Representations & Warranties Insurance Gallagher Management Liability Practice JULY 2017
Representations & Warranties (Reps & Warranties) insurance is designed to provide insurance coverage for breaches of representations and warranties statements made by the seller in a purchase agreement. Sellers are usually required to indemnify the buyer for breaches of the representations and warranties made in the purchase and sale agreement, and often required to hold some level of transaction proceeds in escrow to ensure that funds are available in the event of a breach. Reps & Warranties insurance is intended to supplement or even replace seller indemnity obligations by insuring all (or most) of the representations made within the purchase agreement. The popularity of this insurance has virtually exploded because it may effectively reduce or replace the seller s indemnification or escrow requirements. Recently, some sellers (primarily private equity firms) have even taken a no indemnification, no escrow position. In those cases, the sellers are literally dictating that buyers consider insurance if they seek to get more comfort on the transaction. Indeed, smart buyers are looking for risk mitigation, which is driving interest in this product. Additionally, sellers want to distribute the full proceeds without waiting for indemnification periods to run out or escrow monies to be returned. In many cases, the cost of insurance may be less than the cost of capital tied up by a seller s escrow, so the insurance may deliver upfront value even without claims. Not surprisingly, this insurance product has achieved substantial popularity, specifically for deals whereby a privately owned company is being purchased for a price in the $25M to $3B range. Insurance is available for both asset deals and stock deals, though the latter deal type is obviously more at risk. Quick Marketplace History The Reps & Warranties insurance product was invented early in 1999. Donna Ferrara, then an attorney at Shearman and Sterling (now with Gallagher) was instrumental in the development of this product. Carriers quickly realized that both buyers and sellers were interested in such a product, ultimately leading to the creation of both buyer-side and seller-side policy forms. Today, over 90% of these insurance policies are purchased by the buyer, even if the seller funds part or all of the insurance purchase. This is because the buyer-side policy forms are broader in scope and allow sellers a cleaner exit with reduced escrow and indemnification. Further, the buyers ultimately hold the risks of the transaction going forward and want a policy they can trigger themselves. This is a very specialized marketplace with recent carrier leadership coming from AIG, Ambridge, Euclid and many others. Indeed, several new underwriters have joined this market in the last few years, resulting in a generous availability of capacity for larger deals. For example, getting 10 carriers to collectively put up $250M on a deal is quite possible in 2017. Demand for the product has increased dramatically while the capacity has grown steadily. Significant claims are now paying out, fueling more attention on the viability of this coverage. AIG has noted at recent seminars that they have paid more than $100M in Reps & Warranties insurance claims. While total capacity may easily exceed $250M, most insurance markets are somewhat hesitant to write the primary [or lead] layer for this coverage. Primary coverage has expanded significantly in scope as the definition of loss has been broadened, for example. The better coverage as well as escalation in demand for the product has led to a notable rise in premium pricing of late. The insurance premium is calculated as a percentage of the limit requested. Large escrows and indemnity agreements will push prices lower. Policy deductibles will also affect the insurance pricing, noting that 1.5% to 2% of the deal value is typical. At its inception, pricing was generally in the 4% to 8% of limit range, though oftentimes more. As carriers gained experience and comfort, premium levels dropped to a low of 2% to 3% of limit during the last couple of years. More recently, with the noted qualitative improvements and increased deal flow, premiums typically range from 3% to 4% of limit. Graph 1 is Gallagher s estimate from carrier sources as to the number of merger and acquisition (M&A) transactions that solicited insurance to mitigate the risks from representations and warranties that were made as part of the acquisition process. Graph 1: Reps & Warranties Policies 1000 900 800 700 600 500 400 300 200 100 0 New Policies Placed 2011 2012 2013 2014 2015 2016 Source: Carrier Interviews Graph 2 displays the trend in M&A volume. Deal values jumped in 2015, then came back slightly in 2016. What were the motivations and how do they relate to the usage of Representations & Warranties insurance? Graph 2: M&A Volume Trend ($Tr) 6 5 4 3 2 1 0 M&A Volume ($Tr) 2009 2010 2011 2012 2013 2014 2015 2016 Source: dealogic.com 2016 estimated 2 Gallagher Management Liability Practice Representations & Warranties Insurance
There are many good reasons for growth through acquisition and it is a key part of the expansion plans of most large companies. Graph 3 reviews top reasons for M&A activity based on a survey performed by KPMG. Graph 3: Reasons for M&A Activity 10% 11% 15% 8% 16% 21% 19% Opportunistic Availability Expand Geography Expand Customer Base Enter New Business Value Purchase Competitive Need/I.P. Other Motivations Source: KPMG Survey Graph 4 is a diagram inspired by an Ambridge presentation that illustrates just how responsive, or even instrumental, this insurance product can be in getting a deal done. The vertical dimension shows the opportunity to increase the amount of indemnity, and the horizontal dimension shows how one might extend the expiration of an indemnity. The third or coverage dimension shows how one could also increase the scope of the indemnity. All three of these items may come into play on a deal and this cover can be tailored. Graph 4: Reasons for M&A Activity The same KPMG survey discussed the factors that drive successful M&A activity. Almost 50% cited the importance of correct valuation and effective due diligence as critical to positive results for an acquisition. Another 42% identified a well-executed integration plan as being the best way to realize success for an acquisition. Reps & Warranties insurance is a powerful back-up plan for protection against issues that the diligence or valuation processes may not be able to identify. Amount of Financial Protection Scope of Indemnity The scope, amount and time limits for bringing claims Items of the Purchase Agreement to Insure For those less familiar with either the due diligence process or stock purchase agreements, it is fair to ask what exactly is being insured. Typically, underwriters will review all items within the representations and warranties section of an M&A document and offer a list of items they are willing to insure. We expect