Although transactional insurance is not a novel concept, recent developments in product offerings and coverage have significantly enhanced their effectiveness. At the 2023 Advanced Law Seminar Course for the State Bar of Texas, Walker Eisenbraun’s Bo Boyd and Clare Reilly discussed how these transactional insurance products have been strategically crafted to provide parties with a cost-effective and efficient means of addressing risks, simplifying the deal closing process compared to traditional indemnity and escrow structures.
Innovative solutions are not only streamlining deals but also making them more affordable, marking a noteworthy shift in the dynamics of transactional risk management practices.
Addressing unknown and known risks
Understanding the landscape of risk mitigation tools involves categorizing them into two distinct groups, each tailored to address specific types of risks. First, there are products strategically crafted to cover unknown risks, commonly referred to as reps and warranties insurance (RWI). This category acts as a financial safety net, providing protection against losses resulting from breaches of a seller’s representations and warranties.
Secondly, there are products designed to address known risks, encompassing various forms that are titled based on the specific type of known risk they cover. These insurance products, tailored to address identified risks, help fortify deals against uncertainties and challenges that may arise during the transaction process.
Mastering Reps and Warranties Insurance (RWI) in Transactions
Representations and Warranties Insurance (RWI) serves as a strategic financial safeguard against losses resulting from breaches of a seller’s representations and warranties.
For instance, consider a scenario where a seller represents that the company is not involved in any litigation pre-closing, but post-closing, a lawsuit emerges related to pre-closing matters. In such a case, the breach of this representation could be mitigated by the buyer through coverage under the RWI policy.
It’s important to distinguish between two types of representations: fundamental and general. Fundamental reps pertain to the core aspects of the transaction, such as the seller’s ability to execute the deal. On the other hand, general reps involve the business operations of the company being sold, such as financial statements and litigation history.
RWI fundamentally shifts risk in the deal by relieving the seller of the obligation to cover breaches; instead, the buyer can claim the amount of loss from the insurer. While RWI presents an innovative approach to risk management, it’s important to note that its practical application is generally confined to private deals due to the stakeholders’ support in backing reps and warranties.
Additionally, RWI is more economically viable in deals above a certain threshold, with costs generally not decreasing proportionally with smaller deal values. However, the current soft market, marked by lower transactional insurance costs, has made RWI a viable consideration for deals as low as $20 million, a significant shift from the historical range of $50-$500 million.
Understanding Reps and Warranties Insurance Policy Coverages
To comprehend how RWI policy coverages operate, it’s helpful to contrast them with traditional indemnity schemes. In a typical $200 million deal with a traditional approach, $180 million (or 90%) would be proceeds to the seller, while $20 million (10%) would be held in escrow to secure against potential future breaches.
RWI transforms this structure in a $200 million deal scenario: Instead of allocating 10% to escrow, the escrow portion could be eliminated or significantly reduced. The buyer acquires an RWI policy with a coverage limit of $20 million to replace the escrow, typically costing 3-5% of the coverage (amounting to $600K to $1 million in this example) with a retention of $1.5-$2 million (around 1% of the transaction size). The retention serves as the deductible, delineating the amount of losses the buyer must bear before the insurance policy takes effect. Negotiations between buyers and sellers determine how to share this cost.
If the seller bears the entire retention, their take-home amount would be $198 million even if the full retention becomes due. The benefits are evident: the seller receives almost all proceeds, and the buyer is relieved from pursuing breaches under a seller escrow. Although RWI can cover any level, it’s uncommon for parties to bind an RWI policy for more than 50% of the purchase price. Additionally, emerging RWI products like the Excess Fundamental Policy offer an extra layer covering breaches of Fundamental Reps up to the entire purchase price, with current market pricing as low as 2-3%, presenting a significant evolution in the transaction insurance landscape.
Benefits of Reps and Warranties Insurance to Buyers and Sellers
For sellers, RWI offers immediate access to more funds at the closing table, maximizing returns and providing relief by lowering caps or entirely eliminating indemnity obligations. The streamlined process facilitated by RWI expedites the overall deal timeline, simplifying negotiations and substituting a creditworthy third party to backstop breaches, thus eliminating the need for a seller or parent guarantee. Moreover, RWI minimizes potential post-closing liabilities, providing a level of assurance akin to a “public-style walk-away” for private transactions.
For buyers, RWI replaces reliance on the seller for post-closing obligations, streamlines post-closing collections, preserves relationships with sellers retained post-closing, accelerates transactions, and eases negotiations. RWI’s role in private transactions is progressively becoming more common, with deals referencing RWI seeing a surge to 65% in 2021 and continuing to rise, signifying its growing acceptance and prominence among deal parties.
The insurance market is actively adapting to RWI products, enhancing efficiency, and developing new offerings, resulting in lower premiums and more favorable terms, indicating an upward curve in acceptance.
Buy-Side or Sell-Side policy?
