Mergers and acquisitions are expected to accelerate in 2018. Technology continues to lessen the time and cost of completing deals. Higher volumes and faster pace mean that managing risk during the transaction period is more important than ever. As a result, and for good reasons, the use of Representations and Warranties Insurance (RWI) is increasing as a means to transfer risk during buy/sell transactions.
The Changing Market for RWI
Several general factors contribute to the growing acceptance of and reliance on RWI as a way to offer protection during a M&A transaction.
As RWI gains traction, more insurers enter the market creating a more competitive environment. This increased competition has led to RWI policies with improved terms, including reduced premiums and deductibles. According to the Harvard Law School Forum on Corporate Governance and Financial Regulation, a few years ago, RWI premium amounts generally sat at 3 percent to 4 percent of coverage limits. Deductibles ranged from 1.5 percent to 2 percent of the value of the deal. Today, RWI premiums are often below 3 percent of coverage limits and deductibles have decreased to 1 percent or lower of deal value.
One of the barriers to earlier acceptance of RWI was skepticism that insurance companies would actually pay claims against RWI policies. This has proven untrue and buyers have learned that insurance companies are as likely to pay RWI claims as they are to pay the more traditional seller indemnity coverage claims.
The traditional methods of managing and allocating risk in a transaction are undergoing a paradigm shift. With the use of Reps & Warranties Insurance, deal risk can now be managed on the front end of a transaction by transferring the risk to an insurer for a fixed cost.
The third factor contributing to the growing popularity of RWI is the continuing seller-friendly deal environment. In fact, we are seeing more buyers rely exclusively on RWI as opposed to seller’s indemnities. In the current environment, sellers have the leverage to require a reduction in, or the elimination of, the escrow that traditionally was in place post-closing to protect buyers in the event of a breach of seller’s representations and warranties.
RWI and Seller’s Indemnity
The use of RWI to limit a seller’s indemnity can shorten the deal timeline due to less negotiation over the representations and indemnity provisions in the transaction Typically, a buyer may seek an indemnity for breaches of seller reps equal to 10 percent of the deal value. In contrast, if the same buyer obtains RWI with the same 10 percent coverage limit and a retention of 1 percent of the deal value, the buyer and seller only have to allocate the retention between them. The retention is often split between the buyer and seller with the first 50% allocated as the buyer’s basket and the remaining 50% as the seller’s indemnity obligation. Then, there is usually a drop-down provision wherein the retention drops to 50% after a period of 12- 18 months.
Entirely eliminating seller’s indemnity can further simplify negotiations by taking an item “off the table.” When this option is chosen, buyers and sellers eliminate the seller’s liability for certain breaches. In this scenario, the seller’s reps end at the time of closing.
The buyer relies solely on the RWI policy to recover any losses from covered breaches and the seller will not indemnify the buyer for breaches after closing. Usually offered with a modest premium increase, insurers are now willing to offer a zero-recourse structure. If this approach was chosen in the previous example, the buyer’s total exposure would equal 1% of the value of the deal.
The elimination of the seller’s indemnity can reduce administrative issues since there is no need for an escrow and the buyer works directly with the insurer to handle any claim, rather than having to concurrently seek recovery from the seller for their portion of the retention.
Protecting Buyer and Seller
The shift to using RWI in most large M&A situations has not changed the benefits of the coverage for both buyers and sellers. While most policies in the United States are buy-side, both parties reap the rewards of transferring risk to an insurance company.
In a seller’s market, RWI can make a bid more attractive and shorten the negotiation process. In a competitive process, such as auction, these differentiators allow a buyer to distinguish itself from multiple suitors.
Because buyers make claims to recover directly to the insurer instead of making a claim against the seller, the buyer can:
For sellers, the benefits of RWI are straightforward. During negotiations, topics such as price and deal certainty can take center stage. At close, funds are distributed faster because escrows and holdbacks can be limited or eliminated entirely.
Further enhancements to the policy have developed with the insurer’s often recognizing a full materiality scrape to the extent set forth in the acquisition agreement i.e., they will “read out” materiality qualifiers in the reps for purposes of determining whether a rep has been breached. This is provided when it is evident that the seller made disclosures without regard to materiality.
In addition, insurers will remove the exclusion for multiplied and consequential damages as long as the definition of Loss in the acquisition agreement is silent as to the availability of such losses.
RWI is complicated coverage designed to cover representation breaches. While the benefits are many, the policy does not cover every aspect of an acquisition agreement.
The best way to avoid having any “deal specific” exclusions inserted into the policy, is for the buyer to conduct a thorough due diligence process along with engaging quality advisors where appropriate. If a certain area has not been reviewed, for example cyber exposures, it is likely the insurer will add an exclusion. RWI is not meant to be a substitute for ordinary due diligence in a transaction.
In instances where a potential liability remains uncovered by the RWI policy, it may be necessary to have a “special” indemnity and escrow to address this issue.
A team of trusted advisors is part of every merger and acquisition. While most are familiar with the lawyers, bankers and accountants involved, the changing landscape of risk management and protection shows that as more deals are in process, protection is vital to keep the transaction moving efficiently and smoothly.
For example, Transactional Risk Advisors (TRA), a division of Oswald Companies, includes professionals experienced in the M&A risk space Our dedicated M&A practice includes seasoned M&A attorneys and insurance professionals who understand the complexities, risks and challenges of buy/ sell transactions. TRA has been working with Reps & Warranties Insurance since the early 2000’s.
We have helped many clients navigate the complexities of due diligence and the reps and warranties included in acquisition agreements. Understanding limitations, exclusions, gap coverages and the nuances of a deal require specialized knowledge. Aligning with a proven, professional risk manager early in the process can reduce conflicts, save time and offer the security of having the right protection in place throughout due diligence, negotiation, close and beyond.
Using TRA for your next transaction could be the right solution to minimizing risk, saving time and completing a smoother transaction. If your deal is valued at $20 million or more, talk with the TRA experts and find out if transactional insurance products can facilitate the successful completion of your deals.
Learn more about our Private Equity experience and solutions:
Jeff Schwab, CPCU
Senior VP, Private Equity Practice Leader
Note: This communication is for informational purposes only. Although every reasonable effort is made to present current and accurate information, Oswald makes no guarantees of any kind and cannot be held liable for any outdated or incorrect information. View our communications policy.