Over the last decade the use of R&W insurance in merger and acquisition transactions has grown exponentially. From 2008 to 2018, the total R&W policies bound per year in North America rose from 40 deals, providing $541 million of coverage to 1500+ R&W insurance transactions, providing aggregate coverage of $38.6 billion.[1] We are also seeing a marked increase in the percentage of deals where R&W insurance is being considered and being used. Aon estimates that over 45% of all private M&A transactions in North America had R&W insurance in 2018.[2]
Publicly reported deals also reflect increasing utilization of R&W insurance for transactions ranging in size from $35 million to $21.4 billion.[3] Based on our own experience, for the first time, both strategic and financial parties in almost every deal over $30 million are at least considering the use of R&W insurance. We are also seeing an increase in “no seller indemnity deals”, which Aon estimates to have increased from 12% to 26% of all R&W insurance deals from 2016 to 2018 and, if our experience this year is consistent with that of the broader market, we think those numbers will be even higher for 2019.
Basics
R&W insurance is typically procured by the buyer, with the buyer being the insured party under the policy. In its basic form R&W insurance covers breaches by the seller or target of their respective representations and warranties in the acquisition agreement up to a policy limit. Policies largely incorporate the indemnification terms of the acquisition agreement (including the underlying representations and warranties). Insurers will also insure against pre-closing taxes as part of a basic policy.
Advantages
- For a buyer, the primary benefit of an R&W policy is to distinguish a bid (or, often, keep pace with other bids) in an auction or other competitive process.
- Another significant benefit for a buyer is that the R&W policy allows the buyer to obtain post-closing recourse from a third party (as opposed to the former stakeholders of the target – some of whom may be key employees of the buyer after closing).
- For a seller, R&W insurance significantly lowers the amount of money the seller must place in escrow to cover its post-closing indemnification obligations (approximately 0.5% to 1% of the purchase price as compared to a 10% escrow). And as previously noted, frequently we are seeing “no seller indemnity deals”, where the seller is not required to place any funds in escrow.
- This is particularly advantageous for PE sellers looking to close end-of-life funds and distribute the proceeds from the sale to their investors as quickly as possible.
Premium and Key Terms
Policy Limit – In the current market, the policy limit for an R&W policy is typically 10-15% of the purchase price or enterprise value of the deal. The policy limit plays the role of what would otherwise be the cap on the seller indemnity or the seller escrow.
Pricing – Premium is generally in the range of 2.25% to 3.00% of the policy limit (or $22,500 to $30,000 per $1 million of coverage), including broker commissions (10-20% of the premium) plus underwriting fees (typically between $25,000 and $50,000) and a premium tax.
Claims Period – The typical policy period is three years for non-fundamental representations (i.e., longer than a typical survival period of 12-18 months in an acquisition agreement) and six years for fundamental representations and pre-closing taxes.
Retention – The initial retention is usually 0.75 – 1.00% of the transaction value.
Retention Split – Where sellers are required to place funds in escrow, the retention is typically “split” between the buyer and seller – the buyer takes the first layer of liability in the form of a “true deductible” (usually half of the retention amount), and the seller takes the next layer of liability (the second half of the retention amount), which is often funded through an escrow.
What is not Covered
- Policies do not cover “known issues” (i.e. breaches of representations and warranties that were known by the buyer prior to the inception of the policy).
- Policies typically have a number of standard exclusions, including pension liabilities, purchase price or working capital adjustments, covenant breaches and net operating losses or other deferred tax assets.
- Claims that are covered by other types of insurance are also often excluded or limited.
- Specific exclusions for risks in the life sciences sector such as false claims risk (e.g., Medicare/Medicaid reimbursement related claims), drug efficacy and risk associated with design of or success or failure of clinical trials can often make R&W insurance less attractive for these companies.
- Best practice is to review the policy wording carefully to understand the scope of any exclusions and impact on the transaction. Oftentimes, with additional due diligence and negotiation, certain exclusions can be narrowed or eliminated.
Process
- As more insurers have entered this marketplace and gained experience, the underwriting process has become more streamlined and premiums and retentions have declined.
- The underwriting process can typically be completed in as little as one to two weeks (from engaging broker to binding the policy).
Claims
- Approximately 1 in 5 policies result in a reported claim based on an AIG study covering policies written between 2011-2016, although some of these claims result in loss that would fall within the policy’s retention.
- Buyers have also gotten more comfortable with the R&W insurance claims process and track record of claim payments, resulting in increasing reliance on insurance to limit or eliminate seller indemnities or escrows. However, one of the lingering questions about R&W insurance as an effective transaction tool continues to be payout experience and what it will look like over time.
Key Considerations for Tech Companies
For buyers of technology companies, R&W policies will typically cover most of the important representations and warranties, including those relating to intellectual property ownership, and, under some scrutiny by underwriters, freedom to operate, data privacy and security and compliance with employment laws.
Key considerations for tech companies when considering the use of R&W policies in their deals should include the following:
Scope of Data Privacy Coverage – Coverage for data privacy related liability can be contingent on the target maintaining an underlying cyber or data privacy policy and may be limited to the scope of that policy. Tech companies should review their or the target’s current cyber coverage with this in mind.
Formal Due Diligence Reports – Insurers generally will review third party due diligence reports as part of their underwriting process. Such reports include quality of earnings reports, open source code scans, security audits and any reports regarding applicable regulatory compliance matters (especially for financial services or healthcare IT companies). Buyers and sellers should work to proactively obtain such reports as part of the acquisition process so that they will immediately be available for the R&W insurers to review.
Policy Terms/Scope of Coverage – Buyers of tech companies will want to tailor their R&W policy to ensure that the coverage is in line with their rationale for the acquisition. For example, buyers of recurring revenue based-businesses should consider whether or not the definition of “Loss” is appropriately tailored to their valuation methodology (e.g. an ARR or MRR multiple). Other key coverage areas for technology buyers often include IP, employee classification, sales tax and data privacy/security.
Conclusion
R&W insurance is a tool that is increasingly available for middle-market and larger transactions to facilitate deal-making. Cooley’s M&A lawyers and insurance specialists are knowledgeable and experienced with R&W insurance products and their pros and cons as compared to a traditional indemnity and escrow structure. Cooley has worked with many brokers and insurers in the marketplace and knows what typical market terms should be for a policy, which can help streamline negotiations.
For more on R&W insurance, view our recent Dealology video on the topic.
Contributors
Caitlin Gibson
[1] Source: Advisen – Hemenway, Chad. “Transaction insurance takes the 10-year challenge.” Advisen, 6 Feb. 2019. https://www.advisen.com/tools/fpnproc/fpns/articles_new_1/P/330996328.html?rid=330996328&list_id=1#.XHRha21CsSI.twitter
[2] Source: Aon – “North America M&A and Transaction Solutions Risk in Review 2019.”
[3] Source: DealPointData – Data group includes transactions in which either the seller or buyer filed the acquisition agreement with the SEC, so this data group does not include a sale by a PE firm to another PE firm.
