Richard A. Moore | Financial and Insurance Advisor | Business Consultant
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Mergers and Acquistions

Rep and Warranty Insurance

M & A experts worldwide are using an insurance policy known as a Representation and Warranty (R & W) to transfer risk from the parties in a transaction to an insurance company.  R & W policies are designed to, "step in the shoes" of a seller to pay indemnification claims by the buyer for inaccuracies of the representations and warranties outlined in the purchase/sale agreement.  Due to the low cost of  R & M insurance, sellers are driving the demand for these policies rather than accept large, lengthy escrow or withhold terms.  Buyers are discovering how R & W insurance can enhance their bid without having to raise their offer.

For the seller: 

  1. An R & W policy replaces the indemnification provision and reduces the escrow to 1% or less of the purchase amount.
  2. Enables early and final distribution of proceeds to investors.
  3. Locks in the return and provides a clean exit as contingent liabilities are covered.
  4. Expedites the sale by getting the indemnification issue "off the table".
For the buyer:
  1. Distinguishes bid in a competitive auction, without raising the offer price.
  2. Eases concerns about collecting on seller's indemnification.
  3. Preserves relationship with seller.  In the event the seller is remaining with the company, the buyer pursues the R & W insurer, and NOT the seller in the event of a breach.
  4. Expedites the sale by getting the indemnification issue "off the table".
Underwriting & Placement Process:
1. Secure information for underwriters: 
  •  Acquistion agreement (draft version is acceptable)
  • Seller's audited financials
  • Seller's disclosure statements (if available)
  • Offering memo
2. Within 3 to 5 business days, a no cost, no obligation, non-binding indication (NBI) is provided.
3. Due diligence process is commenced with selected market - requires payment of non-refundable underwriting fee.
4. Conference call is arranged between the underwriters and the applicant's attorneys.
5. Final terms are issued within 2 business days of the final conference call.
Limit Capacity - Up to $100MM on a single policy.  Excess capacity up to an additional $400MM available as needed.
Retentions - commonly 1% to 3% of the purchased price.  Reduces over time.
Premium - 3% to 4.5% of the limits purchased (including taxes and fees).  Minimum premium is $300,000.
Underwriting Fee - From $25,000 to $35,000 in addition to the premium.  Covers the cost of insurer's attorney's fees and due diligence costs to review and manuscript a policy.  Non-refundable.
  • Seller's policy - checks how seller developed R/W
  • Buyer's policy - checks how buyer vetted the Seller's R/W
Terms - designed to match the survival period.  Post survival extensions available upon request.
How much does the policy cost, how much does it cover and for how long?
 As the volume of R & W insurance increases, carriers are trying to standarize policy language.  But this coverage is customized for each deal, and many of the terms are negotiable.  The most common approach is to secure a policy that provides protection up to 10% or 15% of the deal's enterprise value (typically the combination of the equity and debt of the company).  In the U.S., the premiuns are typically 3% to 4% of the policy limit, substantially lower than they were a few years ago.  A commom term is three-to-six years for breaches of nonfundamental representations--basic claims like the accuracy of financial statements and customer contracts.  The limit is usually six years for breaches of fundamental representations--core issues such as whether the seller actually owns the company being acquired and that its tax returns weren't fraudulent.
Which party pays for the premium and covers the deductible in case of a claim?
In general, these details wind up as part of the broader negotiation of the terms of the acquisition agreement.  Either the buyer or seller can offer to sweeten the deal by paying for the R & W coverage.  
Typically, there is a retention (similar to a deductible) that calls for the buyer to absorb the first losses related to the policy.  Sometimes there is a second retention that calls for the seller to cover some of the losses as well.  For example, the buyer might be responsible for the first losses up to a limit of 0.5% of the deal's enterprise value and then the seller would cover losses of the same amount, leaving the insurance company paying claims above 1% of enterprise value up to the policy limit.
Imposing a retention on the seller might seem to be inconsistent with a transaction specifically meant to mitigate the seller's contingent liablilities.  Still, both buyers and insurance companies worry about the moral hazard of an arrangement in which sellers have little incentive to ensure their representations and warranties are accurate.  This often means that the insurance is combined with a traditional escrow arrangement, albeit a smaller one than would otherwise be needed.
Indeed, if the seller has no "skin in the game", many insurance companies will insist that the buyer has a retention of at least 1.5% of the deal's enterprise value.
What is the timetable for underwriting and issuing the policy? 
While the process of underwriting an R & W insurance policy usually does not delay a transaction, it creates some additional milestones for a deal's closing.  It's essential to start shopping for R & W insurance early in the process and to ensure the selected carrier understands the proposed timeable.  As dealmakers get used to the unique rhythms and requirements of R & W insurance, they will find it can be part of a smooth process and diffuse the anxiety of closing a transaction.