As the representation and warranty (R&W) insurance industry continues to mature and new carriers enter the market, some important trends in R&W insurance policies are emerging. These trends are quickly becoming generally-accepted norms, which will have ramifications for buyers and sellers of companies and R&W insurance carriers. Private equity firms, strategic buyers and sellers of companies, as well as their attorneys, investment bankers and other advisors, need to be aware of these trends.

R&W Insurance

R&W insurance is insurance obtained in connection with merger and acquisition (M&A) transactions. In a typical M&A transaction, the seller has the sole responsibility for indemnifying the buyer for losses resulting from breaches of the seller's representations and warranties in the purchase agreement (typically relating to undisclosed or inaccurately disclosed issues with the company being sold), subject to highly negotiated caps, thresholds and baskets. In an R&W-insured M&A transaction, the buyer obtains recovery for some or all such losses from the R&W insurance policy, up to the policy's coverage limit.

In the late 1990s, R&W insurance emerged as a method to shift some or all indemnification risk from the seller to an insurer. Today, coverage is available across all industry sectors. The increase in R&W insurance usage over the last several years has been exponential. So much so that, as competition has increased, premiums have declined to two percent to four percent of the coverage limit for R&W insurance policies. With the growing pervasiveness of R&W insurance premiums, coverage and other terms have settled, however, this is still a developing trend and more changes in premiums, coverage and other terms may come.

Attractiveness to Strategic Buyers, Sellers and Private Equity Sponsors

R&W insurance is attractive to sellers of companies because it increases the amount of sale proceeds that they receive at closing and reduces or eliminates the possibility that they will be required to return sale proceeds to the buyer, either directly or through release of sale proceeds placed into escrow. That is particularly attractive to private equity sellers of companies, as they typically want to return funds to their limited partner investors as quickly as possible after closing of the sale to maximize their internal rate of return from the investment and their carried interest compensation.

R&W insurance is also attractive to buyers in competitive auction processes because it can improve the competitiveness of their bids by increasing the amount of sale proceeds that the seller receives at closing, as compared to non-R&W insurance transactions in which the customary 10 to 20 percent of transaction proceeds are placed into escrow for 12 to 18 months after closing to act as a source of recovery for the buyer relating to undisclosed issues. Buyers submitting an auction bid letter that includes R&W insurance have a marked advantage over other buyers because, other than a standard seller retention (or basket) if required by the R&W insurance policy, any buyer claims covered by the policy will be asserted against the insurance company instead of the seller.

Security and Structure of R&W Insurance

R&W insurance can provide buyers with protection where there is concern over the ability to collect on the seller's indemnification obligation. This can be extremely useful in bankruptcy sales, take-private transactions, distressed sales and ESOP transactions. R&W insurance policies can be either buy-side (procured by the buyer) or sell-side (procured by the seller) policies. Today, buy-side policies are the dominant form of R&W insurance, comprising at least 80% of policies issued annually in the U.S., according to major insurers and market data. The security that R&W insurance provides is structured to limit the seller's indemnity obligation to escrow of 0.5 percent to 2.5 percent of the purchase price (the "retention") – which, as discussed below, is fading away – supplemented with a buy-side R&W insurance policy to achieve a 7.5 percent to 10.0 percent effective indemnity cap/recourse for the buyer. As the market has matured, the process of obtaining R&W insurance has become increasingly more efficient. However, obtaining R&W insurance can still take weeks from start to finish; therefore, buyers should contact the insurance broker or carrier early in the deal cycle. Like all insurance, the premium for a R&W insurance policy will vary based on many factors, including the size of the transaction, the level of risk involved, the deductible and the cap. However, the investment can be fruitful because R&W insurance extends survival of the reps and warranties/buyer's recourse beyond the typical 12-18-month escrow period to as long as six years after closing.

