Insuring risks through R&W Insurance

There is no doubt that Representation and Warranty (R&W) Insurance is an increasingly universal feature in competitive sales processes. 

Insuring risks through R&W Insurance

R&W Insurance is a type of transaction insurance that protects either the buyer or the seller from financial loss resulting from a breach of the target company’s or seller’s representations or warranties contained in an acquisition agreement. 

There are two types of R&W insurance policies: 

  • A Buy-Side insurance policy, in which the buyer is the insured, offers first-party coverage - the buyer files a claim directly with the insurer, which “steps into the shoes” of the seller and indemnifies the buyer directly for losses.
  • A Sell-Side policy, in which the seller is the insured, provides third-party coverage – the seller files a claim for a breach of the representations and warranties with the insurance company and either gets reimbursed by the insurer for payment of claims or the insurer will pay the buyer directly for losses.

In a seller-friendly market where sellers more frequently offer little or no indemnity for loss, this tool has become increasingly utilized, particularly in private equity transactions. 

Exponential Growth 

Marsh noted in its 2014 Annual Transaction Report that demand for transactional risk insurance (which also includes tax and contingent liability insurance) significantly increased in 2014. Marsh reported that the number of policies it placed in 2014 grew 36% from 2013. 

More recently, insurer American International Group, Inc. (AIG) reported that nearly 14% of the global M&A R&W Insurance policies which it wrote between 2011 and 2014 resulted in a claim. According to AIG’s Global Claims Data Study, this “suggests a significant number of M&A transactions worldwide may see issues arise from breaches of deal terms discovered after closing.” 

AIG’s Global Head of M&A Insurance, Mary Duffy, stated that R&W Insurance “is becoming part of the transaction process worldwide.” In fact, Marsh noted that there has been an increased demand for R&W Insurance throughout Asia-Pacific, Europe, the Middle East and Africa.

Private Equity Driving Demand

While corporate buyers are increasingly bringing R&W Insurance to the bargaining table as part of the deal process, private equity companies in particular have been a significant force in driving the demand for R&W Insurance. 

In its 2015 Midyear Transaction Risk Report, Marsh noted that 73% of the policies it placed were private equity policies and that “private equity firms continue to be the heaviest users of transactional risk insurance.”

Why the popularity among private equity? R&W Insurance offers private equity sellers a “clean-exit” from their investments. This allows the private equity fund seller at the end of its term to distribute more proceeds of the sale to its investors without tying up amounts in escrow, while also limiting its post-closing indemnification liabilities from the sale of the portfolio company. These liabilities can result in an unwelcome “LP clawback” that private equity sellers universally would prefer to avoid.  

Conversely, a strategic buyer dealing with a private equity seller may be inclined to obtain R&W Insurance as a form of security in the event that it would be difficult to collect post-closing indemnification payments from such seller whose fund’s term is about to expire. 

For private equity buyers, R&W Insurance serves as a way to remain competitive in an auction or bidding process. While a buyer formerly could use R&W Insurance to enhance its bid, given how commonplace R&W Insurance has become, it might now hurt a buyer’s bid if it doesn’t offer a policy upfront in the process.

Whether you are a private equity buyer or seller, R&W Insurance is something that you should consider introducing at the outset of the deal process. Adding in R&W Insurance will have timing implications for a transaction, as typically insurers will not commence the underwriting process until exclusivity is granted, and the underwriting process itself may raise issues that could impact the terms of the definitive transaction agreement.

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