaches of the seller’s representations, whether it involves issues with their customer contracts, employment agreements, or the super-secret recipe of their product (intellectual property or “IP”). The indemnity package is usually the most contentious part of any merger or acquisition negotiation. R&W steps in to eliminate contention and provide everyone with a cleaner, faster, and safer deal.
Who uses insurance in an M&A transaction?
- Corporate buyers with aggressive acquisition strategies
- Private equity firms looking at close a fund and/or mitigate clawback risk
- Private sellers looking for safeguards in a sale
What problems can R&W insurance address?
- Overcomes obstacles in the negotiation of the transaction
- Extends the life of the warranty
- Bridges the gap between the desires of the seller and the buyer
- Partially funds shortfalls in the escrow, may obtain better investment returns and/or hasten access to funds
The R&W Underwriting Market
There are approximately 23 markets with a wide variety of appetites, experience, claims-paying history and international capabilities. Picking the right one is a nuanced and deal-specific task. The changes we saw at the end of last year are holding firm in the beginning of this year, with standard rates now running 3%-4% of the limit bought. To see a deeper analysis of the figures, read our blog post, RWI Premium Rates: Is the Rise Here to Stay?
|Typical R&W Policy Retention Percentages|
|If your deal size is…||$50 million– $400 million||$400 million– $900 million||$1 billion +|
|Your retention is typically…||1% ↓ 0.5%||0.75% ↓ 0.5%||0.5%|
Changes in Q4-2020 Premiums are spilling into 2021
Check out the full R&W Insurance Guide for more details on the underwriting market for R&W insurance, including the key R&W insurance underwriting factors, including coverage, retention, pricing parameters, and underwriting fees. We also discuss the impact of COVID-19 on pricing and how the market has continued to evolve since 2020.
Key Elements of an R&W Policy
Now let’s walk through how R&W insurance works, how it’s placed, and what it costs. We will also look at likely developments in the coming year.
1. The Typical Policyholder
While either buyer or seller can be the insured, 90% of the policies placed are buy-side, protecting the buyer from any breaches of the seller’s representations. Here are five buy-side details that provide more explanation:
- Buy-side policies have additional fraud coverage that sell-side policies can’t provide.
- The insured buyer can pick a coverage limit and survival period (the period for which the policy is in place) beyond what the seller is willing to give.
- With this coverage, the buyer can avoid suing their newly acquired management team. Should any breaches or misrepresentations come up, they can go directly to the carrier.
- Buy-side policies allow the buyer to offer lower escrows or more competitive terms in an auction.
For more information on buy-side versus sell-side, read our blog post, Buy-Side vs. Sell-Side Policies—Which is Best for You? Part 1 and the accompanying Part 2 post.
2. How Underwriters Assess the M&A Risk
When drawing up the R&W policy, the underwriters evaluate:
- The nature of the sale purchase agreement (SPA) terms and conditions. Examples of this include multiples and consequential damage language, single or full materiality scrapes, and sandbagging language. Underwriters prefer language that is not strongly in favor of either buyer or seller.
- The quality of the due diligence. Underwriters wish to provide coverage for the unknown, so they are looking to “diligence the diligence.”
3. The Exclusions
While the insurance is designed to cover all warranties, certain exclusions are standard:
- Forward-looking warranties (for example, sales projections, etc.)
- Purchase price adjustments
- The availability or usability of net operating losses or R&D tax credits
- Areas of coverage that are difficult to get, such as FCPA violations, union activity, underfunding of pensions, wage and hour violations, etc.
4. Process and Timing for Coverage
Placing R&W coverage is a two-part process:
- Initial non-binding indication occurs one week after receiving the target financials, draft sale and purchase agreement, and any information memorandum that has been prepared by the seller. Underwriters provide initial indications on premium, retention, areas of concern, or heightened risk. Also, it costs nothing.
