Insurance due diligence in M&A
April 2022 | TALKINGPOINT | MERGERS & ACQUISITIONS
Financier Worldwide Magazine
April 2022 Issue
FW discusses insurance due diligence in M&A with Andre Eichenholtz at CAC Specialty.
FW: Could you explain the role of insurance due diligence in a typical M&A transaction? Broadly, what does the process entail?
Eichenholtz: Insurance due diligence is intended to provide parties with a concise review of a target company’s current and historical risk management programme to identify coverage, pricing, structure, compliance and quality of earnings (QoE) issues that would be of concern to them regarding the transaction. Of particular concern to investing sponsors are issues that could create volatility risk to the financial model that supports their investment thesis. Typically, a ‘red flag’ report is generated that focuses on the key risk issues. Typical insurance diligence can include, firstly, identification of financial and operational exposures and assessment of the appropriateness of the current and historical risk management programmes, Secondly, analytical review of claims history, including a retained loss analysis in order to assist the private equity (PE) firm’s financial advisers on QoE diligence. Thirdly, identification of post-closing enterprise value creation opportunities, including collateral recapture, implementation of more efficient risk management programmes and so on. And lastly, a review of loan covenants, leases and third-party contracts to ensure compliance with current risk management programmes
FW: What are the key benefits to both acquirers and targets of conducting insurance due diligence?
Eichenholtz: Acquirers want to know if there is anything related to the target’s risk management programme that could impact their financial modelling of the risk, reprice their bid or cause them to reconsider the transaction. It is important to address any coverage deficiencies and uninsured exposures, as well as verify that the insurance accruals within their financial statements are appropriate. It is important to identify value creation opportunities where the target may be able to utilise insurance as a proactive tool for its business, such as warranty insurance. Additionally, if cost savings can be identified it will lead to earnings before interest, taxes, depreciation and amortisation (EBITDA) value creation. Alternatively, identifying financial deficiencies may save a PE firm from making a problematic investment. Target companies also benefit from due diligence and appreciate having a professional team of experts provide a review of their risk management programmes.
FW: What are the key risks facing those that choose not to perform appropriate insurance due diligence?
Eichenholtz: There are numerous risks. If the target company has not accrued properly for historical insurance costs and retained liabilities, its EBITDA could be overstated, which affects the purchase price. Additionally, if there are exposures that are not adequately covered, they could give rise to uninsured claims, which would negatively impact the balance sheet. There could also be lost opportunities to create enterprise value if cost or collateral reductions are not identified and implemented at closing. We often see companies not fully appreciating their business interruption exposures or adequately reflecting current replacement costs for their properties. We have also seen transactions where there were areas of concern for buyers which could have caused the transaction to fall apart, including environmental exposures and tax-related concerns. Due diligence can identify these issues and solve them in a way that allows both parties to feel comfortable moving forward with the underlying transaction.
“There are almost always ways to add value to a transaction by improving the risk management programme.”
FW: To what extent are you seeing greater awareness of, and demand for, insurance due diligence in M&A? How would you describe take-up in recent years?
Eichenholtz: Diligence has been a standard part of M&A for many years. Today, almost every deal includes insurance due diligence, with most also including employee benefits diligence. Some exceptions would be small transactions, minority stakes or asset purchases. With the increase in the use of transactional products, such as representations & warranties (R&W), tax and contingent risk insurance, we have seen most R&W underwriters expect and utilise insurance and benefits diligence reports.
FW: Drilling down, what specific areas of risk and exposure are typically assessed as part of the insurance due diligence process?
Eichenholtz: Financial and operational risk are key elements of due diligence. Due diligence should help identify items from a risk management perspective that could give rise to financial or operational loss. This includes all first-party exposures to employees and assets, as well as third-party losses for which the company may be liable. These are broad statements which make the diligence process so important. Once this work has been done, attention then turns to how to protect the company from those potential losses, including mitigation strategies and the transfer of risk to third parties.
FW: How do the results of the process contribute to building a profile of the target company, and evaluating transaction viability and value?
