M&As Fuel Reps and Warranties Coverage
Demand for representations and warranties coverage is on the rise for a number of reasons: increased M&A activity, a continued seller-friendly market, and the increased acceptance of the insurance product by deal makers, including law firms and investment bankers.
When the product became available about 10 years ago, buyers primarily purchased R&W as supplemental indemnity coverage when they were unable to get sellers to provide what they considered to be adequate indemnification protection under the transaction agreement, said Kirk Sanderson, senior vice president, transactional risk at Equity Risk Partners in New York City.
Sanderson’s firm was recently acquired by HUB International Ltd.
But in today’s market, sellers are essentially mandating that buyers take a reps and warranties policy to remain competitive in an auction scenario while providing very limited indemnification and zero escrow to buyers, Sanderson said.
“Private equity firms and their outside counsel have really pushed the envelope over the past three to four years on developing the R&W insurance policy into a highly efficient and economically favorable capital solution,” he said.
Renee Szalkowski, senior vice president and transaction liability practice leader at Lockton in New York City, agreed. Sellers in prospective M&A deals now have more leverage to demand that buyers take out R&W policies to suit their own purposes, she said.
“They are dictating terms, including providing little or no indemnity in deals where they don’t have to set aside a large percentage in escrow for 12 or 18 months,” Szalkowski said.
Moreover, there is greater acceptance of the product because pricing — at 3 percent to 4 percent of limits purchased — is more reasonable, and the underwriting process more streamlined, she said.
The manuscripted polices are now underwritten by ex-M&A attorneys and are more insured-friendly, based on “actual knowledge” definitions, with limited subrogation against sellers and an increased appetite for certain types of damages, she said.
The “actual knowledge” exclusion in older vintage policies was much more expansive, said Matthew Heinz, managing director at Aon in New York City, and a 2016 Power Broker® in the Private Equity category.
He said the current exclusion is much narrower and makes it harder for the carrier to prove that the insured had actual knowledge of a breach at binding and to prove that the exclusion should apply.
In general, Heinz said, reps and warranties coverage terms have gotten a lot better, and are closer to the traditional indemnity provided by sellers in transactions.
Some exclusions, such as those limiting the breadth of recoverable loss for consequential damages or diminution in value, are frequently removed, providing the buyer with coverage terms that more closely approximate the types of loss the buyer would seek to recover from the seller if there is a breach.
An example would be the availability of consequential damages in connection with a seller’s breach of a regulatory compliance representation.
“If a target company was not compliant with some regulation and must pay a fine and shut down a portion of its operation as a result, the buyer would seek to recover not just the immediate financial impact of the breach (i.e., the fine), but also any consequential damages resulting from the shut-down, including lost profits,” Heinz said.
“Today’s policies allow for this coverage,” he said.
Using R&W Strategically
Reps and warranties policies are also more strategic now, as opposed to being driven by concern over heightened risk, Heinz said.
“Clients are strategically incorporating policies into the front end of deals, rather than when an issue comes up,” he said. “Sellers have been able to exit deals more cleanly by pushing buyers to obtain insurance coverage.”
Without insurance, sellers might have to indemnify the buyer up to 10 percent of the deal size, and potentially leave an escrow in place up to that amount, Heinz said. But now the seller may only need to put 1 percent or less in escrow, with the remainder of risk allocated to the insurance market in the form of a buy-side reps and warranties insurance policy.
Premiums have also come down from a range of 4 percent to 6 percent pre-2008, to the 3 percent to 4 percent range in the current market, he said.
Szalkowski and her team expect reps and warranty insurance will continue to be in high demand over the next year as the M&A landscape remains competitive.
“Sellers are retaining post-closing equity positions more frequently and selling management is staying involved,” she said.
“This will result in buyers continuing to use reps and warranties policies to protect these relationships post-closing.”
However, clients should not expect prices to fall further in the near future just because “quite a few” carriers have entered the R&W insurance market, Szalkowski said.
“Notwithstanding increased supply and given increased demand, the fact that insurers that have been around for a while are paying claims means that overall pricing is holding steady,” she said.