Retention Options in Representations and Warranties Insurance

A common question among clients in 2019-2020 focused on how to approach the costs of retention in a representations and warranties insurance policy. When seeking out an RWI policy, aside from carefully reviewing the extent of the coverage, the insured needs to consider the costs of the premium and the costs and structure of the retention. Retention is essentially a deductible—the amount the insured is responsible for paying out of pocket before the insurance policy starts paying out on a claim. A typical retention amount in an RWI policy is 1% of the enterprise value of the transaction. If a claim exceeds the retention amount, the insurance policy will cover the losses that are in excess of the retention amount but within the policy limit.

Parties in an M&A deal typically negotiate to determine which of them will be responsible for covering the costs of the premium for the RWI policy (typically between 2.5% and 3% of the limit of the policy) and which of them will be responsible for the retention. The retention amount is often tied to the escrow amount negotiated in the deal and the options offered by the insurers in the RWI policy.

Insurers are typically willing to offer two retention options: a “50/50 split option” and an “NSI (no seller indemnity) Option.” The 50/50 split option is used in about 70% of RWI deals and the NSI option in about 30% of these deals. The deal terms negotiated by the parties may call for the buyer to be responsible for the entire cost of the policy premium and for the entire amount of the retention. Alternatively, they may provide that the parties must share in the costs of one or both. The insured, when working with their RWI broker, needs to determine whether it would make sense to structure their insurance policy as a 50/50 split or as an NSI. Below are some tips on navigating through these two options to find the best solution for your deal.

The 50/50 Split Option

This is the more typical option that allows for a split of the retention (aka deductible) of the RWI policy between the buyer and the seller. Despite the name, the split does not have to be even. Insurers are often willing to follow the retention sharing structure that the parties set up in the purchase agreement. Parties often designate in the purchase agreement which of them will be responsible for covering the first portion of the retention. Typically, the buyer is responsible for the first portion of the retention and the seller indemnifies the buyer for the second portion of the retention. The parties often link the retention payment to funds left in a holdback or held in escrow. Some tie the retention payment to indemnity baskets.

Pro

• Because the seller stays on the hook for at least a portion of the retention amount, thereby, in theory, reducing the seller’s moral hazard, this option provides more comfort to the insurers and they are more willing to offer it.

Con

• This is a less attractive option for the seller because it requires the seller to cover a portion of the retention amount. It makes the buyer’s purchase offer less attractive and may be the difference between a winning and a losing bid in an auction.

Tips

Insurers usually offer a retention drop-down feature which allows for a 50% reduction of the retention amount after the first 12 months of the policy. Keeping this in mind, it may make sense for the parties to structure their holdback or escrow requirements to match the retention drop-down schedule. To avoid misunderstanding or confusion, it is always a good idea to run a possible retention sharing structure by the insurer before agreeing to it.

The NSI Option

The no seller indemnity option, or NSI, may be beneficial to the insured in some deals but is not offered by insurers in all situations. It allows the buyer to be responsible for the entire amount of retention and to eliminate seller’s liability for breaches of representations and warranties post closing. With the NSI option, the seller has a lot less “skin in the game” because the buyer is solely responsible for covering the entire amount of the retention. As a result, insurers consider it a riskier option and do not offer it across the board on all deals.

However, parties have been asking for this option with greater frequency, and insurers have been willing, for a slightly higher premium, to offer the same limit and scope of coverage as well as other terms as they would for a 50/50 split option. The NSI option is becoming more popular. By some estimates, its use increased from about 15% to 30% of RWI deals between 2016 and 2018.

Pros

• This option is often sought by buyers who are participating in an auction process because it makes their bid more attractive to sellers. It may also provide better coverage to the buyer under the policy for two reasons.
  • First, some of the policy language will not need to be reconciled with heavily negotiated indemnity provisions in the purchase agreement. For example, in a typical purchase agreement, the seller may insist on having explicit exclusions for consequential and multiple damages, thereby causing the insurer to exclude these kinds of damages from the policy as well. However, if the NSI option is on the table, the seller may not insist on having these explicit exclusions in the purchase agreement and the insurer will typically leave the policy language silent as to the treatment of consequential and multiple damages, allowing for a possibility of them being covered in case of a claim.
  • Second, with the 50/50 split option, most insurers will require the purchase agreement to have a full materiality scrape before they agree to include a full materiality scrape in the policy. With the NSI option, some insurers will agree to include the full materiality scrape in the policy even if the purchase agreement does not have one. A full materiality scrape is the concept of disregarding or “reading out” materiality qualifiers in representations and warranties to determine the amount of losses resulting from a breach or whether the breach has occurred. However, it is worth noting that insurers will only do this if they are certain that the seller provided wholesome disclosure in the disclosure schedules without hampering that disclosure with some arbitrary materiality threshold. In essence, the seller cannot take a high-level light-touch approach to the disclosure schedules with the idea that RWI policy will cover the reps.
• Considering that the seller would not be on the hook for indemnifying the buyer for breaches of reps and warranties, the seller may be willing to provide more robust reps and warranties in the purchase agreement and reduce the use of knowledge qualifiers, thereby increasing the buyer’s chances for recovery under the RWI policy.
• Lack of post-closing recourse against the seller for breaches of reps and warranties may go a long way towards continuing a good working relationship with the seller’s management team which may be joining the buyer’s team after closing.
• In an NSI deal, the difficulty of the buyer’s claim process is reduced considerably. Instead of seeking recovery from the seller and the insurer and coordinating timing, notice, consent and settlement processes with both the seller and the insurer, the buyer can seek recovery from one source, the insurer.

Cons

• The NSI option typically comes with a slightly higher policy premium.. Why? Because the insurer perceives this option as riskier due to the increase in the theoretical moral hazard of the seller. However, over the last year, the differential between premium amounts for a 50/50 split option and the NSI option has decreased considerably and is usually not a significant incentive for picking one over the other. The range in increased premium is usually between 0.05% and 0.10%.
• Some insurers are not willing to offer this option in some of the transactions. The riskier the deal is from the insurer’s perspective, the less likely the insurer is to offer the NSI option.
• In addition, the buyer will have only one source of recovery: the RWI policy, which will not cover known issues or covenants. The seller, which may have agreed to indemnify the buyer for breaches of fundamental representations and warranties in excess of the RWI policy in a non-NSI deal is unlikely to do so in an NSI deal, leaving the buyer responsible for those costs.

Tips

• When choosing the NSI option, conduct the same diligence process as would have been conducted if an RWI policy was not being placed.
• Negotiate with the seller to retain a pre-closing tax indemnity to ensure broader coverage for pre-closing taxes. The RWI policy coverage will be limited to unknown tax issues, which is a narrower coverage than what is typically covered in a seller’s pre-closing tax indemnity.
• If your deal has an unusual retention structure, (e.g., the buyer and seller are not splitting the retention evenly) run it by the insurer and get the insurer’s sign-off before the structure is finalized.
• If specific issues are known to create contingent liabilities, negotiate with the seller to provide an indemnity for those specific issues.

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