Representation + Warranty Insurance
The Anatomy of a Deal Newsletter September 27, 2019
Each month, Eric Duffee looks at a different piece of The Anatomy of a Deal – a series of easy-to-digest articles that break down complicated aspects of business transactions – helping you better understand terms + processes that can shape the direction of your business.
This piece is a collaboration with Vince Stasiulewicz, a Certified Public Accountant and Client Executive at Hylant, a full-service insurance advisory firm.
Throughout this series, we’ve talked a great deal about the allocation of risk between the Buyer and the Seller. Using this dynamic, the results are largely binary: more protection for the Buyer means greater risk to the Seller.
For many years, there was no alternative to this dynamic, which led to some contentious negotiations in many deals. There has to be a better way, right? In some deals, there is! Representation and warranty (R+W) insurance has emerged and is becoming more and more common, particularly in deals with purchase prices of $40 million plus.
What is it?
Like any other insurance product, the idea of R+W insurance is to shift the risk of losses to the insurance company. If the Buyer discovers a breach of the representations and warranties the Seller made in the purchase agreement, R+W insurance effectively stands in the place of the Seller and reimburses the Buyer for its losses – of course, subject to certain exclusions.
Also, like other insurance policies, there are deductibles and policy limits that apply, and the cost of the policy depends, in part, upon what deductibles and limits are selected.
In short, R+W insurance is a good option for almost any deal in which the coverage is available at a reasonable cost. That’s the kind of hard-hitting analysis you’ve come to expect from The Anatomy of a Deal.
Who pays for the policy?
You already knew the answer had to be “it depends!” There are actually different types of policies: a Buyer’s policy or a Seller’s policy. A Buyer’s policy provides direct coverage to the Buyer for its losses resulting from a breach of the Seller’s representations and warranties in the purchase agreement. A Seller’s policy provides coverage to help fund the Seller’s obligations in the event the Buyer makes a claim against the Seller under the purchase agreement.
From a Seller’s perspective, the Buyer’s policy is much preferred because it removes the Seller from the process almost entirely – the Buyer simply looks to the insurance company for payment, rather than the Seller. By contrast, the Seller’s policy only kicks in once the Buyer makes a claim against the Seller, which the Seller still has to defend and then make a claim against the policy proceeds. As such, you typically only see Seller’s policies when the Buyer has refused to accept an R+W insurance policy. Therefore, you would rightly expect that Seller’s policies are paid for by the Seller.
On the other hand, there are often negotiations as to who pays for a Buyer’s policy. Sometimes – particularly in an auction process – the Buyer may offer to pay for the entire cost of the policy in an effort to sweeten its offer. Alternatively, the parties could agree to split the costs of the insurance.
If the Seller is paying for any portion of the insurance premiums, the Seller must decide whether the cost is justified or whether the Seller would rather self-insure the risk. After all, if the Seller was 100% certain there would be no risk of post-closing claims, the Seller would be better off not buying the insurance. But that’s the nature of insurance generally; you’re paying for the benefit of shifting the risk of unknown future losses to the insurer. Nobody needs insurance until they need it. #analysis
How much does the coverage cost?
There are several components that contribute to the cost of the coverage, namely: (a) the policy limit, (b) the state in which the Buyer is domiciled, (c) a one-time underwriting fee charged by the insurer, and (d) the perceived risk of the deal by the underwriters. The premium charged for issuing the policy can vary but is typically within 2.5% to 4% of the coverage limits.
The most common R+W limit (i.e., amount of coverage) is roughly 10% of the deal's value. The retention is generally roughly 1% of the deal's value, subject to a minimum of approximately $500,000, which may be able to be reduced by one-half after 12 months.
Thus, for a $36 Million deal:
- The limit would be approximately $3.6 Million to $4 Million and
- The retention would be approximately $500,000
Current pricing indications for estimating would be in the expected ranges of:
- Premium: $120,000–$125,000
- Plus Surplus Line Tax: $3,100 (again, different percentage based on state the Buyer is domiciled in)
- Plus Underwriter's external legal fee: $30,000–$35,000
Thus, the estimated total costs are likely to be in the range of $153,000–$163,000.
How long does it take to put coverage in place?
The R+W process – with all info available – should be allotted 4+ weeks. The underwriting process to purchase R+W insurance can be as short as seven days, though the initial phase of the effort can start much earlier.
The first stage of the process involves working with an insurance broker to provide basic information and drafts of the transaction documents to one or more insurance companies.
There are four key deal documents which the R+W underwriters require, as follows:
- Letter of Intent (LOI)
- Most current draft of the Sale/Purchase Agreement (SPA)
- Confidential Information Memorandum (CIM)/”Road Show” Document, if any
Audited financials of the Seller for the past 2–3
full fiscal years + interim info
NOTE: If audited financial statements are not available, the underwriter will likely insist upon a quality of earnings report issued by a qualified CPA firm
Upon receipt of the aforementioned information, the insurance companies then provide non-binding indications of the coverage they would be willing to provide, with premium estimates. If the parties proceed, there is a non-refundable underwriting fee (usually between $15,000 and $40,000) for the insurance company to proceed with its diligence. After it has performed its diligence, the insurance company will provide a draft insurance policy, and this is often followed by some negotiation over the coverage.
