Is Representation and Warranty Insurance Appropriate for Your M&A Deal?

Representation and warranty insurance (“RWI”) is a risk allocation tool intended to protect the insured against losses arising from unanticipated and unknown breaches of the seller’s representations and warranties (“R&Ws”) in a purchase and sale agreement.

In essence, RWI is available to help protect both buyers and sellers from losses suffered from inaccurate R&Ws, by shifting the indemnity risk to the insurer. While most RWI policies are issued for buyers (buyer-side policy), RWI policies can be obtained for the seller (seller-side policy).

A buyer-side policy is a first party policy, the purpose of which is to ultimately have the insurer indemnify the buyer for the seller’s breach of R&Ws in the purchase and sale agreement. A seller-side policy is a third party policy, where the buyer would first need to pursue an indemnity claim against the seller under the purchase and sale agreement in order to trigger a claim by the seller for indemnification by the insurer under the RWI policy.

Reasons for Obtaining the RWI Policy

From a buyer’s perspective, RWI may be beneficial in a variety of situations, including where:

  • the buyer is unable to obtain from the seller its desired level of indemnification or a sufficient duration for the survival period for indemnification;
  • the buyer has concerns over its ability to collect from the seller, whether it be as a result of transacting with a financially-distressed seller, a seller in an unfamiliar jurisdiction or multiple sellers located in multiple jurisdictions;
  • the buyer desires to provide protection over key relationships, for example, if the buyer values its pre-existing commercial relationship with the seller and wants to avoid having protracted negotiations with the seller regarding appropriate levels of indemnification and/or having to sue the seller in the event of a breach; and
  • the negotiation of R&Ws, indemnities and survival periods between the buyer and the seller have come to an impasse.

Additionally, a seller may find value in obtaining a RWI policy in the following situations:

  • the seller desires to reduce its exposure to contingent liabilities associated with the sale;
  • the seller desires to either reduce or eliminate the seller’s customary indemnity for breach of R&Ws;
  • the seller desires to have a clean break from the sale with a resulting ability to distribute the sale proceeds earlier, whether it be by reducing the amount or the duration of the purchase price holdback;
  • for strategic considerations; for example, in an auction process, the seller may look to RWI to offer an indemnity or survival periods greater than the seller would otherwise be willing or able to provide to potential buyers on its own; and
  • to protect passive investors and shareholders.

Scope and Coverage and Duration

The scope of coverage provided for in a RWI policy is typically customized to each transaction. It can be used as a replacement for, or supplement to, the indemnity provisions in the purchase and sale  agreement. Coverage is available for both fundamental and non-fundamental R&Ws, as well as for specific R&Ws when appropriate.

For a seller-side policy, the term of coverage for the RWI policy generally corresponds to the indemnity survival period in the purchase and sale agreement. On the other hand, a buyer-side policy can provide coverage in excess of the indemnity survival period in the purchase and sale agreement, by protecting the buyer against breaches of R&Ws that become apparent only after the survival period in the purchase and sale agreement has expired.

Exclusions from the RWI Policy

As with any type of insurance product, the RWI policy will contain exclusions from coverage. While the extent of the exclusions will ultimately depend upon the insurer’s due diligence on the underlying transaction and the negotiation of the particular policy, some of the standard exclusions under a RWI policy include:

  • actual knowledge of a breach;
  • projections or forward-looking statements;
  • adjustments to the purchase price pertaining to working capital;
  • fines and penalties;
  • liabilities related to pension funds; and
  • breaches that occur during the interim period between signing and closing of the purchase and sale agreement.

In addition, fraud will be excluded from coverage on a seller-side policy (however, a buyer-side policy can include coverage for seller fraud).

Costs to Obtain the RWI Policy

The costs generally associated with obtaining a RWI policy are the underwriting fee, the premium and the retention amount; although there may be additional costs, such as premium taxes and an insurance broker fee, that are applicable to obtaining the policy.

The underwriting fee charged by the insurer will typically fall in the range of $30,000 to $50,000. The underwriting fee covers the costs of the insurer and its outside counsel engaged to review the due diligence process conducted by the parties to the transaction and/or conduct further due diligence.

The premium charged by insurers for issuing the RWI policy is typically a one-time fee that is paid up-front (at the time the policy is issued) and generally falls between 2% to 4% of the coverage limit, although it has been suggested that premiums for RWI policies have been decreasing in recent years on account of increased competition in the RWI underwriting market. To provide a simple example, if the transaction value was $50 million with an indemnity cap of $10 million, the premium on a RWI policy (with coverage for $10 million) would be expected to fall in the range of $200,000 to $400,000. The premium can be paid be either party, regardless of whether the policy is a buyer-side policy or a seller-side policy.

The cost of the RWI policy will also include a retention amount, which functions like a deductible in that a specific amount of losses must be incurred before the insurer’s obligation to payout insurance proceeds is triggered. The retention amount is typically a minimum of 1% of the transaction value, often landing somewhere between 1% to 3% of the transaction value. For example, in a purchase and sale agreement with a transaction value of $50 million, the retention amount would be expected to be between $500,000-$1,500,000. However, depending on the policy, some insurers are now offering a drop-down feature on the retention amount, which effectively cuts the retention amount in half at the 12-month anniversary of the closing date of the transaction.

It should also be noted that most insurers will charge a minimum premium between $100,000-$150,000, regardless of the coverage limit. As a result, the use of RWI is generally viewed as less suitable for transactions that carry an indemnity cap of less than $3 million. That said, the attractiveness of RWI to buyers and sellers in transactions that involve indemnity exposure below $3 million will remain, in part, dependent on the transaction value and, by extension, the retention amount.

Recent Market Data regarding RWI Policies

While RWI products have been around since the 1990s, the use of RWI in Canadian M&A transactions has started to gain traction within the last decade. In terms of more current growth, Marsh JLT Specialty recently issued its 2019 global M&A year-in-review study (the “Marsh Report”), which provides that the number of transactional risk insurance policies placed by Marsh in North America in 2019 represented a 28% increase over 2018. The increased demand for RWI policies has, in part, led to increased market competition among RWI underwriters, resulting in more favourable terms to insureds. By way of example, the Marsh Report suggests that the market competition has resulted in a favourable premium rate environment for insureds, with premiums in 2019 declining by 11% from 2018, and down 34% from 2015.

Additionally, a recent RWI claim study issued by AON (the “AON Study”) analyzed in excess of 2,450 RWI policies placed by AON in North America between 2013 and 2019. The AON Study notes a steady increase in claims made on RWI policies year-over-year, resulting in an aggregate increase of more than 400% in total claims made on RWI policies in 2018 versus 2014. This dramatic rise in claims is largely attributed to the increase in the number of RWI policies issued during the same time period.

As RWI becomes more widely available and affordable, it is becoming increasingly prudent for buyers and sellers to consider using it to help facilitate transactions in the appropriate circumstances.

Note: This article is of a general nature only and is not exhaustive of all possible legal rights or remedies. In addition, laws may change over time and should be interpreted only in the context of particular circumstances such that these materials are not intended to be relied upon or taken as legal advice or opinion. Readers should consult a legal professional for specific advice in any particular situation.