Guide to Representations & Warranties Insurance
June 7, 2022
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:
9 Reasons to Use Representations & Warranties Insurance
While R&W has been around for some time, it has only gained popularity in the last five or six years. These days, you can obtain broader coverage with better pricing, and the process is more streamlined than when the product first came out. While that has helped increase the use of this insurance product, the following benefits demonstrate why R&W appeals more than ever to today’s market. RWI helps you:
- Close the Transaction More Quickly
- Achieve a Smooth Transition
- Mitigate Concerns Surrounding Solvency of Seller
- Negotiate Your Terms
- Vet the Transaction
- Choose Your Protection
- Gain Peace of Mind
- Present Competitively in an Auction
- Best Practice in Corporate Governance
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 (i.e., 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.
Here is a snapshot of the underwriting market for RWI, followed by details on who uses it and for what purposes.
R&W Insurance: The Current Underwriting Market
|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%|
Who uses insurance in an M&A transaction?
- Corporate buyers who want the ease RWI brings to the transaction and are seeking to maximize their attractiveness to potential sellers
- Private equity firms looking to maintain strong relationships with management post-close
- Private equity firms looking to close a fund and/or mitigate clawback risk
- Public companies looking to protect the balance sheet after they divest a subsidiary
- Private sellers looking for safeguards in a sale
What problems can RWI address?
- Overcoming obstacles in the negotiation of the transaction
- Extending the life of the warranty
Extending the dollar amount of protection
- Bridging the gap between the desires of the seller and the buyer
- Partially funding shortfalls in the escrow; may obtain better investment returns and/or hasten access to funds
What are the key R&W insurance factors?
- Markets: 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.
- Coverage: Each contract is individually negotiated.
- Pricing Parameters: This is dependent on the size of retention/escrow and other deal factors; 3%–4% of coverage limits are required (e.g., $10 million at $300,000–$400,000). The market has experienced some severe price fluctuations in the last year, so keeping up to date with pricing is an ongoing process.
- Retention: This is customized to the deal—usually 1% of transactions, dropping down to 0.5% after 12 months.
- Underwriting Fee: There is typically a $30,000–$45,000 non-refundable fee due at the time of legal review.
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, 97% of the policies placed are buy-side, protecting the buyer from any breaches of the seller’s representations.
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.
- The nature of the specific warranties being given in the context of the transaction.
- 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 (e.g., 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.
- Known issues
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–$45,000 upfront “diligence fee.” Underwriters and their counsel are granted access to the data room and begin reviewing the diligence reports and the disclosure schedules. It involves a two- to three-hour diligence call with underwriters, deal team members, and third-party diligence providers. Twenty-four hours after the call, a draft policy and any follow-up questions will be provided. It doesn’t make sense to start underwriting before the diligence is mostly complete and a draft disclosure letter has been produced.
5. How Pricing Is Determined
- Risk retention is expressed as a percentage of overall transaction size.
- 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 more information, see our blog post, “Reps and Warranties—Who Pays for What?”
5 Main R&W Exclusions
R&W insurance is continually evolving. There are four buckets of exclusions you generally find in a policy, as well as one common practice that functions similarly to an exclusion.
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. However, crooks beware: if a buyer is the insured, they are protected against any fraud by the seller but not against 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 years, although we have recently seen some shift in their 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
A longtime standard exclusion, we’re also seeing movement toward a more “case-by-case” attitude among underwriters.
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 in the industry for which underwriters will not accept liability, such as Medicare/Medicaid in healthcare (although it is increasingly possible to get coverage in this area) or FCPA in construction.
4. World Event 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.
While the initially broad language sought to cover any loss even vaguely attributable to COVID-19, it has since 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.
There has also been a trend toward interim COVID-19 exclusions included at the time of signing but removed once the deal closes. 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
Russia and Ukraine
Underwriters have taken a less draconian approach to the Russian invasion of Ukraine. Although we saw some blanket exclusions early on, a more nuanced approach is the norm.
5. Deemed Deleted/Altered Language
This is 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 instead of a hammer to a particular rep or warranty rather than excluding the whole thing.
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 on a much higher deductible. In certain tech deals where IP was a primary concern, we have found that sellers are more willing 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 the 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.
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.
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 10% of the overall transaction size. So, in a $100 million transaction, a $10 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.
- 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.
Does RWI Pay Claims?
The most important part of any policy is how it reacts in a claims situation.
In August 2020, Lowenstein Sandler published survey results showing that 87% of respondents received at least a partial payment for all R&W 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.
Both Liberty and AIG publish annual reports on their claims’ statistics. What’s interesting is how similar their statistics turn out to be.
There are also similar statistics on what triggers claims.
Notifications continue to run roughly one in five policies; we know this both from the market and our own experience. In our own practice, we agree that Accounting and Financial are the most prevalent claims, followed by Tax.
The Future of RWI Claims
Getting more granular, there are also claims areas that seem to be becoming more frequent.
- Undisclosed liabilities
- Material contracts
- Third-party claims
For more details on claims activity, we recommend the Lowenstein survey and both the AIG and Liberty claims reviews.
Choosing a Specialty Broker
R&W Insurance has been around in various forms for several years, both in Europe and the US. However, in the last five years, we have seen a major shift in its use and format. It is essentially a new but no longer emerging product.
This is true in terms of the product itself and the markets that write it. Four 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.
Here’s what to look for (and watch out for):
- When picking an underwriter, terms and conditions and pricing matter, but also look out for the makeup of the team. Do they have insurance professionals as well as those with M&A experience?
- Does the underwriter manage a general agency?
- How long has it been underwriting?
How committed is the underwriter to this space?
- How does the agency or underwriter handle claims, and what experience does it have with claims to date?
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 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 your organization’s insurance needs and present a holistic solution.
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