Transactional risk insurance is a type of insurance coverage that helps protect buyers and sellers in merger and acquisition (M&A) deals. Carriers often offer several types of transaction risk insurance so businesses can customize their coverage based on risks within their deal, such as a buyer purchasing contingent liability insurance to protect against exposure to ongoing employment matters.
The current business and economic landscape has led to a slowing of M&A activity. Fewer deals are happening, and those that are tend to move slowly. Increased interest rates, geopolitical volatility, and environmental and employment issues could expose buyers and sellers to potential transactional risks. This post reviews how transactional risk insurance helps businesses identify risk levels and create a management plan to address those risks.
Understanding Transactional Risk
Transactional risks are the uncertainties that may affect the outcome of a corporate transaction. These uncertainties create risk exposure to both buyers and sellers during an M&A transaction. In most cases, transactional risks are those situations that could prevent the deal from going through or greatly change the intended outcome. Sometimes, people use representations and warranties (R&W) and transactional risk insurance interchangeably, but that’s inaccurate.
R&W insurance is a type of transactional risk insurance, but it is specifically designed to cover breaches of representations and warranties made in connection with a business transaction. Buyers typically buy R&W insurance in mergers and acquisitions, but sellers can also purchase it.
Transactional risk insurance, on the other hand, is a broader term encompassing a more comprehensive range of risks, including contingent liabilities, tax liabilities, environmental liabilities, intellectual property liabilities, employment liabilities, and regulatory liabilities. Both buyers and sellers can purchase transactional risk insurance in various business transactions, including mergers and acquisitions, divestitures, and capital markets transactions.
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The Role of Insurance in Managing Transactional Risk
Insurance can play a vital role in ensuring the success of M&A transactions. A robust insurance strategy can help buyers and sellers reduce their exposure to transactional risks. Additionally, adding third-party insurance coverage can reduce the need for businesses to create complicated indemnity or purchase agreements. Reducing or replacing these complex transactional documents with insurance makes business transactions smoother.
Transactional risk insurance can help optimize an M&A deal by addressing and mitigating risk exposure. A transactional risk insurance policy transfers potential transactional risks to an insurance provider instead of the buyer and seller. With coverage in place, companies can focus on the details of their business deal with less worry about potential disruptions.
What Transactional Risk Insurance Covers
Transactional risk insurance offers a variety of coverage options to protect businesses during a deal. Businesses usually customize their exact coverage to fit the needs of a specific deal, but transactional risk insurance generally includes three risk management solutions:
- Representations and warranties insurance
- Transactional tax insurance
- Contingent liability coverage
Let’s take a closer look at the different components of transactional risk insurance to understand better how they help you offset risk.
Representations and Warranties Insurance
This type of coverage serves as a seller’s warranty to protect the buyer and seller in a business transaction. The seller or target company of the deal lays out certain representations of their business in the purchase agreement of the deal.
Sometimes, these representations are unintentionally inaccurate. Representations and warranties coverage covers breaches of these representations that result in financial loss for the insured, including defense costs. The insured party can be either the seller or the buyer.
Transactional Tax Insurance
Tax law constantly changes, and previous business tax decisions could potentially implicate the business. If that business is part of an M&A deal, the new owner will want to protect the company from unexpected tax liabilities or issues.
Transactional risk insurance generally includes tax insurance or tax indemnity coverage to help remove the burden of tax uncertainties from the business deal. Tax insurance covers known tax exposures uncovered during the sale’s due diligence process. This policy protects the insured from unexpected additional taxes, penalties, or interest charges from a previous tax filing.
Where representations and warranties insurance coverage protects businesses from unknown liabilities in a business transaction, contingent liability insurance protects against identified risks. During the transaction negotiation process, buyers and sellers will identify risks associated with the deal, such as litigation or environmental exposures. To protect both sides from these risks, the parties in the deal might create complicated escrow arrangements or warranties.
Contingent liability insurance generally reduces or eliminates the need for lengthy liability agreements. This coverage works by removing the known risks of a business deal from the transaction. The insured party receives coverage if an identified risk exposure comes to pass.
Scenarios Requiring Transactional Risk Insurance
Transactional risk insurance can be essential to a risk management strategy for M&A deals. Take a look at a few M&A situations where having transactional risk insurance can provide protection.
Post-Closing Liability Issue
A larger firm bought out a software company. After the deal was closed, it was discovered that the smaller company had violated some intellectual property laws, leading to a costly legal dispute. The buyer, who had procured transactional risk insurance, could file a claim covering the legal costs and the settlement amount, allowing the buyer to avoid unexpected financial loss.
Undisclosed Employee Issues
In another example, a fashion retailer acquired another retail brand. Post-acquisition, they were hit with an unexpected wrongful termination lawsuit from an employee who was let go before the transaction occurred. Fortunately, the acquiring company had transactional risk insurance, which kicked in to cover the litigation expenses and potential settlement or judgment costs.
Misrepresentation of Financial Statements
A private equity firm purchased a manufacturing business. After the transaction closed, it was revealed that the seller had misrepresented the company’s financial health during due diligence. The misrepresented details caused the buyer to overpay for the company. However, the private equity firm had transactional risk insurance, which allowed them to recover the difference between the purchase price and the actual value of the acquired company.
A private equity firm acquired a majority stake in a software company. The purchase agreement included representations and warranties from the seller about the company’s financial performance and intellectual property portfolio. After the acquisition closed, the private equity firm discovered that the software company had been overstating its revenue and had infringed on a competitor’s intellectual property. The private equity firm filed a claim under its transactional risk insurance policy, and the insurer paid out a significant settlement to cover the company’s losses.
A larger competitor acquired a public company. The purchase agreement included a tax indemnity provision, which obligated the seller to reimburse the buyer for any unexpected tax liabilities arising from the transaction. After the acquisition closed, the IRS audited the buyer and assessed a significant tax liability. The buyer filed a claim under its transactional risk insurance policy, and the insurer paid the full tax liability.
A company was selling its manufacturing plant to a foreign buyer. The purchase agreement included representations and warranties from the seller about the environmental condition of the plant. After the acquisition closed, the buyer discovered the plant was contaminated with hazardous waste. The buyer filed a claim under its transactional risk insurance policy, and the insurer paid out the cost of cleaning up the contamination.
How to Effectively Implement Transactional Risk Insurance
Transactional risk insurance is usually a one-time insurance policy created for specific business transactions. While you may not need constant coverage from transaction risk insurance, knowing how it works can provide smoother business transactions. Additionally, incorporating transactional risk coverage into your broader risk management strategy will help you reduce common risks associated with the buying and selling of businesses.
Suppose you have an upcoming business deal, such as merging with another company or buying a smaller business. You’ll want to talk with a trusted commercial insurance broker to learn about your options.
Transactional risk insurance and other necessary insurance policies can help protect business finances while streamlining M&A deals. Talk with your commercial insurance broker today about your options for transactional risk insurance and how you can incorporate it into your next business deal.