- Representation and warranty insurance 101
- November 17, 2017 | Authors: John G. Marvar; Ilirjan Pipa
- Law Firm: McDonald Hopkins LLC - Cleveland Office
Representation and warranty (R&W) insurance policies have grown in popularity in merger and acquisition (M&A) transactions. This blog post offers insights into what R&W insurance is, its history, how it works, and when and why parties in an M&A transaction should use it.
WHAT IS R&W INSURANCE?
R&W insurance is a type of insurance product used to complement traditional escrow and indemnification measures in M&A transactions. While R&W insurance has existed for roughly two decades, its popularity is only now growing due to a handful of factors, including lower premiums, a more efficient underwriting process and better insurance terms offered by insurance providers to insured parties.1 The policy will cover losses stemming from a party’s breach of the representations and warranties in a purchase agreement that are in excess of the retention amount and up to the policy’s coverage limit. The retention amount (or the deductible) under the R&W insurance policy usually ranges from 1 percent to 3 percent of the purchase price2 and the policy’s coverage limit usually ranges from 10 percent to 30 percent of the purchase price.3 This type of insurance product is used most commonly in transactions with a valuation ranging between $20 million and $1 billion dollars due to premium costs, the amount of professional fees and expenses involved in the process of procuring the policy and the risk appetite of insurers.4
HOW DOES R&W INSURANCE WORK?
Representations and warranties and indemnification provisions traditionally have been used in M&A agreements to allocate some of a buyer’s risk of buying a business to a seller. If a seller breaches a representation and warranty provision, then the indemnification provisions will define when and how much that seller must pay to the buyer for losses it has suffered as a result of the breach. Parties typically will agree on an amount of the purchase price to be placed into an escrow account to cover indemnification obligations. Tension often arises in negotiating these terms as a buyer’s desire for broad indemnification coverage conflicts with a seller’s desire for limited indemnification obligations. R&W insurance can alleviate these issues by shifting some of the risk of a breach from the parties in an M&A transaction to an insurance provider.5
Buyer-side R&W insurance policies (where the buyer is the insured party) are more popular than seller-side policies (where the seller is the insured party). (For that reason, this post is focused on the terms of buyer-side R&W insurance policies.) In the underwriting process, typically a buyer in an M&A transaction will engage an insurance broker on its own or through its counsel. Then, the broker will connect the buyer with an insurance provider which will provide quotes and begin underwriting for a policy.6 The cost of procuring the policy (or the premium) typically ranges from 2 percent to 4 percent of the policy’s coverage amount.7 Depending on the negotiating power of the parties in an M&A deal, the cost of the premium can be split between the parties or it can be allocated to one of the parties.
Buyer-side R&W insurance policies typically have a policy period (i.e., the time during which the insured party may make a claim for recovery of losses from the insurer) that extends beyond the traditional survival period in M&A agreements. The policy period is usually limited to three years from the closing date for breaches of ordinary representations and six years after the closing date for claims involving breaches of fundamental representations.8 Generally speaking, R&W insurance does not cover losses caused by breaches of covenants, purchase price adjustment provisions or matters that were already known to the insured’s deal team (including all matters disclosed in schedules or discovered during diligence such as pending litigation matters or environmental issues).9
WHY USE R&W INSURANCE?
There are several advantages to using R&W insurance in an M&A transaction.
1. It protects a buyer where a seller has more leverage and negotiates limited indemnification terms.
2. It provides a form of security to a buyer who cannot collect from a seller for various reasons. For example, a seller may be a fund that distributes the purchase price proceeds to its investors after the closing.
3. It preserves a continuing working relationship between a buyer and seller under circumstances such as when a seller stays on to manage the acquired business or seller and buyer have another business relationship aside from the M&A transaction.
4. It can help buyers in competitive bids stand out from other potential buyers.
5. The R&W insurance policy may provide for a greater indemnification cap and a more extensive representation and warranty survival period than the purchase agreement would have otherwise made available.10
The need for R&W insurance will vary deal by deal. There are many issues that must be considered in transactions that utilize R&W insurance, including negotiating and providing for a mechanism through which buyer may recover losses that are below the policy’s retention amount or above the policy’s limit. For information on whether R&W insurance is appropriate for your deal and to assist you in obtaining a policy for your M&A transaction, contact one of the attorneys listed below.1. Ronald E. Whitney, Matthew J. Moussiaux and Matthew R. VanWasshnova, Representation and Warranty Insurance for M&A Transactions, Thomson Reuters Practical Law: Corporate & Securities (2017), page 2.
2. See footnote 1 above, page 6.
3. See footnote 1 above, page 5.
4. See footnote 1 above, page 2.
5. See What’s Market Analytics: Representation and Warranty Insurance, Thomson Reuters Practical Law: Corporate & Securities (Sep. 24, 2015).
6. See footnote 1 above, page 9-10.
7. See footnote 1 above, page 7.
8. See footnote 1 above, page 6-7.
9. See footnote 1 above, page 5-6.
10. See footnote 1 above, page 3.