What are the common exclusions?
The most obvious “exclusions” are the deductible and the policy limit. The Buyer generally addresses the deductible by requiring the Seller to be responsible for at least some portion of the deductible amount. Sometimes that means making the Seller responsible for the entirety of losses within the policy deductible; sometimes it means a sharing of risk between Buyer and Seller for the policy deductible. For example, the Buyer may bear the risk for the first half of the policy deductible, but the Seller is responsible for the remainder of the policy deductible.
A policy limit ends up working much like indemnity caps, which we’ve discussed in previous installments. As such, in a Buyer’s policy, the Buyer needs to be careful to set the policy limits at a level it believes to be sufficient. In that case, the Buyer takes virtually all risk for any losses that exceed the policy limits.
There are other important exclusions as well. First, environmental claims generally don’t fall under R+W insurance. For environmental issues, you often need a separate environmental insurance policy. Second, underfunded pension liabilities often are not covered.
Perhaps the most important limitation, however, is that the R+W insurance will not cover known issues. As such, anything the Buyer discovers during due diligence will become a policy exclusion. For these items, the Buyer will need to make sure that it has recourse against the Seller under the indemnification terms of the purchase agreement.
Remember also that – as the name implies – R+W insurance only provides protection against breaches of the Seller’s representations and warranties. It won’t provide protection for other items for which Sellers generally have indemnification obligations, such as breaches of covenants (e.g., non-competition/confidentiality covenants, tax covenants, etc.).
For all of the above reasons, it’s common that the Seller will still have some continuing indemnity obligations and that there will be some limited escrows in place to ensure that the Buyer has recourse. However, these escrows are usually much smaller when R+W insurance is in effect because the Buyer has successfully shifted much of the risk to the insurance company.
Are there certain industries in which R+W insurance is not a viable option?
There used to be certain industries that insurers would shy away from insuring. However, competitive market dynamics have forced insurers to narrow and eliminate many exclusions and also insure industries that were previously shied away from. The policies now have broader coverage with generally no restrictions on industry sector.
Some industries, such as healthcare, used to be challenging to insure, but certain insurers have developed expertise in these areas and are now able to offer fulsome coverage. Insuring title on upstream oil and gas transactions can be challenging, although recent innovative products have been introduced to address this issue.
What does the presence of R+W insurance do to the negotiations between the parties?
If R+W insurance will be in place, the parties and their counsel need to be very careful to make sure that the purchase agreement and the insurance policy work well together. Otherwise, gaps could lead to unintended exposure that the insurance company won’t cover. If there’s a Buyer’s policy in place, that policy should also explicitly bar the insurance company from pursuing the Seller for claims the insurer pays to the Buyer.
One of the more interesting effects of having R+W insurance in place is that negotiations over the representations and warranties in the purchase agreement become extremely Buyer-friendly. The insurance policy will mirror the representations and warranties in the purchase agreement. So, if the Seller negotiates to limit the scope of the representations and warranties – something that is very normal in a deal where there is no R+W insurance – the effect is to make the insurance less protective. As such, Buyers generally expect that the Sellers will not meaningfully attempt to limit the scope of the representations and warranties.
While this seems simple in concept, recall that the Seller still has certain indemnity obligations. So the Seller ends up taking some enhanced risk on the representations and warranties, but its maximum exposure is more limited than what would typically exist.
Should I use R+W insurance in my deal?
If someone else is paying the premiums, then absolutely! If you’re paying for any part of the premium, then there’s a cost-benefit analysis to be completed. It’s worth talking with an experienced insurance broker to get a sense of what coverages might be available and what it may cost.
The broker will become an important partner in the process of securing insurance, as he or she has a fiduciary duty to provide the best R+W terms to the policyholder while balancing the need to deliver a budget-appropriate solution. R+W insurance is much stricter as far as eligibility standards, due diligence, documentation and other requirements are concerned, and you need an expert on your side to walk you through the process.
A qualified broker also excels in execution – making sure all the processes are done in the timeframe that’s right for the deal. This benefit brings together many of their qualities:
- In-depth knowledge of R +W insurance to make sure you get the appropriate coverage
- Contacts with insurance company underwriters to get the best terms possible, balancing coverages and cost
- Experience with the application and underwriting process to make sure you don’t make a mistake that creates delays
The most important role played by brokers comes when a claim for a breach of the Seller’s reps is reported. Experienced brokers understand the requirements of the insurer to get the information necessary to evaluate the loss before they cut a check.
What is the future of R+W insurance?
Remember that R+W insurance is an insurance product like any other and is subject to market forces. After starting years ago with policies that provided poor coverage at high costs, the market has shifted, with good policies now being offered at competitive pricing. As such, the usage of R+W insurance has exploded in recent years. In fact, for many private equity deals, the use of R+W insurance is almost automatic.
As claims continue to be made – and paid – by the insurers, there will probably be a correction in the marketplace to increase costs somewhat. That said, even with some shifts in the economic model, it appears that these policies will continue to serve as an important tool to facilitate deals and provide protection for both Buyers and Sellers into the future.
Next Month: Employee Incentives: Part 1
Read last month’s piece: Life Cycle of a Deal