What is the leading best practice to follow to reduce post-closing risks? Founder of Rubicon Insurance Services, Patrick Stroth walks us through buyers’ and sellers’ top risk mitigation plan: rep and warranty insurance.
But before we dive in let’s break down some of the key terms and things to know about rep and warranty insurance.
What is Rep and Warranty Insurance?
Insurance Business America defines representation and warranties insurance (R&W) as a type of insurance that is:
“..designed to cover unknown and unintended breaches of representation and warranties made in business mergers and acquisition agreements.”
R&W is sometimes also referred to as warranty and indemnity insurance (W&I).
The Benefits of Rep and Warranty Insurance
Litigation is a part and parcel of M&A and because of this buyers and sellers have been pushing for a greater deal structure in order to reduce post-closing risk. The legacy escrow holdback system that was the mainstay was proving too cumbersome.
Sellers were finding themselves at a disadvantage on account of this escrow system and were walking out with less cash on exit. This can be traced back to the average 10 to 15% of the total purchase price that was being withheld as a form of guarantee. Thankfully this is no longer the case anymore owing to W&I.
With R&W claims are processed and paid for by the insurer giving both buyer and seller peace of mind as they move on post-closing.
In its short history, R&W insurance has already evolved from simply being a type of seller protection to a product that’s specifically targeting buyers for the most part.
This brings us to our next point, the two main forms of R&W insurance that exist.
Rep And Warranty Insurance Types
1. Buyer Side Policies
Buyer-side policies are structured to safeguard buyers against misinformation inclusive of things such as falsified financials, intellectual property disputes with third parties, and the extent of permits problems.
2. Seller Side Policies
Seller-side policies were created to provide liability cover to sellers for innocuous misrepresentation in purchase agreements.
Now that we know what R&W insurance is, its benefits during mergers and acquisitions, and the types that exist, we present to you a series of Patrick Stroth’s top R&W insurance insights.
R&W Insight #1: An R&W benefits both buyer and seller
The seller doesn’t have to live with the constant dread of clawback and litigation. Furthermore, they leave with more cash which they can actually spend. On the buyer’s end, they know where they can send their claims for compensation in the event of a problem.
Takeaway: “The buyer benefits because they have certainty that if something does explode and they suffer a loss, they can collect and they don’t have to litigate against the seller.”
R&W Insight #2: R&W insurance available for SMB deals
What’s neat about R&W insurance today is that small and medium M&A deals can now get insured too. There’s no longer an exclusive preference to insure deals that are worth $50 million and more. Even $10 million deals qualify for insurance in the current market.
Takeaway: “$15 to $20 million is probably the sweet spot where we’re seeing more and more [R&W insurance] transactions.”
R&W Insight #3: R&W insurance pricing isn’t based on deal size
A welcome piece of news regarding R&W insurance policies is that they aren’t one-size-fits-all. Thankfully, the policy price isn’t determined by the size of the deal but rather by the amount of insurance both parties have negotiated. Most insurers will however have a minimum policy cap of $200,000
Takeaway: “The smallest policies are maybe $2 million, $3 million limit policies.”
R&W Insight #4: Include R&W in your LOI
Inclusion of R&W as part of your M&A LOI removes any potential awkwardness about having to raise the subject of insurance during a sit down. As a built-in clause, the buyer takes note of it and will address it during talks.
By building it into the LOI it can also help move the deal along much faster. Additionally, it shows you’ve carefully thought about liability and insurance on your end as the seller.
Takeway: “The best time to introduce rep and warranty as a concept is in the LOI.”
R&W Insight #5: R&W carriers and claims data
The R&W industry is still in its infancy but certainly growing as more carriers join the market. Some of the bigger names in the game today include AIG and Lloyds, Chubb, CNA and Hartford.
Where claims are concerned, up to 70% of policies have not as yet had claims reported against them according to Liberty Mutual. In fact, fewer than 5% of these claims have actually been paid thus far. What’s also worth noting is that these figures represent the larger deals with $100 million policies.
Fortunately, the lower middle-market hasn’t had to deal with a host of claims.
Takeway: “There’s not a lot of data on claims and quite frankly it’s because there haven’t been enough policies. But carriers like AIG are getting better at this.”
Get the help you need
If you would like to discuss post-closing risks, due diligence, or any other M&A topic in greater depth, our team of seasoned M&A advisors is only one phone call away.
Sun Acquisitions boasts an experienced M&A team that can assist you to navigate mergers and acquisitions regardless of whether you’re a buyer or seller. Don’t hesitate to contact us.