- Underwriting requires a $30,000–$50,000 upfront “diligence fee.” Underwriters and their counsel are granted access to the data room and begin reviewing the diligence. It involves a two- to three-hour diligence call with underwriters, deal team members, and third-party diligence providers. Underwriting takes one week but is dependent on the timing of the deal process. It doesn’t make sense to start underwriting before the diligence is mostly complete, and a draft disclosure letter has been produced.
In the full guide, we break down the process a little more and show how it fits into the deal flow.
5. How Pricing is Determined
Risk Retention is expressed as a percentage of overall transaction size. The minimum is 1% of the transaction, meaning a $100 million transaction has a minimum $1 million retention, which can be in the form of a seller’s escrow, the buyer’s deductible, or a combination of the two. This drops down to 0.5% after 12 months.
Premium is expressed as a percentage of the limit of coverage bought and is not related to transaction size. Currently, premiums are ranging from 3%–4% of the limitation of coverage. For example, a $10 million limit would mean a $300,000–$400,000 one-time payment for a six-year policy. It’s worth noting that currently, minimum premiums are running around $150,000, so we generally don’t recommend this product if the insured is seeking less than $5 million of coverage.
For more information, see our blog post, “Reps and Warranties—Who Pays for What?”
Read our 2021 Trends Report: Private Equity and Transactional Risk Insurance for insights on the M&A insurance market, including claims trends and reps and warranties rates.
Underwriters in the early days of COVID-19 were seeking broad exclusions to cover any possible complication due to the pandemic. We are now seeing a trend towards more specific exclusions as the pandemic’s impact is better understood.
“Underwriting to risk” exclusions, such as the failure to provide contracted services or goods due to an inability to obtain raw materials are becoming more common, geared specifically to events that affect the supplier and customer contracts.
Pricing has remained relatively consistent given the uncertain M&A climate the pandemic created with a slight trend towards minority investments, not only in the private equity space but also with special purpose acquisition companies (SPACs).
5 Main R&W Exclusions
R&W insurance is continually evolving. We have seen a shift in 2020 to push back hard on some of the standard ones, with good results. Here we discuss the four main types of policy exclusions and the trends we see, especially with the global impact of COVID-19 in 2020.
1. Conduct/Behavior Exclusions
The buyer is required to sign a “no claims” declaration at the start of a policy. If they make a false statement about what they know, that could potentially nullify any claim related to that fraudulent statement, if not the entire policy. Crooks beware, though: it’s worth noting that if a buyer is the insured, they are protected against any fraud by the seller, but not their own fraud. A standard exclusion on a policy would be “any issue known prior to signing/closing,” or a similar version of that. Defining and interpreting this exclusion is a vital issue, and its breadth is highly dependent on the specifics of the language.
2. Standard Exclusions
Net Operating Losses and Tax Credits
Net operating losses and tax credits have been an exclusion for a long time, although we have recently seen some shift in its application. This exclusion can now be dependent on the nature of the target and the amount of diligence around the area. Tax indemnity policies are also available to cover this more specifically if a favorable opinion has been written.
Wage and Hour
Long a standard exclusion, we also see movement to a more “case-by-case” attitude taken by underwriters. For example, we are more likely to see this being applied in a deal in the retail space than in the software space.
While this remains in full force as an exclusion, we have seen a shift of onus. We now expect underwriters to draw attention ahead of time to those warranties which they believe have a forward-looking element, rather than having this be a potential guessing game.
Underfunding of Pensions
This remains a standard exclusion.
3. Deal-Specific Exclusions
Deal-specific exclusions refer to specific known issues or problems inherent to the industry which underwriters will not accept liability for, such as Medicare/Medicaid in healthcare (although it is increasingly possible to get coverage in this area) or FCPA in construction. As with all exclusions, the tightness of the language is key and, as discussed above, getting granular on known issues is vitally important. Try to identify the kind of breaches you are most likely to have—whether it’s intellectual property, cyber concerns, or environmental—to make sure your organization focuses their diligence to aid in removing those exclusions from the policy.
4. COVID-19 Exclusions
In early March 2020, exclusions related to COVID-19 (including any resulting COVID-19 sickness, SARS-CoV-2, or any mutation or variation thereof) started showing up in R&W policies.