them to indicate coverage for all of the items listed unless there is a unique circumstance requiring either a separate insurance policy or additional premium beyond what is typical. Frequent examples are significant environmental issues or patent liabilities. Below are some of the more common representations and warranties made by the seller within the agreement: Ownership structure Accuracy of financial statements No undisclosed liabilities Status of known litigation or liabilities, or statements of no material litigation Insurance Relationship status with customers and suppliers Employee relationships Compliance with laws No material adverse changes Title to shares Capitalization and authority Employee benefit plans Intellectual property Taxes Personal property Environmental matters Contracts Time limit for bringing claims As to actual claims activity, according to our own extensive experience, as well as a review of studies performed by M&A experts at JPMorgan, AIG and others, most claims fall into the following categories illustrated in Graph 5. Graph 5: Reps & & Warranties Claims Tax Issues Open Litigation Financial Statements Undisclosed Liabilities Intellectual Property, Employment, and All Other From a frequency perspective, based on escrow data as well as AIG s own review of its product history, one out of every four deals has at least one claim of a breach of the reps and warranties declarations. 3 Gallagher Management Liability Practice Representations & Warranties Insurance 29% 13% 15% 23% 20%
Underwriting There are numerous determinant factors when underwriting the risks of providing insurance for the representations and warranties declared in a purchase and sale agreement. Preliminary review of a transaction by insurers requires a draft of the acquisition agreement, audited financial statements from the business being acquired, as well as information regarding the nature of the business. Non-binding term sheets are generally easy to obtain at no cost to the client. Once an insurer provides a term sheet, should the client elect to move into formal underwriting, the insurance providers will carefully assess the risk by collaborating with selected outside counsel. As part of the due diligence process, the client would be expected to pay for this carrier counsel. Usually a non-refundable underwriting fee in the range of $25k to $40k is charged. Underwriters will typically sign confidentiality or non-disclosure agreements, as well as nonreliance letters, when requested to review drafts of purchase and sale agreements, disclosure schedules and due diligence reports. The underwriters and their counsel will also need access to the data room to facilitate their review. It is very common that emails, often at all hours of the day on fast moving transactions, as well as underwriting calls, will supplement the data room information. This is an intense and quick process, allowing your insurance quotes to be ready to bind when the deal is being signed. In particular, some of the key underwriting factors will include the following: Level of due diligence performed, including review of internal and external memos Fairness of representations (knowledge qualifiers, etc.) Appropriate materiality basket Level of indemnification Length and complexity of reps & warranties Additional retention/deductible Structure of product (above escrow or replacement of) Financial stability of target company As such, a list of underwriting information requested should include: Copy of purchase and sale agreement Financials of the buyer and seller, including pro-formas Copy of confidential investment memorandum Copy of all due diligence info requested and received Summary of transaction, including purpose, deal value, parties involved, advisors and timing Intended limits and retentions Intended escrow and other indemnifications as applicable Summary and Concluding Thoughts The representations and warranties insurance market is an exciting and dynamic marketplace. This insurance is being used more than ever to facilitate deals. Buyers are often in a rush to complete the acquisition, perhaps to allow for optimal timing of the announcement or to begin benefitting from the synergies of the acquisition. They may also have deadlines from a competitive auction. As such, a certain amount of execution risk is natural. Once in the marketplace, you will find that: The insurance marketplace is growing, providing numerous carrier options. Buyer policy forms are most popular, though seller forms are available. Policy forms differ distinctively from carrier to carrier, thus final terms are negotiable. Pricing is now typically 3% to 4% of the limit purchased, though a minimum premium may apply. There will likely be a non-refundable underwriting fee (about $25k to $40k) as well as a nominal fee charged to share results with excess markets (if applicable). Typical retention is 1.5% to 2% of deal value; for additional premium, you can move it closer to 1%. The policy period can conform to the warranties survival as defined within the purchase and sale agreement, which may be different than the state statute of limitations, but survival can also be extended for additional premium. Limits purchased most often range from about 10% of deal value for large deals to 25% of deal value for smaller ones. For example, a company making a $100M acquisition may typically elect to purchase between $15M and $20M of limits. We expect that the buyer s risk management department may also want to drill down further and examine the reps and warranties as to the likelihood of each potential breach and how material it could be in terms of both expenses and the time investment required to resolve the issue. This analysis may drive the decision to purchase, along with the size and scope of any escrow or indemnity agreements. Certainly, the insurance offers extraordinary protection in cases where the diligence process is under time pressure. The fact that the insurance underwriting team is being added to the due diligence team is by itself quite valuable. Finally, note that some M&A claims may also involve catastrophic issues such as environmental, cyber, pension funding, customer disputes or litigation with a large supplier. As such, other insurance policies (for example, extended reporting tail or run-off policies for D&O, cyber, fiduciary and employment practices) may be equally important in managing the risk of an unlikely yet extremely costly event. 4 Gallagher Management Liability Practice Representations & Warranties Insurance
2850 Golf Road Rolling Meadows, IL 60008 Gallagher Management Liability Practice About the Author Phil Norton, Ph.D. is a Vice Chairman for the Midwest Region and a Managing Director in Gallagher s Management Liability Practice. This practice focuses on providing insurance and risk management solutions related to executive and management liability issues. For more information, contact: Phil Norton, Ph.D. Gallagher Management Liability Practice phil_norton@ajg.com www.ajg.com/mlp 17GGB29154A