Updated: 24 Oct 2024
Representations and warranties (R&W) insurance is designed to cover unknown and unintended breaches of representations and warranties made in business mergers and acquisitions (M&A) agreements. This type of coverage is also known as warranty and indemnity (W&I) insurance.
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 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 representations and warranties insurance became a hot product, dealmakers would collateralize R&W with escrow holdbacks. Simply put, they would withhold typically around 10 to 15% of the purchase price within an escrow fund to guarantee the outcome of R&W made by the seller.
The importance of R&W insurance raises several important questions, including:
Insurance Business sheds light on these and more relevant questions about representations and warranties insurance.
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. RWI is insurance that protects against losses that may result from real or alleged breaches of the representations and warranties in an acquisition agreement.
For the buyer in an M&A, purchasing a new asset or business entails risk. Private equity fund managers, corporate executives, risk managers, and other stakeholders have found that they can mitigate some of the uncertainty with the appropriate contractual protections in the underlying purchase agreement. Participants in mergers and acquisitions are also increasingly using representations and warranties.
"Representations and warranties insurance protects a buyer or seller against financial loss suffered due to a 'breach' – an inaccuracy in a representation or warranty given by the seller to the buyer in an acquisition agreement," says Michael de Feo, senior vice-president of Jencap Specialty Insurance Services.
"Claims often arise from financial statements, legal compliance, tax and/or material contract misrepresentations. Acquisitions often lead to claims. While claims by a company’s own shareholders against its own management team may be covered by D&O policies, claims by the acquiring company against the selling company are typically excluded by D&O policies due to breach of contract exclusions, for example.”
He adds that in an acquisition, money is often put aside in escrow for a certain period. This allows the buyer to confirm that representations and warranties made by the seller in the sale documents are correct.
"R&W insurance can be used to reduce or replace escrow requirements. By giving the acquiring company a sense of security and insuring this exposure, acquisitions can close more easily, and an acquirer may be willing to pay more to close the acquisition."
To illustrate the role of RWI further, let’s assume your client was in the process of merging with or acquiring a very large company and the deal is in the tens to even hundreds of millions of dollars. They would likely be taking the seller’s word about its financial and operational condition. So, what if the seller’s representations about their company were inaccurate or in bad faith? This short video tells of a few details about how representations and warranties insurance works:
Representations and warranties insurance can be a crucial form of business coverage. Find out the other types of business insurance your company needs in this guide.
The main function of representations and warranties insurance in M&A is to serve as economic protection to parties involved in such transactions. R&W insurance is more advantageous, compared to the traditional indemnification method that requires sellers to place a portion of their proceeds in an escrow to cover indemnifiable losses by buyers.
In general, R&W insurance gives coverage for all representations and warranties of a target company or the seller(s) in an M&A purchase agreement. An R&W policy is meant to protect an insured against financial loss — including defense costs — resulting from breaches of such representations and warranties.
There are two types of representations and warranties insurance policies:
Buy-side R&W policies protect buyers against misrepresentations by sellers, both innocent and fraudulent. Examples of misrepresentations include:
These policies also provide coverage for pre-closing tax indemnities, but only to the extent that the seller’s financials were incorrectly calculated regarding those taxes. You could say that R&W insurance in this case works like other critical insurance that not many companies know about or use.
Seller-side R&W insurance policies offer liability protection to sellers for innocent or accidental misrepresentations in purchase agreements. This enables sellers to isolate the risks associated with the disposal.
R&W insurance doesn’t offer protection from known breaches, which must be disclosed.
“Forward-looking statements regarding the performance of the acquired company, breaches already disclosed in the acquisition agreement, or 'sandbagging' – breaches known by the buyer who proceeds to close the acquisition despite this knowledge," de Feo says.
"Generally, claims arising from the acquisition but brought by third parties other than the buyer, would not be covered under the R&W insurance but could be covered under a directors & officers liability insurance policy of the acquired company, for example.”
Other exclusions in representations & warranties insurance can include:
A lot of R&W insurance claims revolve around taxation issues which arise after the purchase. Other common claims include:
Most insurers charge 2% to 4% of a transaction’s indemnity exposure as the policy premium. As policies are written on a case-to-case basis for each transaction, insurers also tend to charge an additional underwriting fee.
"For the smallest transactions, a $100,000 minimum premium in addition to a $25,000 to $50,000 underwriting fee is typical," de Feo says.