From initially broad language that sought to cover any loss even vaguely attributable to COVID-19, the language has evolved to exclude any losses directly attributable to the failure to protect employees, directors, customers, suppliers, and other related parties from the transmission of COVID-19.
Also, there has been a trend towards interim COVID-19 exclusions included at the time of signing, but which would be removed once the deal had closed. Circumstances that would be favorable to the removal of the COVID-19 exclusion at closing include:
- The extent of the continued impact of COVID-19 on the company
- The nature of the discussions between buyer and seller relating to the impact of COVID-19 on the target’s business in the interim period
- A list of instances of COVID-19 cases or illnesses at the target
- The nature of any concerns expressed by the target’s customers or suppliers about meeting targets or maintaining expected activity levels.
It is difficult to predict the long-term effects of COVID-19 on R&W exclusions. However, it seems likely that focus will become less broad and more concentrated on exposure to transmission, labor-related issues, various levels of government stimulus related to the pandemic, and appropriate due diligence.
While the type of exclusions remains unchanged in the past few years, we are now seeing that underwriters have increasing flexibility to underwrite at a higher level of granularity and take on some additional risks in these areas.
In part, this is a response to a shift in attitude, forcing underwriters to justify why an exclusion should be in the policy rather than leave the onus on the client/broker to prove why it should not. We expect to see this continue into 2021.
COVID-19 had a seismic impact across every aspect of the global economy, and its lasting impact remains to be determined. The industry continues to pivot to stay commercial during an unprecedented economic climate that changes weekly.
5. Deemed Deleted/Altered Language
Not strictly speaking an exclusion but it functions in much the same way. We are seeing an increase in deemed deleted/altered language. In this way the underwriter can take a scalpel rather than a hammer to a particular rep or warranty rather than excluding the whole thing. A good example would be the addition of a knowledge qualifier so that a rep read “to the knowledge of the seller” rather than as a flat rep. Obviously this would only be for the purposes of the policy and not impact the agreement at all.
Structuring Your Program In Different Ways
We’ve talked about standard retentions and premiums, but what if you want something a little different?
You can certainly save serious premium dollars if you are willing to take a much higher deductible. In certain tech deals where IP was a primary concern, we have found a seller’s willingness to have a high-cash deductible for a limited time. Even if it’s only for a year, a higher deductible will save a considerable amount of premium.
Fundamental warranties are a little different from general warranties. On the simplest level, they cover ownership and ability to sell. In other words, a breach of fundamental warranties would likely result in a catastrophic/total loss as the buyer has bought something the seller was not legally entitled to sell.
However, these are rarely breached and usually well documented during the due diligence phase. As a result, coverage for only the fundamentals is substantially less expensive. Insureds typically use this approach when they are comfortable with the general representations but require certainty with the fundamentals.
We have seen a trend to include several items within fundamentals, such as IP, employee matters, tax, etc., which changes the nature of the risk and broadens it considerably. The price savings will be significantly reduced as a result.
Another way to save substantially on the premium is through the concept of the time escrow. In this case, you structure the deal with a 10% cash escrow, which is returned after 12 months. The insurance is structured to only kick in a year later, once the cash escrow has been returned. Any claims pending against the escrow will be excluded from the policy. Still, it’s a way of maintaining the escrow’s value while giving relief to the seller at lower premiums.
We began to notice a slight trend in minority investments in early 2020, mainly with private equity investors. That trend has also moved into the SPAC space. This can present some challenges to determining whether the coverage is pro-rata of the coverage investment or 100%.
If a private equity company buys 25% of the company, are they entitled to 100% R&W coverage, or do they only receive the 25% pro-rata that they have in share capital?
While it is possible to buy 100% minority investment coverage, it is expensive, and only a small segment of the market offers it. If the minority position is less than 50%, 100% coverage would be at a premium cost.
One question we often hear is: “How much do people generally buy?” The answer to that varies greatly, depending on the size and nature of the deal. We also look at the question: “What’s the smallest amount of coverage that makes sense and will that change?”
