Representations and Warranties Trends for 2023

With 2022 fully in the rearview mirror, we would like to highlight some trends we expect to see continuing into 2023.

The economy continues to face tremendous uncertainty. According to the World Bank's Global Economic Prospects report, global growth will slow from 2.9% in 2022 to 1.7% this year. The outlook has several downsides, including the possibility of increased inflation, tighter monetary policies, financial stress, and rising geopolitical tensions.

However, this gloomy economic picture does not tell the whole story for mergers & acquisitions (M&A). In their 2023 outlook, Foley and Lardner predict a return to pre-2021 levels in 2023. They see potential for a spike among private tech companies, especially those that had to alter their initial public offering (IPO) or special purpose acquisition company (SPAC) plans. They also point to fintech, which has seen sharp drops in value and is now a prime area for potential mergers.

In December, Ernst and Young (EY) predicted the appetite for tech deals would return in 2023 despite global conditions. EY cited a recent study that found 72% of tech CEO respondents plan to pursue M&A in the next year.

So how will this impact the representations and warranties insurance (RWI) marketplace? Let's take a look.

Premium: Rates Will Stay Low

Premiums saw a sharp drop in the first quarter of 2022 from a high in Q4 2021. Then, they continued to drop at a less accelerated rate throughout the rest of the year. In the final quarter of 2022, we saw rates settling between 2.8% and 3.5% of the limit bought.

Some particularly attractive deals were even in the low 2-percents. These lower rates held true regardless of size of deal and size of limit, with even large towers evening out around the 3% level overall. In early 2023, we are seeing the same rates being quoted.

Last year, we asked how high rates have to go before RWI stops being a useful alternative, and we believe that is around 5% to 6%. Now, we are asking how low rates will go before it's no longer an attractive risk for underwriters to take.

We don’t think there is much more room for a decrease. However, underwriters may see rates dip into nonprofitable business to maintain market share later in the year.

Retentions: Going Lower

Retentions were at 0.75% to 1% earlier in 2023 but are now trending downward at 0.5%-0.25%.

Minority Investments: A Continuing Trend

Minority investments became more of a staple last year. However, underwriters have different views on them. The market is still stabilizing its approach. We expect the trend towards minority investment to continue.

A minority deal has specific considerations to unpack when evaluating the use of RWI. We covered the nuances of RWI for minority deals in our January blog, Minority Investments and RWI: Choosing the Right Policy.

Secondaries: Full Steam Ahead

With investors looking for liquidity events this year, we expect the trend of secondaries that picked up in 2022 to go full steam ahead into 2023. As with minority investments, there are specific aspects to consider when using RWI in a secondary. The diligence is lighter, the price is cheaper, and the process is simpler.

The RWI markets have become increasingly keen on writing this business. For a deeper dive into the specifics, please see our blog on The Rise of RWI in Secondary Financing.

Distressed Deals: More Coming

Whether it’s a soft or hard landing, there is likely to be financial turmoil in 2023. As a result, we expect to see more distressed company sales this year.

These are typified by fast speed and light diligence; these sales have been problematic historically. However, there are some new methodologies evolving to utilize RWI. We have seen policies bound that allow for deeper diligence post-close, with bracketed exclusions at the time of signing. We've also seen policies that shy away from the financial aspects but provide coverage for operational issues that are just as likely to cause problems post-close as they are with a profitable business.

Softening Exclusions

We do not expect the COVID or Russia/Ukraine exclusions to disappear, but we continue to see them soften. However, all exclusions are not created equal, and if COVID or the war in Ukraine is part of your transaction concerns, then it is wise to cast a broad net when getting initial quotes. There is a wide disparity between different carriers and their approach to coverage for these concerns.

Severability of Fraud: The Push Continues

Last year, we saw several attempts to introduce severability of fraud into RWI subrogation rights. Part of the popularity of RWI comes from its ability to allow the seller a clean exit. Instead of an escrow, the buyer has an insurance policy. Instead of requiring the seller to make the buyer whole in case of a breach by one or more reps, the buyer goes directly to the insurer.

To facilitate maximum value from an RWI policy, insurers waive all rights to subrogate against the seller except in cases of fraud. If that waiver was not offered, the policy would not be of much use because the seller would merely replace one creditor (the buyer) with another (the insurer).

Because insurers can only subrogate for fraud, they are sensitive to changes in the definition of fraud. They understand it is challenging to prove fraud and costly to pursue a seller for fraud, so their right to subrogate is more of a deterrent than a real-world mechanism.

However, despite it being a theoretical risk more than an actual one, sellers’ counsel has been pushing back on the concept and trying to insert the concept of severability of fraud into the definition of fraud.

Here is an example. Let's say $100 million was paid for a company split between four founders. It turned out post-close that the CFO (chief financial officer) had lied about the numbers knowingly, and the company had no actual value. If fraud had severability, the insurer could only pursue the CFO for recompense for his $25 million, even though it had paid out $100 million to the buyer.

The severability of fraud is a common aspect of directors and officers (D&O) policies, but for assorted reasons, we do not see this aspect becoming a standard part of RWI policies. We believe this push will continue and that it will be rebuffed.

Interim Breach Coverage: Not Much Interest

We heard lots of noise last year about the availability or other aspects of interim breach coverage. Despite its greater potential availability, we have not seen take-up from clients. You can read more about this topic in our blog When R&W Insurance Works to Cover Interim Breaches.

As you can see, there will be many moving parts to the economy throughout 2023, which will affect M&A and RWI. At Woodruff Sawyer, we look forward to helping our clients navigate this ever-changing world.