Countless articles have been written over the past year about the merits of using insurance in the context of M&A transactions, including not only policies that insure representations & warranties (“R&W”), but also those covering tax, litigation, fraudulent conveyance, successor liability and other contingent risks. At a minimum, most sophisticated M&A practitioners now understand the value proposition of deploying an R&W insurance policy in place of, or in tandem with, a traditional indemnity for breaches of representations & warranties. And those that don’t will certainly soon realize that their deal-making toolkit is woefully lacking, as the use of insurance to effect transactions is not just a fad or trend, but rather a deal mechanic that we believe will eventually be as much a part of the fabric of M&A as working capital adjustments and closing dinners.

A number of trends have been developing with respect to the use of these insurance products. The purpose of this article is to explore some of those trends in the current market. Click here for a high-level summary of the suite of transaction liability insurance products.

R&W Insurance—An Overview

Buy-side R&W insurance allows the buyer in an M&A transaction to look to an insurance policy in the event of unknown breaches of representations & warranties for a fixed premium.1 In exchange for that premium, the R&W insurers will provide coverage above a self-insured retention (akin to a deductible) in the event of covered breaches discovered after inception of the policy. Below is an example of what a typical R&W policy might look like:


Enterprise Value     
$100,000,000

Premium


 
 
$400,000
 
Indemnity Cap/Escrow
 
1%
 
$1,000,000
 
Policy Limit
 
10%
 
$10,000,000
 
Total Protection
 
11%
 
$11,000,000

In the above table, the total purchase price of the target company is $100 million. The seller, in this case, is providing an indemnity capped at 1% of the purchase price. This indemnity cap, along with any deductible being borne by the buyer under the indemnification provisions of the purchase agreement, will comprise the self-insured retention under the policy (e.g., if the deductible is 1% of the purchase price, the total retention from the insurer’s perspective will be 2% of the purchase price). On top of that, the buyer is seeking protection for up to 10% of the purchase price in order to replicate what they might obtain under a typical indemnity structure with a strategic seller. In the event that loss is experienced for a breach (or series of breaches) of the seller or company representations & warranties in excess of $1 million, the policy will be available and make the buyer whole (subject to the policy limit) for that loss. The cost of this coverage is typically a one-time fee of 3.5%-4.5% of the limit being purchased.

The goal of R&W insurance is to cover the full suite of representations & warranties given by the seller and/or the company in the purchase agreement.1 The policy typically serves to extend the survival of these representations & warranties beyond customary terms (particularly in sponsor sales) as the policies usually run for three years for general representations and six years for fundamental and tax representations. The scope of coverage can substantially mimic what would be available under a typical indemnification arrangement and in some ways go beyond (e.g., a buyer can obtain coverage up to the full purchase price for breaches of any R&W, not just fundamental R&W). Policies are put in place within the typical transaction timeline, with the process running less than two weeks from start to finish (and in certain situations, the policies can be put in place much more quickly).

Of course, a well-crafted insurance policy only has true value if it performs in the event of a loss. One concern about R&W insurance is that carriers will look to exclude claims. While there are limited published figures on this, we can report that so far insurance carriers have generally paid out on valid claims. One carrier alone paid out over $100 million in claims last year globally in respect of R&W policies. One of the few things that can stop the momentum the product has garnered is if carriers stop paying valid claims. All insurers recognize the critical importance of good claims practices and to date we have not had issues getting valid claims paid. We believe that the carriers will continue to prioritize the importance of good claims practices and we are optimistic that valid claims will continue to be paid.

Clean Exits

Every seller of a business dreams of achieving a “sky high” valuation when they decide to sell. But price is actually only one piece of the puzzle. A large escrow or indemnity cap coupled with a long survival period for the representations & warranties can make an otherwise great deal seem less attractive. Indeed, sellers in hot auction processes have long tried to convince bidders that their asset was worthy of a completely clean exit, a structure that has historically been reserved only for public companies (and only there largely due to the impracticalities of seeking recourse against a disparate shareholder base) and certain large private companies owned by private equity firms. Rarely were sellers of companies in the middle-market able to effect the same style exit and instead often found themselves faced with post-closing indemnity exposure capped at 5-20% of purchase price, which survived for one to three years (and was often supported by a cash escrow, depending on the identity and creditworthiness of the sellers). When middle-market sellers tried to be aggressive by suggesting that they would not accept bids with any form of post-closing indemnity, they usually found themselves facing an uphill battle as few serious bidders were willing to go completely “naked” on a private company acquisition.

Enter R&W insurance and the “seller flip” construct, which was first introduced in 2012 and under which a seller sought to achieve an almost completely clean exit. With the introduction of R&W insurance, sellers suddenly were able to line up an alternative to a large post-closing indemnity that gave buyers the protection they sought while allowing the seller to maximize cash proceeds at closing. At the start of an auction process, a seller would seek to obtain R&W insurance quotes that can be “flipped” to a buyer along with a signal, usually in the auction draft purchase agreement, that the seller will not entertain a traditional indemnity (instead offering to only provide indemnification for up to 0.5%-1% of the purchase price or, in some cases, no indemnity at all). This approach has come to be known as “stapled” R&W insurance. By going out ahead of time to get quotes, the seller signals to bidders that this is not an empty proposal (i.e., insurance is available and the terms, including the cost, are quantifiable for the transaction). In the robust seller’s market that we are currently experiencing, this has become an extremely popular way to kick off a sales process and has exposed a number of new parties to the concept of R&W insurance.