The chart below summarizes typical program pricing indications, for eligible risks. Eligibility will be based on the class of business and review of the acquisition or sale agreement or similar document. Certain classes will be ineligible or carry higher rates.
|
Deal Size/Transaction Value |
$5 million |
$10 million |
$15 million |
$20 million |
|
100% of transaction insured for each policy |
||||
|
Seller policy covering unknown breaches |
$5M limit at $35,000 |
$10M limit at $70,000 |
$15M limit at $105,000 |
$20M limit at $140,000 |
|
Buyer policy covering fraud or known breach |
$5M limit at $49,500 |
$10M limit at $99,000 |
$15M limit at $148,500 |
$20M limit at $198,000 |
|
Total program premium |
$84,500 |
$169,000 |
$253,500 |
$338,000 |
|
|
|
|
|
|
|
75% of transaction insured for each policy |
||||
|
Seller policy covering unknown breaches |
$3.75M limit at $30,000 |
$7.5M limit at $60,000 |
$11.25M limit at $90,000 |
$15M limit at $120,000 |
|
Buyer policy covering fraud or known breach |
$3.75M limit at $41,250 |
$7.5M limit at $82,500 |
$11.25M limit at $123,750 |
$15M limit at $165,000 |
|
Total program premium |
$71,250 |
$142,000 |
$213,750 |
$285,000 |
|
|
|
|
|
|
|
30% of transaction insured for each policy |
||||
|
Seller policy covering unknown breaches |
$1.5M limit at $21,000 |
$3M limit at $42,000 |
$4.5M limit at $63,000 |
$6M limit at $84,000 |
|
Buyer policy covering fraud or known breach |
$1.5M limit at $25,500 |
$3M limit at $51,000 |
$4.5M limit at $76,500 |
$6M limit at $102,000 |
|
Total program premium |
$46,500 |
$93,000 |
$139,500 |
$186,000 |
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 representations and warranties insurance, is often shared between the buyer and the seller. Retentions often range from 1% to 2% of the enterprise value.
In M&A transactions, there are several benefits of representations and warranties insurance for both the buyer and seller.
R&W insurance enables buyers to make more competitive bids by recovering from an insurance policy rather than relying on a traditional holdback or escrow. This makes the buyer's offer more attractive in auction scenarios.
With RWI, buyers can protect and preserve their ongoing relationships with sellers and management teams by reducing the likelihood of pursuing indemnification claims directly against them. While claims can arise in case of a real or alleged breach, representations and warranties insurance can maintain harmony between the parties after completing the M&A transaction.
R&W insurance can reduce, if not eliminate the need for traditional holdbacks. This allows buyers to receive a higher proportion of proceeds at closing, thereby enabling a quicker transaction turnaround.
Buyers can negotiate broader indemnification terms with sellers, knowing that any potential losses resulting from breaches can be covered by insurance. This adds an extra layer of security to their investment.
Sellers can enjoy a cleaner exit from the transaction as representations and warranties insurance shifts potential liabilities from them to the insurance company. RWI can ensure they are not drawn back into any post-closing complications. Reps and warranties insurance can also serve to enhance the reputation of the parties involved as well.
2. Swift deal negotiations
Having R&W insurance facilitates quicker negotiation since sellers don't have to stand behind many of the representations made. This eases the negotiation of representations and warranties in the purchase agreement.
The presence of representations & warranties insurance can lead sellers to accept more favorable terms during negotiations. This is because buyers may be willing to waive certain liabilities in exchange for the coverage provided by the insurance.
4. Maximed Internal Rate of Return (IRR)
Sellers can maximize their IRR since the reps and warranties insurance reduces or eliminates the need for contingent reserves or holdbacks. This allows for immediate distribution of proceeds to stakeholders.
Several insurance providers offer representations and warranties insurance in the US. Here’s a list of some of the key players:
Insurance brokers have become an essential part of the M&A process. According to Charles Fogden, former national director Canada, Aon M&A and transaction solutions at Aon, “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 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 due diligence, no insurance.”
Representations and warranties insurance plays a vital role in today's M&A transactions.
Even in times when there are fewer M&A deals, R&W insurance won’t go away anytime soon; other factors can increase demand for transactional risk insurance like this. R&W insurance remains a robust mechanism for mitigating risks associated with unknown breaches of contract.
As businesses need to navigate the complexities of M&A transactions, R&W insurance can serve as a strategic tool for buyers seeking to protect their investments. For sellers, R&W insurance is a crucial asset for ensuring they have a clean and uneventful exit. Thanks to the support of specialized insurance providers and brokers, stakeholders can leverage R&W insurance to enhance their negotiating positions and provide more favorable outcomes for both parties.
If you’re looking for insurance brokers to provide coverage, bookmark our Best in Insurance Special Reports page. Browse the industry’s top providers and find insurance professionals to model your career after.
Did you find this article on representations & warranties insurance informative? Let us know in the comments.