In choosing transaction insurance, parties decide between Buy-Side and Sell-Side policies. Sell-Side policies, while rare, involve the seller’s liability for indemnification, compensated by RWI for losses. Buy-Side policies, more prevalent, make the buyer the insured party, reducing a seller’s indemnification obligations and providing extended coverage, with 3 years for general and 6 years for fundamental reps.
Payment responsibilities are negotiated; typically, costs are shared, with common arrangements like a 50/50 split of retention and separate negotiations for the premium. Without sharing, the buyer covers the premium.
Proceeding with a Buy-Side Policy involves early broker engagement, kick-off calls, and interactions for non-binding quotes. Assuming buyer exclusivity, an insurer is chosen, leading to diligence, underwriting calls, and policy language negotiations, with binding at the purchase agreement signing or closing.
In claims, policies typically cover general reps for 3 years and fundamental reps for 6 years. Despite this, around half of all claims emerge in the initial 12 months. When a claim occurs, the buyer identifies the breach, determines the loss, and may submit a demand against the seller’s escrow. The claim is then submitted under the RWI policy, and the insurer may request further information before deciding on coverage.
Drafting Considerations in RWI-Backed Deals
Navigating the introduction of Representations and Warranties Insurance (RWI) into a deal requires careful consideration of drafting nuances in definitive agreements. Several key considerations arise in the drafting process:
- Sandbagging Provisions: RWI inherently opposes sandbagging, covering only unknown breaches.
- Scope of Reps and Warranties: Agreements with RWI often entail broader representations, balancing the seller’s risks.
- Adjustments to Standard Qualifiers: Materiality and knowledge qualifiers are adjusted, with fewer in RWI deals, though RWI policies may read out materiality qualifiers during breach determinations.
- Disclosures Between Signing and Closing: In transactions involving a signing followed by subsequent closure, a situation becomes more challenging if disclosed information results in a loss in coverage under RWI policies.
- Waivers of Indirect Damages: Explicit waivers in a purchase agreement may exclude recovery for indirect damages under the RWI policy.
- Limited Seller Indemnities: While some deals eliminate seller indemnities with RWI, others maintain limited indemnification regimes, covering losses not under the policy.
- Role of Fraud: RWI policies often waive subrogation but not in cases of seller fraud, allowing the insurer to claim reimbursement.
Common RWI claims involve breaches of financial statements, information, or legal compliance, including employment, contracts, or customer issues. However, claim submission doesn’t guarantee coverage, requiring vigilance. Coverage exclusions, like losses from harmful elements, environmental concerns, medical malpractice, diligence gaps, criminal acts, and specific industries like cannabis, should be understood. RWI focuses on unknown risks, excluding matters revealed in due diligence, while known risks demand other tailored tools for transactional contexts.
Creative Solutions for Known Risks: Contingent Risk Insurance
What happens when known risks emerge during diligence? This is where Contingent Risk Insurance steps in, providing a strategic approach to managing identified uncertainties. While not universally applicable, parties must carefully assess potential liabilities against costs, deciding whether contingent insurance is a prudent choice.
Distinguishing itself from Representations and Warranties Insurance (RWI), contingent risk insurance isn’t confined to private transactions; it extends its applicability to public deals. Various known risks find coverage under this umbrella, including tax matters, litigation, environmental concerns, under-funded pension plans, and intellectual property issues. Tax Insurance, a leading contingent risk tool, proves instrumental in mitigating pre-closing tax exposures and safeguarding future tax credits.
The scope of coverage extends beyond specific losses, embracing broader financial elements such as interest, penalties, contest costs, and even gross-up provisions. Notably, the diligence process for tax insurance doesn’t demand a formal tax opinion, enhancing accessibility. Other identifiable risks, like environmental contamination, under-funded employee plans, and intellectual property claims, also find solutions through insurance.
In the realm of Litigation Risk Insurance, two primary policy types serve distinct purposes: Adverse Judgment policies shield defendants from catastrophic litigation outcomes, while Judgment Preservation policies lock in judgment value, diminishing appellate risks. Insurers exhibit flexibility and creativity in tailoring solutions, making contingent risk insurance an invaluable ally in managing risks that might have historically jeopardized deals.
As corporate transactions evolve, so do the tools available to manage risks. RWI and Contingent Risk Insurance have become integral components, offering flexibility, efficiency, and cost-effectiveness. Practitioners utilizing these creative solutions can better represent their clients and navigate deals to successful conclusions, tackling risks head-on. Understanding these tools is paramount for getting more deals across the finish line.
- SRSAcquiom, Executive Summary: 2017 M&A Deal Terms Study.
- AON: Empower Results, M&A Insurance: A Strategic Approach to Managing Deal Risk.
- Representation and Warranty Insurance for M&A Transactions, Practical Law Practice Note w-000-4767.
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- Atlantic Global Risk, Representations & Warranties Insurance: A Practical Analysis.
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- Representation and Warranty Insurance for M&A Transactions, Practical Law Practice Note w-000-4767.
Authors – Bo Boyd and Clare Reilly