Strategic Use

As mentioned above, a positive side effect of the “seller flip” model from a product acceptance vantage point is that it has introduced the concept of R&W insurance to countless strategic buyers who had not come into contact with it previously. R&W insurance has historically been a tool of financial sponsors who were savvy enough to deploy it on the buy-side as a method of arbitrage (e.g., smart buyers could offer a clean exit to a seller at a discounted price, which discount was greater than the cost of an R&W insurance policy). Those same buyers, when seeking to exit the same portfolio companies they had acquired via the use of an R&W policy, would look to use a “seller flip” to prevent that same arbitrage from being imposed upon them. When these financial sellers brought their assets to market, there was very often a strategic acquirer on the other side who was being faced with R&W insurance for the first time. For the strategic acquirer, obtaining their typical 5-20% indemnity/escrow was not in the cards, as any such request in an auction process where R&W insurance was being deployed by other bidders would make them wholly uncompetitive unless their valuation was simply head and shoulders above that of the other bidders. So, many strategic bidders had no choice but to give R&W insurance a try. And the product has really caught on with this contingent. Thus far in 2015, approximately 26% of the insureds under R&W policies placed by Aon have been strategic acquirers and the expectation is that this number will only continue to grow over time. A number of strategic acquirers who had an R&W policy essentially forced upon them have come back on subsequent deals noting how well the product worked and how much smoother the transaction/process went with the insurance in the backdrop.

Industry-Specific Considerations

While the use of R&W insurance has exploded throughout the M&A middle-market, a couple of industries have historically proven difficult to insure. Deals in the financial services industry, for instance, have been challenging if not impossible to insure due to the fact that many of the representations customarily made in transactions in that sector relate to projections and adequacy of reserves, things that are extremely difficult to underwrite. Similarly, until recently, healthcare transactions, though comprising approximately 20% of all M&A activity, have been a blind spot for the R&W markets because of billing fraud in payor programs (e.g., Medicare and Medicaid). However, that has begun to change. For example, Aon recently announced an exclusive product that is intended to facilitate the procurement of fulsome insurance coverage for breaches of representations & warranties in healthcare deals. By combining the coverage offered by traditional R&W insurance providers with a tack-on policy offering from IronHealth, Ironshore's healthcare division, acquirers of healthcare companies are able to get the full suite of representations & warranties made in healthcare transactions covered by an R&W policy. This should facilitate more transactions in the healthcare space as it will greatly reduce escrow/indemnification requirements, making initial investments and subsequent exits in the space much more attractive, particularly for financial sponsors.

Tax Insurance

In addition to R&W insurance, another type of transaction liability insurance that has grown significantly in popularity over the past year is tax insurance. Like R&W insurance, tax insurance is an effective tool to efficiently structure a transaction in a way that allows a seller to provide a smaller escrow or indemnity cap. For M&A in particular, the real benefit of a tax insurance policy is that it provides certainty and often allows a buyer and seller to move past a difficult negotiation over an uncertain issue and close a deal. In M&A, this often arises with respect to an issue discovered during due diligence, such as a prior “tax-free” restructuring or reorganization of a target, a deferred compensation plan’s qualification under 409A, or the target’s qualification as an S Corp. Tax insurance frequently is used where the parties are reasonably comfortable with the risk, but where there is a disproportionately large tax exposure that may not be resolved for many years. Aon has placed $2.5 billion of insurance in the past 24 months to solve these types of issues and enable transactions to go forward.

Conclusion

Transaction liability insurance has been around for a few decades, but has only recently become recognized as an effective tool that can help get transactions done on better terms for all parties involved. As more and more M&A practitioners deploy these policies in their practice, awareness about these products will rise, further cementing their place in the dealmaking landscape. Aon alone anticipates placing in excess of $10 billion in policy limits globally this year, which indicates broad acceptance of the products and their ability to provide a cost-effective risk transfer solution for M&A transactions. There will undoubtedly be trends that develop with respect to the use of these products, be it new strategies or new products, but there can be no questioning that in some form, these transactional risk tools are here to stay.

Endnotes

1 Sell-side R&W insurance is far less common and will provide a backstop to an indemnity/escrow arrangement, as opposed to replacing it or bolstering it.  From a seller’s perspective, the benefit of a sell-side policy is that it provides “sleep at night” comfort, guaranteeing that the escrow (over and above some deductible) will be there when the reps under the agreement lapse.  It does not, however, free up money from the escrow and thus is not as valuable to a seller focused on opportunity cost/cost of capital.

2 Nearly every policy contains exclusions for matters actually known to the insured or disclosed on the disclosure schedules, forward-looking statements, covenants, working capital adjustments, asbestos and polychlorinated biphenyls, and pension underfunding and withdrawal liability.