A lack of insurance and risk management due diligence in an M&A transaction can leave equity investors exposed to increased risks that could negatively impact EBITDA in the short term and diminish long-term value of the asset.
Often, middle market transaction insurance due diligence is not the top priority for a deal team, but it should be one of the priorities. It’s important to understand the risks faced by the investment and to work with speed and certainty pre- and post-close.
We have applied our 25 years of experience working in the private equity and venture community to create this Guide to Insurance Due Diligence for Middle Market Transactions. It should help you identify, quantify, mitigate, diminish, or otherwise transfer the potential risks that could negatively affect EBITDA for the portfolio company.
Why Does Insurance Due Diligence Matter?
- Understand how EBITDA is being protected at the company level. The overall goal of due diligence is to uncover the potential land mines that can negatively affect EBITDA for an acquisition in both the short and long term.
- Understand the foundation of insurance and the general risk management strategy that has been implemented historically to protect the business prior to investment. How has the management team viewed insurance and risk management up to the point of selling the company? Which of the company’s risks are uninsured, underinsured, deficiently insured, or adequately insured? How has the team developed, implemented, and maintained the Employee Benefits offering?
- Watch for implications on total cost of risk. Uncover opportunities for cost structure improvement post-close. Is the target company overpaying (or underpaying) for insurance? Are there opportunities for the target company to take on more risk (via retention or deductible strategies) that will improve the cost structure and EBITDA over the long term? Are there ways of restructuring the Employee Benefits program or adjusting contribution strategies to the advantage of the company while also broadening the overall Benefits package?
- Avoid exclusions or issues with the Representations and Warranties insurance process. In almost every deal where RWI insurance is a component, the underwriter will request a report or memo for the insurance and benefits programs in place. The insurer will also ask questions about historical Employee Benefits offerings as well as run-off and go-forward implications for coverages like Directors and Officers Liability, Cyber Liability, and Professional Liability. If not answered correctly and adequately, exclusions may be added to the RWI policy.
- Understand historical losses. Frequent losses are indicative of management’s approach to risk management. Are historical losses likely to persist post-close? Is the current program set up to handle those losses? Do the losses indicate a potential for higher retentions or loss sensitive financing arrangements to better control risks?
- Coordinate run-off policies: Some existing policies could be exposed to run-off provisions. Insurance due diligence helps the deal team understand the potential risks of buying run-off or tail policies at close (or not), ensures protection of the asset from close, and provides a clearer understanding of who is responsible for what risks, why, and when.
- Get a sense for evidence-based benchmarking. How much commercial insurance does the target purchase? Is it enough? Is it too much? How does the Benefits program compare to peer companies?
- Identify potential new program needs. A new Property, Casualty, Management Liability, and/or Employee Benefits program may need to be implemented at close depending on the transaction structure and agreement language.
- Integrate add-ons. These are inevitable, and the insurance foundation must be equipped to scale with both organic and inorganic growth.
- Respond to lender requests. When new lenders are being added to the financial structure, they will require certificates naming them as additional insured and/or lender’s loss payable on the insurance program. Like RWI insurance underwriters, lenders will require a base review of the insurance program. There will be certificates required for closing.
How to Weave the Insurance into Your Transaction Timeline and Better Manage Your Risk
In any given transaction, myriad items can arise that will lengthen (or shorten) a transaction timeline. The two main insurance-related workstreams are the RWI process and the due diligence process. Understanding how these two simultaneous workstreams weave into the broader transaction timeline will help avoid delays at the end of the process.
Phase 1: Pre-LOI Through Execution of LOI
We have found that insurance due diligence advisors are not typically engaged until an LOI has been executed and there is a definitive timeline and action plan to close. Pre-LOI, there is very little insurance due diligence to be performed, and private equity firms typically do not initiate the insurance diligence workstream.
However, pre-LOI is often the time when an RWI broker partner is selected and gets involved. We recommend including a fully vetted RWI proposal when a private equity firm nears completion of the LOI and looks toward submitting a second or final round bid for a target. This demonstrates to a seller that the prospective buyer is not only committed to procuring an RWI policy as part of the transaction, but that the buyer has also engaged with a broker and has gone through the initial stages of obtaining quotes and vetting out initial terms, conditions, and pricing. This sends a clear signal of the bidder’s intent.
- Information needs:
- CIM or Management Presentation
- Financials (audited or reviewed)
- Draft purchase agreement (preferably buyer)
LOI Best Practices
- Involve insurance advisor early in the deal process.
- Include a vetted RWI proposal near completion of the LOI.
- Complete administrative work on the due diligence side.
- Get familiar with the target company by reviewing the Confidential Information Memorandum, financials, management presentations, and initial insurance-related information.
Phase 2: Period of Exclusivity and Insurance Due Diligence
Once the LOI has been executed and there is a definite close date on the horizon, the buyer will typically kick off all third-party diligence workstreams. Insurance and Employee Benefits due diligence should be one of these workstreams.
- Non-refundable underwriting fee is paid (Day 1)
- Data room access granted to insurer and outside legal team (Day 1)
- All due diligence reports are supplied to the underwriter (Day 1)
- Two-hour underwriting call (Day 3)
- Draft policy and follow-up questions delivered to buyer (Day 5)
- Policy negotiation (Day 5–close)
- Close date—policy bound
Phase 3: Pathway to Close and Closing
Once the due diligence is completed, several things need to happen prior to closing.
- Phase I of the RWI process is completed when the private equity firm’s deal team chooses a RWI insurer to underwrite the transaction, executes the expense agreement for the chosen insurer, and wires the non-refundable underwriting fee directly to the insurer.
- Phase II of the RWI process can move forward once the primary, underlying transaction due diligence has been completed and reports for each diligence workstream can be provided to the underwriter.
- Coordination of run-off coverage for any policies that have a Change in Control provision
- Go-forward coverage solicitation
- Certificate of insurance coordination
Phase 4: Post-close Brokerage and Implementation
Once the deal closes, the real work and partnership begins between the deal team, the new portfolio company, and the insurance
advisor. Post-close is when the advisor begins to push forward any recommendations that could not be or were not implemented at close. It is also the time where the due diligence advisory team works hand in glove with the management team to develop a comprehensive insurance and risk management strategy for the short, medium, and long term.
The Importance of Transaction Insurance Due Diligence
Insurance due diligence may not be the top priority on a deal team’s radar. There are certainly myriad other priorities during the hectic deal process. But a solid and comprehensive risk management and insurance strategy can bolster a company’s EBITDA and protect against long-term issues.
Read the Guide to Insurance Due Diligence for Middle Market Transactions for a better understanding of how to avoid these risky land mines, protect the investment in the short and long-term, and ensure a cleaner exit.
Related Blog Posts
Part 1 of this three-part blog series reviews the insurance implications associated with asset versus stock transactions.