What is representations and warranties insurance?

Representations and warranties (R&W) insurance – also known as warranty and indemnity (W&I) insurance – is designed to cover unknown and unintended breaches of representations and warranties made in business merger and acquisition (M&A) agreements.  

The R&W components in an acquisition agreement are often heavily negotiated by both parties. Representations are statements of fact about the current state of the business that’s for sale, which are intended to induce the buyer to enter into the contract. Warranties are the assurances that the statements made in the representations are true.

In the past few years, there has been a surge in demand for R&W insurance, largely because of the hot litigation environment surrounding M&A. It has also been proven as a more affordable option to the traditional escrow holdback approach, especially for larger deals.

Before R&W insurance became a hot product, dealmakers would collateralize R&W with escrow holdbacks. Simply put, they would withhold typically around 10-15% of the purchase sum within an escrow fund to guarantee the outcome of R&W made by the seller.

R&W insurance was initially developed as an alternative way to protect the seller, but it quickly transformed into a buyer’s product when private equity became interested in the efficiency of using insurers’ capital as a substitute collateral instrument.

What is the scope of R&W insurance?

There are two types of R&W insurance policies: buyer-side policies and seller-side policies. Buyer-side policies protect buyers against misrepresentations by sellers, both innocent and fraudulent. Examples of misrepresentations include things like mis-stated financials, unknown third-party claims over intellectual property, and failure to obtain environmental or legal permits. Furthermore, the policies typically provide coverage for pre-closing tax indemnities, but only to the extent that the seller’s financials were incorrectly calculated in regard to those taxes.

Seller-side policies offer liability protection to sellers for innocent or accidental misrepresentations in purchase agreements. This enables sellers to “ring-fence the risks associated with the disposal,” according to Willis Towers Watson.

Typical exclusions in R&W insurance policies include:

· Breaches of R&W whose origin was known by a member of the deal team prior to the inception of the policy;

· Breaches relating to covenants or post-closing statements;

· Items listed on the seller’s disclosure schedules;

· Post-closing adjustments to purchase price or working capital (as long as they weren’t a direct result of an R&W breach);

· Unfunded or underfunded benefit plans

· Asbestos or PCBs

What are the most common types of R&W insurance claims?

A lot of R&W insurance claims revolve around taxation issues which arise after the purchase, according to Rhodes Williams Insurance. Other common claims include disputes around financial statements, compliance issues, contracts, intellectual property and employee issues.

How much does R&W insurance cost?

In a general rule of thumb, most insurers charge 2% to 4% of a transaction’s indemnity exposure as the policy premium. As policies are written on a bespoke basis to each transaction, insurers also tend to charge an additional underwriting fee, which can sometimes be from $20,000 to $40,000, to provide a formal quote.

Coverage limits for seller-side policies typically mirror the transaction’s indemnity exposure, while limits on buyer-side policies depend on their unique risk appetites. The policy deductible, defined as a retention within R&W insurance, is often shared between the buyer and the seller. Retentions often range from 1% to 2% of the enterprise value.

Which insurers in the US offer R&W insurance?

A number of markets offer R&W insurance in the US. Here’s a list of some of (but not all) of the key players:

· AIG

· AXA XL

· Chubb

· The Hartford

· Everest Re

· Beazley

· QBE North America

Many of the large insurance brokerages like Aon, Marsh, Willis Towers Watson, and Lockton all engage in the distribution of the specialty product.

The role of the broker  

Insurance brokers have become “an essential part of the M&A process,” according to Charles Fogden, national director Canada, Aon M&A and transaction solutions at Aon. He told Insurance Business: “The leading brokers in this field are tolled with the appropriate diligence suites and networks. Deal teams looking to complete an M&A transaction should seek out a broker with all the tools in the toolbox to be able to close a deal. I like to use the house inspector analogy – if a seller says a roof was replaced three years ago, who is checking that statement on behalf of the buyer? The general rule of thumb is – no diligence, no insurance.”

As more and more brokers develop specialized diligence toolboxes, clients can be assured of better decisions with M&A insurance products, which will continue the boom in the market.