M&A contingent risk insurance
May 2020 | TALKINGPOINT | MERGERS & ACQUISITIONS
Financier Worldwide Magazine
May 2020 Issue
FW discusses M&A contingent risk insurance with Tim Kennedy and Charles Turnham at Ambridge.
FW: Could you provide an overview of the key function of contingent risk insurance? In an M&A transaction, which party purchases coverage?
Kennedy: In M&A transactions, identified, contingent risks – risks that may or may not crystallise or where the quantum of potential loss is undetermined – can become deal points that lead to scuttling of a transaction or, at the very least, disruption of the economics for one party to the transaction or the other. Because neither buyer nor seller wants to retain the identified risk, a contingent risk insurance policy may be a solution which allows the parties to conclude a transaction in a manner most efficient for all. For example, limited or no indemnity for the seller and satisfactory protection for the buyer. Typically, the buyer in the M&A transaction is the insured, since – in most cases – the target in the transaction is the entity that retains the risk going forward. The party that pays for the insurance is typically a negotiated point between the parties.
Turnham: Contingent risk insurance provides the insured party with coverage against the adverse financial impact of an identified actual or potential legal exposure. This contrasts with representations and warranties (R&W) and warranty and indemnity (W&I) insurance, which provides coverage against unknown risks or defective disclosure by the seller in an M&A transaction and which will generally exclude known risks. The contingency product group would also technically include specific tax insurance. Conceptually, the products are the same in that they provide protection against known legal risks. Contingency risk coverage can be purchased by either the seller or buyer in an M&A transaction, although it is perhaps more common for a policy to be placed with the buyer as they will be the party controlling the target and the conduct of the underlying issue post-closing. Contingency risk insurance can also be placed outside the context of an M&A transaction for general risk management or asset distribution purposes.
FW: What types of M&A contingent risk are typically covered, and what criteria is necessary for a risk to be insurable?
Turnham: A contingent risk offering underwrites a wide variety of exposures, including litigation risks, regulatory exposures, intellectual property (IP) matters, and contractual and statutory interpretation issues. Factors relevant to insurability include a clear rationale for the insurance request, the robustness and consistency of the legal regime and decision-making authority applicable to the issue, and a fulsome understanding of the factual and legal background to the risk. While all these points are important, the latter point is particularly key, as insurers will need to carefully consider any ‘information risk’ where key aspects of the factual background or positions of the relevant parties cannot be ascertained through the underwriting process. The most obviously suitable opportunities for contingent risk insurance are those where the insured risk centres as closely as possible on a legal, rather than factual or commercial, issue.
Kennedy: Contingent risk insurance typically covers one-off legal, judicial and legislative risks that may inhibit or prevent completion of transactions, or present undue risk exposure to involved parties. Some examples of contingent risks that are often covered are successor liability, avoidable transfer, ongoing litigation, most typically risks at the appeal stage, and contractual liability. In terms of criteria, in order for the risk to be insurable, the key facts underlying, and legal arguments supporting, the contingent risk should be ascertainable and made available to the insurers. In addition, the risk should not be against public policy, or a financial or performance guarantee.
“Alignment of interests offers comfort to insurers in respect of the insured’s motivation and will generally facilitate the negotiations.”
FW: What limits to be insured are generally placed on a deal?
Kennedy: The limits to be insured typically are not directly linked to the size of the deal. Rather the limits purchased are aligned with the amount of potential loss that could be suffered or incurred by the insured under the contingent risk insurance policy. Additional limits are often purchased to cover the costs to defend or contest the contingency, in the event such costs are incurred.
Turnham: The limits purchased on contingency risk insurance are case-specific and will be informed by the quantum of the exposure arising in the case.
FW: Based on your experience, could you provide any specific examples of how contingent risk insurance can benefit a transaction?
Turnham: A target company in an M&A process received a letter from a former customer alleging breach of contract and claiming substantial damages in excess of $90m. The purchaser would not proceed unless security was offered in respect of the contingent liability. The parent company of the target purchased specific contingency insurance, which provided primary and excess cover as part of an insurance programme of over $80m. This transferred the vast majority of the exposure from the target to the insurer and enabled the sale to complete. In another M&A transaction involving the acquisition of a portfolio of distressed consumer loans out of insolvency, the purchaser was concerned about loss of value through borrower claims in respect of regulatory issues affecting the portfolio. No recourse was available from the insolvency practitioner who required the assets to be sold on an ‘as is’ basis. A policy with a limit exceeding $110m was offered in order to facilitate the execution of the transaction.
Kennedy: Often, a contingent risk can be a significant deal point to an M&A transaction. Contingent risk insurance allows a seller to exit an investment with no or very limited indemnity obligation with respect to the issue, while also providing the protection that a buyer requires. As a result, a transaction that might otherwise collapse because of the identified issue, or that could be economically less efficient for one party or the other, can be completed in a much more effective manner for all parties by utilising contingent risk insurance.
FW: How should a contingent risk insurance policy be tailored to the specific circumstances of an M&A transaction? What do you consider to be the essential components of an effective policy?