Eichenholtz: Due diligence digs deep into the company’s risk profile and identifies areas of improvement. There are many instances where companies have risks that they assume cannot be solved by the insurance marketplace. Quite often that is not true, and insurance markets as well as capital market solutions can be identified. Being able to use traditional and non-traditional risk transfer creates a broader array of options for parties. Additionally, it is imperative that insurers truly understand the company’s risk profile in order to conduct in-house underwriting and to be able to properly communicate the risk to the markets. If carriers have any uncertainty about a company’s risk profile, they will either price it inefficiently or not quote at all. It is the job of risk solutions organisations to give the carriers a reason to write the programme by making them comfortable with the risk, and to do so on specific proposed terms. It is extremely rare that any items related to the insurance programmes will cause a transaction to not be viable, but efforts are always made to try to add value to a transaction. There are almost always ways to add value to a transaction by improving the risk management programme.
FW: How would you characterise the role of brokers in the insurance due diligence process?
Eichenholtz: In the diligence process, parties want to know they can trust the work that is being done and that they have access to concise, accurate and timely information as it relates to the risk management programmes of their target acquisition. That is why in every transaction, no matter the size or complexity, there must be an accurate assessment of the risk, solutions to deal with any red flags that have been identified, and ways to increase value. M&A transactions are complex from many standpoints, and parties want partners who make their job easier.
FW: What advice would you offer to buyers and sellers that may be contemplating whether to include insurance due diligence in their M&A process?
Eichenholtz: We would advise every buyer to conduct diligence on a potential acquisition as the benefits will far outweigh any nominal diligence fee, and it will most likely be required for the transaction products coverage. Additionally, due diligence processes should includes an in-house underwriting process that identifies cost savings and programme efficiencies, which will add value to the transaction.
FW: How do you expect insurance due diligence to evolve over the months and years ahead? To what extent are M&A activity levels driving insurance innovation?
Eichenholtz: The basics of insurance due diligence have been consistent over the years and many new entrants have started to offer what they call ‘due diligence’. I would argue that most firms only provide a high-level programme review and then try to sell a post-closing insurance or benefits programme to the buyer. Risk solutions organisations continue to find ways to improve their deliverables and are increasingly utilising data and analytics to make decisions based on fact, not feeling. PE sponsors are large consumers of data, and when it comes to risk management it has always been challenging for our industry to provide meaningful data on how to better manage risk. Proprietary technology platforms can more easily and efficiently capture and use data and analytics to support the due diligence process. The historical challenge in doing this has been obtaining the necessary data from each portfolio company. Artificial intelligence (AI) and other technologies make the data-gathering process much simpler for PE firms and their portfolio companies. The benefits of this are the ability for a PE firm to view and evaluate its total cost of risk by portfolio company and across its entire portfolio. This level of data allows for a more focused strategy to reduce claims, and an ability to implement more efficient risk management programmes. It is important to break down the total portfolio in order to see claims by insurance line, entity, carrier and in the aggregate across the portfolio by insurance line and by carrier. Add to this the projection of ultimate claims by line, and that provides data that highlights the inefficiencies inherent in the insurance industry. For example, if a PE firm has 10 portfolio companies that purchase the standard level of insurance coverages, they may have anywhere from 25 to 75 carriers on their collective programmes. And when you look at the entire loss ratio, often you will see a loss ratio well under 50 percent and some as low as 25 percent. What this means is that PE firms are not spending their risk management dollars efficiently. And with so many carriers on the programmes, it is almost impossible to create relationships and economies of scale.
Andre Eichenholtz is an executive vice president and diligence and portfolio solutions leader at CAC Specialty. He also co-leads the property and casualty practice. Before joining CAC, he was with JLT Specialty and worked as head of M&A diligence and placement, focusing on M&A transactions for private equity firms and corporate clients. He brings deep expertise in due diligence and complex casualty. He has previously built two private equity M&A practices, providing services such as diligence, transaction liability products, post-closing risk management programmes, and portfolio programme solutions. He can be contacted on +1 (347) 715 0104 or by email: andre.eichenholtz@cacspecialty.com.
© Financier Worldwide