Zero Seller Recourse Deals

Skin in the Game and Moral Hazard

R&W insurance has not traditionally exculpated sellers from all liability to buyers. As a way of ensuring that sellers have some "skin in the game" and addressing the "moral hazard" risk of a seller failing to provide full and accurate disclosure to the buyer concerning the company being sold because the R&W insurer, rather than the seller, will bear the risk of losses relating to undisclosed issues, R&W insurance policies have traditionally provided for the retention described above, after which buyer losses for undisclosed issues are covered by the R&W insurance policy, up to its coverage limit. Although the retention amount is significantly less than the 10 to 20 percent of transaction proceeds placed into escrow in non-R&W insurance M&A transactions to act as a source of recovery for the buyer, it provides some assurance to R&W insurance carriers that the seller will be vigilant in preparing the disclosure schedules to the purchase agreement and otherwise ensuring complete disclosure to the buyer concerning the company being sold.

However, as new carriers have entered the R&W insurance market, competition among them has increasingly resulted in R&W insurance policies being underwritten in which there is no recourse to the seller. The buyer absorbs losses for the deductible/basket amount and the R&W insurance policy covers any losses in excess of that amount, up to the coverage limit. Some brokers active in the R&W insurance market have estimated that 50 percent or more of R&W insurance policies now being underwritten provide for no-seller-recourse, up significantly from prior years.

Convergence in Premiums

Although there have always been no-seller-recourse R&W insurance policies, the premiums for those policies have historically been meaningfully higher than for R&W insurance policies with seller recourse, due to the additional risk to the R&W insurance carrier, which has tended to reduce their prevalence. However, with the rise in competition among R&W insurance carriers, some of which may be new entrants focused on increasing market share, potentially at the expense of ultimate profitability, the spread between premiums for policies with seller recourse and those without seller recourse has compressed substantially. This has made R&W insurance policies in which there is no recourse to the seller much more attractive to buyers, which typically bear the cost of the policy's premium. A notable trend in no-seller-recourse R&W insurance policies is for the seller to be required to pay a portion (sometimes up to half) of the policy's premium, to help offset any increase in the premium resulting from the elimination of seller recourse.

Other Incentives for Full Disclosure

The compression in the premium spread between recourse and non-recourse R&W insurance policies could be interpreted as indicating that fears of moral hazard are overblown and sellers will be vigilant in providing full disclosure to buyers, regardless of whether they retain post-closing indemnification liability to buyers. Consequently, continuing this argument, there may not be sufficient incremental risk associated with no-seller-recourse R&W insurance policies, as compared to policies in which there is seller-recourse, to justify a large spread in premiums. There is anecdotal evidence to support this argument, as some industry participants underwriting R&W insurance policies have not noticed a substantial difference in the thoroughness of disclosure in no-seller-recourse R&W insurance policies, as compared to seller-recourse policies. Some incentives for sellers to provide full disclosure, regardless of whether they retain liability, include the reputational harm that would come from incomplete disclosure and resulting indemnification claims, as well as the fact that sellers always retain liability for failure to disclose issues that amounts to fraud. In addition, sellers have ample motivation to provide full disclosure in M&A transactions in which the buyer is a private equity firm and the sellers are management team members who will continue to manage the acquired company after the acquisition, because the sellers will essentially become partners with the private equity firm and undisclosed issues coming to light after closing could damage that relationship.

An Unsustainable Trend?

Some more seasoned R&W insurance market participants feel that this is an unsustainable trend that will reverse over time, as carriers incur losses from no-seller-recourse R&W insurance policies and either exit the R&W insurance market entirely or increase the premiums that they charge for such policies to more accurately compensate them for the additional risk. Because of the 12 to 18-month "tail period" between when an R&W insurance policy is underwritten upon closing of an M&A transaction and when indemnification claims are typically made by buyers, usually after completion of audited financial statements and filing of consolidated tax returns including the acquired company surface issues that become the subject of claims, it is probably too early to determine the effect of the recent trend toward the increased use of no-seller-recourse R&W insurance policies. If the widely-watched AIG R&W insurance claims survey expected to be released in the summer of 2018 shows substantial additional claims being made on no-seller-recourse R&W insurance policies, as compared to policies in which there is seller recourse, it could have a meaningful impact on carriers' underwriting practices and their pricing of premiums for no-seller-recourse policies.