Kennedy: By tailoring the coverage grant under the contingent risk insurance policy to specifically address the risk at hand, the insurance solution can effectively take the issue ‘off the table’ for the parties negotiating the transaction. Often, the M&A sale agreement references the policy itself, and how it interacts with, or replaces, any indemnity obligation of the seller. The most essential components of a contingent risk policy are a clearly defined coverage grant and appropriate conduct provisions so that all parties are aware of and agree on what is being covered, and their respective rights and obligations going forward.
Turnham: This will, of course, depend on the circumstances of the particular transaction. Relevant considerations are, however, likely to include the following. First, a precise definition of the risk to be covered by the contingency risk policy. This should dovetail with the agreed position of the transaction parties around liabilities relating to the contingent issue which the parties have agreed to retain and allocate between themselves under the transaction documentation. For example, the amount of any ‘excess’ or self-insured retention under the insurance policy, and provision for defence costs where these are not covered under the policy itself. Second, consideration as to who should be the insured party under the policy, and how the conduct obligations of that party under the policy will align with the practical requirements of each of the parties going forward.
“Contingency risk insurance is a natural complement to the R&W and W&I insurance that has become a staple in the M&A transaction setting.”
FW: From an insurer’s perspective, what are the most important issues that need to be considered when negotiating contingent risk coverage?
Turnham: The key issues from an insurer’s perspective will include the rationale for insurance, ensuring interests are aligned between insured and insurers, and conduct rights in respect of the insured risk. Consideration of the rationale will involve ensuring that the product is sought only in respect of the financial consequences of a legal risk, and not, for example, solely as a result of the failure to meet any specific financial or performance target. Alignment of interests offers comfort to insurers in respect of the insured’s motivation and will generally facilitate the negotiations. The most obvious way to achieve this is through the insured taking a ‘first loss’ position through a self-insured retention. Policies will generally include robust conduct rights – including the right to receive information, comment on draft documentation and discuss strategic decisions – for the benefit of insurers, which is important as the insurers will wish to have reasonable control over decisions which could impact the outcome of the contingent exposure once the policy is on risk.
Kennedy: Insurers need to be provided with all material facts and analyses available to the proposed insured. This will allow for the most efficient and effective underwriting process, allowing the insurers to understand the risk as quickly as possible, and as a result, offer as comprehensive coverage as possible. In addition, the insured must have the ability to control the defence or contest of the insured event under the policy, with the insurers having the right to effectively associate with the insured in respect thereto.
FW: What advice would you offer to parties considering a bespoke M&A contingent risk insurance policy?
Kennedy: Since contingent risk insurance can be a very effective solution for parties to an M&A transaction, we recommend they reach out to their insurance brokers to discuss any potential deal points that might be impacting the negotiation of the transaction. We also recommend sellers proactively consider contingent risk insurance coverage prior to an M&A transaction, since covering off a contingent risk prior to the transaction negotiations may lead to a more efficient sales process and a potentially higher valuation.
Turnham: As the process involves constructing a bespoke solution for each case, a precise formulation of the exact parameters of the risk for which cover is requested at an early stage is key. It will also be very helpful to have a fulsome and detailed factual and legal analysis of the risk available for review by insurers to enable them to review and provide a meaningful response. Where the request for contingency insurance arises in the context of an M&A transaction, it is also prudent to ensure that all parties to the deal are comfortable with the insurance proposal and are aligned on the scope of the risk to be transferred to insurers and any residual risks to be retained by the transacting parties.
FW: How do you expect the appetite for contingent risk insurance to develop in the years ahead? What factors are set to drive future trends in uptake?
Turnham: We expect appetite for contingency risk solutions to continue to increase, driven by the following factors. First, a growing awareness and knowledge of the product and its capabilities among advisers and users. Second, investment by underwriters and brokers in specialist personnel with expertise in such products. Finally, market conditions, which, in the short to medium term, may result in the parties looking to free up excess capital or buyers being less willing to absorb risks in relation to known matters and look to the insurance market for protection.
Kennedy: Contingent risk insurance is currently an underdeveloped market and we expect the appetite for contingent risk insurance to increase significantly in the years ahead. Contingency risk insurance is a natural complement to the R&W and W&I insurance that has become a staple in the M&A transaction setting, as it provides coverage to the buyer for identified, but not yet crystallised, risks, whereas the R&W and W&I product is designed to cover the unknown. Because deal professionals, private equity firms and, increasingly, corporates have accepted the R&W/W&I insurance product as a standard tool to be utilised to allocate risk among parties to an M&A transaction, the notion that insurance can be a useful solution in a transaction has been firmly established. This acceptance of insurance products, combined with increased awareness of contingent risk insurance capabilities, is expected to drive an increase in the use of this insurance solution.
Tim Kennedy is the president, North America and group chief underwriting officer at Ambridge Group, a managing general underwriter of transactional insurance products. He has been underwriting transactional insurance for over 20 years and is currently responsible for overseeing the global underwriting and development of Ambridge’s insurance products. He can be contacted on +1 (212) 871 5403 or by email: tkennedy@ambridge-group.com.
Charles Turnham joined Ambridge Europe in 2015 and has been part of the leadership team in respect of warranty and indemnity (W&I) and contingency insurance underwriting. Prior to joining Ambridge, he worked in private legal practice in London for seven years as a corporate M&A lawyer at Slaughter and May and then at Olswang. He can be contacted on +44 (0)20 3874 0057 or by email: cturnham@ambridge-group.com.
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