Why do I need representations and warranties insurance?
You’re involved in the purchase or sale of a company. Maybe even your company! Buyer or seller, it doesn’t matter. You want to protect yourself from the high (and growing) risk of litigation post-acquisition.
Representations and warranties insurance (RWI), also known as “transactional risk insurance,” is a proven solution for reducing M&A risk as far out as six years from the date of transaction.
In any deal, the seller will make representations about their company that will guide the buyer’s decision. These can be related to finances, taxes, litigation/compliance, workforce, corporate structure or any number of other assurances made over the course of a negotiation. Buyers will require sellers to stand by their representations in the form of contractual requirements.
If it’s then discovered down the road that any of these representations were inaccurate and the buyer suffers a financial loss, a massive lawsuit is just around the corner. Insurance can protect both the buyer and the seller from some ramifications of this dispute.
Beyond that, buyers often compete with one another and need to make themselves more attractive. And sellers are sometimes financially weak and want liquidity (as well as the confidence of their prospective buyers) sooner than escrow would allow. These deals aren’t simple — what happens when the sides disagree on indemnification or due diligence requirements and want to find a middle ground?
In these situations and countless others, representations and warranties insurance is the perfect vehicle for easing fears and transferring risk from your business to the insurance company. When combined with tail coverage on your directors & officers insurance policy, the right representations and warranties insurance policy can effectively reduce your risk so you can focus on life after the deal sooner rather than later.
What is it?
If it’s true that a good compromise is when both sides are left dissatisfied, representations and warranties insurance would be the cure for a good compromise. It relieves pain points on both sides of the deal!
On the buy-side...
Why: Buyers purchase a representations and warranties policy so they can rely on the accountability of a massive financial institution instead of a promise from the seller.
Buyers also make themselves more competitive when they protect themselves with representations and warranties insurance. Any buyer who comes to the table with more lenient indemnification, escrow or due diligence requirements of the seller will have an easier conversation with them.
What: A representations and warranties insurance policy will protect the company from the financial impact of accidental inaccuracies about the nature of the acquired company. It does this by indemnifying the buyer per the terms of the agreement with the seller up to the limit in the policy.
Who: Buyers or sellers can purchase the policy but, historically, buyers are more likely to purchase the policy. Why is this?
Buyers want help. They want sellers to stand by their word and protect the buyer from their mistakes. But they also don’t want to have to rely on that help as a last resort. The last thing a buyer wants to worry about is the financial strength of the seller down the road in the event they need to be indemnified. The idea of discovering a problem 2 years down the road and having to track down the seller and sue them is enough to give most executives ulcers.
On the sell-side...
Why: Sellers will push for this policy for more reasons than just protecting themselves from massive lawsuits. In practice, they can improve the conditions of the deal and move on from the transaction faster. If the buyer can get comfortable with asking the seller to put less money in escrow for a shorter period or for shorter elimination periods on representations or for more lenient indemnification terms (or with getting rid of these conditions entirely) then both the seller and the buyer can walk away with a win.
What: A representations and warranties insurance policy will protect the company (and any specified people) from suits from the buyers alleging a breach of the terms of the agreement. It will do this by providing capital for defense costs and judgments/settlements against the seller. It will also reduce risk for the buyer which can be used as a bargaining chip during negotiations.
Who: It may be surprising then that sellers are less likely to purchase this policy. It’s the seller’s representations or warranties that we’re trying to back up with insurance, after all. In truth, the high probability of insurance being purchased on the buy-side is more a function of the dynamics of negotiating M&A deals than a reflection of true risk.
One major insurer actually found that sellers were more likely to deal with claims even though they only purchased a fraction of the carrier’s total policies. (Notably it was buyers, however, who came in first place in terms of total claim size).
There is limited claims data for this type policy as a result of the confidential nature of these discussions. What information is available to the public suggests there are high costs associated with breach of representations claims.
Since policy pricing is largely based on deal size, companies subsequently get the most bang for their buck when the deal exceeds $20 million in total enterprise value. Of course there are exceptions but, often times, transactions under $20 million require premiums that are too high relative to the deal’s size.
Policies are often offered with terms as long as 6 years from the date of the transaction. This is important because a significant portion of claims take time to develop, sometimes long after both parties have moved on to bigger and better things. According to one carrier, more than a quarter of their representations and warranties insurance claims were reported a year and a half or more after the closing date.
How do I protect my company and myself?
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