Representation and Warranty Insurance May Enhance Acquisition Transactions
Once reserved for only very large transactions, recent changes in the insurance markets have made representation and warranty insurance policies (RWI) more available for merger and acquisition transactions involving smaller dollar amounts.
In most acquisitions, the seller and its owners are required to make substantial representations and warranties about the business they are selling and buyers rely upon those representations in deciding to complete the transaction. Sellers typically indemnify the buyer for losses incurred because of a breach of those representations, creating possible personal liability for a period of time after closing. Buyers face the risk that the sellers, even if personally liable, no longer have assets available to pay for the loss incurred from a breach. Further complicating the issue are transactions in which some of the seller’s ownership group remain as co-owners of the surviving business, i.e. as a partner of the buyer or as a key employee, making recourse by the buyer more complicated.
RWI is an insurance policy that provides coverage for indemnification claims arising out of a breach of the seller’s representations and warranties in the transaction agreements. Buyers and sellers may choose to obtain RWI to enhance the transaction by providing an alternative funding source, other than the seller’s assets, as the buyer’s primary method of recovery for such losses. Policies can be purchased by either the buyer (a “buy-side policy”) or seller (a “sell-side policy”) but most frequently, the buyer is the party that seeks the coverage.
RWI generally covers most of a seller’s representations and warranties with a few exclusions which are set by the RWI provider. Common exclusions include matters that were known by the buyer’s deal team (the insurance is intended to cover a loss from unknown matters), pension underfunding, uninsurable fines and penalties, breaches of covenants in the agreement, and purchase price adjustments. Exclusions may also be based upon matters that surface during due diligence.
RWI will be subject to a “retention” which serves as the deductible under the policy. The retention sets the amount of the loss that must be incurred prior to the insurance company paying a claim. The retention is set based upon the value of the transaction and, in some cases, the amount of the retention may decrease over time, such as after the expiration of the survival period of the representations under the agreement. Frequently, the seller will be responsible for some portion of the retention amount.
Policies contain a period of time after closing during which claims may be made. The policy period for general representations may extend for three years post-closing and a longer period, such as six years, for more fundamental representations. This is frequently longer than the survival of the representations under the acquisition agreement and in these cases the retention amount under the policy may decrease.
The amount of RWI coverage purchased also varies but generally would range from 10% to 20% of the transaction value. For example, in a $25 million transaction, buyer and seller might obtain insurance coverage of $5 million.
Policy premium amounts will vary and are negotiable. In general terms, premiums range between 2% and 4% of the coverage amount. The party bearing the cost of the premiums is, of course, also negotiable. An underwriting fee will also be required.
Some of the benefits to the seller for obtaining RWI include:
Buyers frequently benefit from obtaining RWI because these policies:
According to Harry Wallace, Senior Vice President – Mergers & Acquisitions at Marsh, “more underwriters are competing for fewer deals. As a result, pricing, coverage and appetites have reacted in a way that makes these products more accessible and affordable to buyers than ever before.”
While insurance carriers had previously focused on larger deals (above $50 million), the market seems to have matured with transactions in the $10 to $20 million range now being insured by RWI.
In our experience, buyers and sellers should consider RWI at the earliest stage of the transaction. As the market has made this insurance more available for smaller transactions, both parties should consider whether they would benefit from such a policy and how to share the cost and benefit that is available.
For additional information about RWI and its use in merger and acquisition transactions, contact any of our acquisition transaction team below.
Bretton Crane, Jr.email@example.com
Will Jones firstname.lastname@example.org