Broadened Scope and Reduced Exclusions

Another prominent recent trend in R&W insurance has been toward broadened scope of coverage and reduced exclusions from coverage. This trend is the result of buyers' desire to reduce "gaps" in coverage under the R&W insurance policy, as compared to the protection from losses resulting from undisclosed issues that they would obtain from the seller in a non-R&W insurance M&A transaction. That is the case because liability resulting from matters excluded from coverage under the R&W insurance policy is typically either effectively borne by the buyer or becomes the subject of a negotiation process among the buyer and the seller, which can slow down the transaction process and weaken the buyer's competitive position versus other bidders in auction scenarios. Sellers have put pressure on carriers to eliminate these gaps to further reduce their residual risk and prevent negotiation with buyers over treatment of excluded issues.

Broadened Scope

The scope of coverage under R&W insurance policies has broadened through reduction of the scope of the stated exclusions to coverage under the policies. Historically, R&W insurance policies have excluded certain categories of issues involving heightened risk – environmental and government payments-related liabilities are some prominent examples – which R&W insurance carriers have viewed as either more appropriately being the subject of a stand-alone insurance policy or presenting such an outsized, unmeasurable risk, as compared to the premium received for the R&W insurance policy, that it cannot be responsibly underwritten. However, increased competition among R&W insurance carriers has led to reduced use of broad categories of exclusions and instead to exclusion only of specific issues relating to the acquired company that are identified by the carrier during its due diligence process.

Reduced Exclusions

Competitive dynamics in the R&W insurance marketplace have also manifested themselves in a reduction in the number of issues that are listed in the exclusion schedules to R&W insurance policies. Carriers want to appear reasonable and market-friendly to R&W insurance brokers, which are increasingly gatekeepers for deal flow for new R&W insurance underwritings, when proposing exclusions from coverage. In situations in which there are several carriers competing for an underwriting, a carrier that proposes a long list of exclusions from coverage under the R&W insurance policy may knock itself out of contention, particularly if the issues proposed to be excluded are perceived as not being material as compared to the size of the transaction.

Consistent with the fundamental premise of insurance as insuring only against unknown liabilities, R&W insurance carriers have customarily excluded issues known by the buyer from coverage under policies. Known issues can be excluded from coverage under an R&W insurance policy either by listing them on the exclusions schedule to the policy or by operation of the provisions in the policy that exclude issues that are known to the buyer's transaction team from coverage under the policy. This results in pressure from buyers to reduce the number of issues included in the exclusions schedule to the R&W insurance policy. Carriers have responded by conducting thorough due diligence in connection with underwriting R&W insurance policies and seeking to put the buyer's transaction team on notice of the matters that they identify during underwriting calls, thereby excluding them as known issues under the policies' terms. This forces buyers to not turn a "blind eye" to issues that should have been known. From the carriers' perspective, however, this is an imperfect solution, as memories can fade from the time when underwriting calls occur and the time, often one or more years later, when claims are made under the policies, potentially creating factual issues about what exactly was known to the buyer's transaction team that lead to disputes over coverage under the policies. Most buyers, however, do not rely on R&W insurance to employ a "blind eye" approach to due diligence, as they would prefer to "turn over the rock" and deal with the consequences square on, rather than ignore issues and pursue claims on the policies later.

Conclusion

As discussed above, the emerging trends in R&W insurance policies discussed in this article have important ramifications for buyers and sellers of companies utilizing R&W insurance policies and R&W insurance carriers, which will continue to play out over the coming years. While many established R&W insurance providers view new market entrants skeptically as short-term players in the industry, the increased competition among carriers is creating a dynamic and constantly evolving market and resulting in more favorable R&W insurance terms for both buyers and sellers of companies.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.