Currently, the average limit of insurance is roughly 12% of the overall transaction size. So in a $100 million transaction, a $12 million limit would be the average. However, statistics can oversimplify, and the purchased limit varies from deal to deal.
There are two things to consider:
- The nature of the deal: In a standard deal, the 10% rule is reasonable. The choice of a limit is often determined by what the buyer would have considered an ideal escrow amount. This is not the case, for instance, in an IP-heavy technology deal where a failure of the IP representation could decimate the value of the entire transaction. Such reps are often considered fundamental, and a much higher percentage limit may be sought to reflect this higher level of potential damage.
- The size of the deal: If a deal is on the larger end (over $750 million), it’s entirely possible that the insured amount may be smaller than 10%, because even 5% still represents a large enough dollar amount to be material to any likely breach.
Deciding upon the appropriate limit is based on the specifics of your deal; there is no one-size-fits-all answer. This is another good reason to make sure your broker has experience with a broad range of deal sizes and industries.
Does RWI Pay Claims?
In August 2020, Lowenstein Sandler published survey results showing 87% of respondents received at least a partial payment for all reps and warranties claims that exceeded the self-insured retention. However, a large percentage of the claims resulted in a loss that fell entirely within the retention amount set in the policy, typically 0.75%–1% of the enterprise value. Read our Private Equity and Transactional Risk Insurance Trend Report, for more information on current and forecasted market conditions.
According to a 2020 AIG annual claims study, AIG Mergers and Acquisitions 2020 Claims Report, while the claim frequency remained consistent, averaging one claim for every five policies, the largest claims (those valued over $10 million) constituted 19% of all material claims over $100,000 in 2019, with an average claim size of $20 million.
With more than 20 issuers of RWI insurance currently, the cost of the policy is under scrutiny. If insurers are pressured to reduce retention amounts to accommodate more claims, they are unlikely to do so without charging higher premiums or imposing significant limitations on coverage.
However, 2020 clearly demonstrated the market’s willingness to adapt and react to rapid changes. We are confident the market will continue to rise to unanticipated challenges.
Choosing a Specialty Broker
R&W Insurance has been around in various forms for a number of years, both in Europe and the US. However, in the last three to four years, we have seen a major shift in its use and format. It is essentially an emerging product.
This is true both in terms of the product itself and the markets that write it. Two years ago, there were six long-term stable markets that wrote R&W in the US. Today, there are 24, and each market is different.
Some are staffed by former M&A lawyers, some by former private equity professionals, and some by CPAs. Many of these people are brand new to insurance and have varying degrees of understanding and experience. The size of the teams vary greatly, and so does the commitment from carriers.
What to Look For… and Watch Out For
Make sure your broker has a good sense of:
- The members of your team and their familiarity with insurance
- Whether the underwriter is a managing general agency
- How committed the underwriter is to this space
- How the agency handles claims and the kind of experience the underwriter has with claims to date
It’s important to remember that some of this applies to brokers, which will help you pick the most appropriate market for your risk. Many brokers are new to this product and don’t have tenured relationships with the underwriting markets or depth of experience with the product.
Beware the “boutique broker” who only focuses on reps and places no other lines of coverage. Because reps and warranties interrelate with all the company’s insurance lines, all of those coverages need to be reviewed by experts. You may need to put other insurance in place, so it’s important to have a broker who can handle all aspects of your situation.
Reps & warranties insurance is a complex and fast-growing marketplace. It requires a dedicated insurance broker who understands this type of coverage and is backed by the resources to handle all the insurance lines and questions that come out of a transaction.
Here at Woodruff Sawyer, we believe that clients are best served by having a team dedicated to reps and warranties day in and day out, with access to broader resources that can review all of your organization’s insurance needs and present a holistic solution.
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Related Blog Posts
The question that this insight into RWI answers is: Do these policies actually pay claims? Read more for information about the Lowenstein Sandler survey results, RWI pricing, claims, and the impact of COVID-19.