Should Parties in Merger and Acquisition Transactions Seek Representation and Warranty Insurance (RWI)?
Buyers in mergers and acquisitions are increasingly turning to insurance policies to protect themselves from financial loss stemming from misrepresentations or inaccuracies in merger or acquisition agreements. While representation and warranty insurance (RWI) is pretty well-established in transactions involving private equity firms, the policies have also become more common among companies looking to make strategic acquisitions, as buyers become more familiar with these policies and their associated costs decrease.
RWI policies generally cover either the buyer (a buy-side policy) or the seller (a sell-side policy). Both kinds of policies can preserve the value of a deal by shifting potential liability for breaches of representations and warranties to insurers for a fixed cost. Buy-side policies make up a majority of the RWI policies in the United States.
From a seller’s perspective, buy-side policies have the advantage of reducing the risk of contingent liabilities from future representations and warranties claims that may be made against them under a purchase agreement. It can also eliminate the need to establish purchase price escrows or holdbacks, which allows the seller to make a clean exit and distribute more of the purchase price to investors.
Also, when the transaction involves multiple sellers, buy-side policies protect those who haven’t been actively involved in the management of the target business from unintentional breaches of representation and warranties. It also shields those with deep pockets from being forced to shoulder a disproportionate amount of claims made against the sellers as a whole.
There are also some key advantages for buyers. For example, RWI can distinguish a bid in a competitive auction by accepting a lower indemnification cap from the sellers. It also helps to lessen collection risks when the seller is in poor financial shape, when there are numerous sellers or when there are foreign sellers who might be difficult to locate.
It can also help protect relationships, as buyers avoid a situation where they are seeking recoveries from “friendly indemnitors” (i.e., sellers with whom the buyer has continuing business relationships). The ability to recover directly from an insurer may also lessen distractions that might otherwise come with an indemnity claim. Furthermore, RWI will often extend coverage past the period contemplated by the purchase agreement, giving buyers more time to detect and report problems that might exist with a newly acquired business.
Impact on Timing and Process
RWI can eliminate indemnity negotiations and other obstacles to closing, which helps to expedite the sale and has the potential to increase the purchase price. The policies can also offer a way to bridge the gap between the buyer and seller when the two sides aren’t able to agree on terms of indemnification of the buyer or the amount of the purchase price that will be held from distribution or placed in an escrow account.
To be sure, getting an RWI policy comes with its own expenses and negotiations. The side proposing the use of insurance will need to get a broker to engage with a carrier. You can also expect a non-disclosure agreement will have to be signed before the underwriting process can begin. It’s worth noting that with the surging popularity in RWI, particularly for middle-market deals, more brokers and lawyers are looking to break into the space. Buyers and sellers need to make sure that the people guiding them have the necessary expertise.
Putting an Insurance Policy In Place
Assuming all goes well, the carrier will draft an insurance policy, which is then negotiated between the two sides. The negotiations will focus on a number of key issues, including defining the scope of losses included and excluded from the coverage. It is important the buyer pay close attention to what is excluded from coverage to make sure it is sufficiently protected against future losses. Generally, the insurance will not cover, among other things, issues that the buyer was aware of at the time the policy was issued, such as those that were included in due diligence reports. The buyer and seller will also need to decide who is responsible for the underwriting fee/insurance policy premium and hash out the details about what portion of the purchase price, if any, will be placed into escrow to mitigate the retention amount of the policy.
How Much Does it Cost?
RWI typically costs between 2.5% and 4% of the coverage limit. In addition, the carrier typically requires an up-front underwriting fee to cover their due diligence costs in writing coverage. These fees are usually between $25K and $50K. Standard deductibles for RWI ranges from 1% to 3% of the total transaction value. Often, the hold-back from the purchase price is equal to the RWI deductible to place the risk on the seller.
Inaccuracies in representations and warranties made by the seller during an M&A transaction can result in costly liabilities. RWI can offer benefits to both buyers and sellers, allowing them to efficiently allocate risk and increase value in the deal. Parties involved in a transaction should evaluate the circumstances of a proposed transaction to determine whether insurance is appropriate and how it should be structured. If the parties agree that RWI is appropriate, they should seek out a qualified adviser early in the process to engage a carrier that can provide coverage at a price that makes sense for the size of the transaction in a timely manner.