Why do you need Representations & Warranties Insurance?

If you’re involved in the purchase or sale of a company. Maybe even your company! Buyer or seller, it doesn’t matter. You need 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 the transaction.

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. Let’s take a look at three critical scenarios:

Seller

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.

Inaccurate Representations

If it’s discovered down the road that any of the sellers’ 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.

Buyers

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?

What is Representations & Warranties Insurance?

R&W insurance is a type of insurance policy purchased in connection with corporate transactions. It covers the indemnification of certain breaches of representations and warranties in the transactions agreements. 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 this 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.

Protect Yourself and Your Company

What does Representations & Warranties insurance cover?

You will have to consult your policy documents to confirm exactly what is and what isn’t covered by Representations and Warranties insurance but here are a few scenarios that typically would be covered:

Breaches of purchase agreement
R&W insurance is generally meant to cover breaches of all general and fundamental representations and warranties within a purchase agreement
Pre-closing tax indemnities
Pre-closing tax indemnities are generally covered but only to the extent where the seller’s financials are incorrectly calculated.
Seller Fraud
A typical buy-side policy does provide the buyer with the benefit of coverage for seller fraud.

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