December 2021 Issue
Every M&A deal carries a level of risk – the key is to manage it. In recent years, representations and warranties insurance (RWI) has become an increasingly popular means of transferring some of that risk, allowing transactions to proceed with a greater level of certainty.
Typically, RWI benefits both buyers and sellers, by transferring some or all of a seller’s indemnification obligations for breaches of representations and warranties in the merger agreement to a third-party insurer. RWI provides the buyer with potential recovery in the event of a breach.
As such, RWI is a vital tool in bridging risk gaps in M&A transactions. It supplants traditional escrow arrangements with an insurance product to back up the deal, freeing up cash for the seller while providing a solvent third-party for the buyer to recover from.
Historically, the use of RWI in M&A transactions was relatively limited. Policies were initially offered in the US in the late 1990s as a way for sellers to offset some of their indemnification obligations. It took more than a decade for the product to gain any real traction.
Today, however, it is one of the fastest-growing solutions to help facilitate M&A transactions in the US, Europe and elsewhere. According to the American Bar Association, in 2018-19, 52 percent of private company transaction agreements referred to RWI, up from only 29 percent in 2016-17.
Supply and demand
At the start of the coronavirus (COVID-19) pandemic there was a significant slowdown in M&A transactions and a corresponding decrease in RWI placements. But in the second half of 2020 and throughout 2021, we have seen a rebound to record high M&A volumes. This, combined with increased acceptance of the product, has led demand for RWI to outstrip supply – a trend that has become even more acute since Q3 2020.
According to Nicholas E. Rodríguez, a partner at Jones Day, another driver is the growth of private equity and family office investing, which has helped fuel the RWI market. Indeed, RWI has become practically essential for transactions involving PE-backed sellers. “Initially, PE investors used RWI to make their offers more attractive to sellers in auctions,” he explains. “Thereafter, as private equity investors began to sell off their investments, they insisted on RWI to avoid having to put any money into escrow or avoid any clawback of the purchase price. Strategic companies have also utilised RWI to maintain competitiveness in private M&A transactions.”
But the surge in deal activity over the last 12 months has greatly stretched the capacity and resources of RWI insurers to meet market demand, which has affected how policies are sourced and processed. “Certain transactions continue to experience a more circumspect market as reflected by fewer non-binding indication letters (NBILs) returned as part of the initial outreach to the market and increased scrutiny during the underwriting process once an insurer is selected,” points out Jan A. Larson, a partner at Jenner & Block.
Paul M. Tiger, a partner at Freshfields, concurs that there are simply not enough carriers in the market to handle demand. “Even for those carriers that are active, we are hearing anecdotally that some have written enough policies in 2021 that they are starting to reach their aggregate risk limits for the year,” he warns. “As a result, carriers are becoming much ‘choosier’ in terms of the deals they decide to bid on or underwrite. That has led to a hardening of terms, both in terms of pricing but also carriers’ willingness to negotiate around the scope of policy exclusions and to insert qualifications in representations and warranties that are not in the underlying agreement, such as ‘knowledge’ and ‘written notice’.”
Key elements of an RWI policy
There are several important elements of an RWI policy, including policy limit, coverage, retention and survival. According to David Taubenfeld, a partner at Haynes Boone, buyers and sellers need to pay particular attention to definitions and exclusions. “The goal is to have the policy cover the seller’s representations in the M&A agreements,” he says. “Insurers may attempt to whittle the scope of their coverage down using sometimes restrictive definitions of ‘claim’, ‘loss’ and ‘purchase agreement’.
“They may also include exclusions, some of which are common to all policies, but some of which are ‘deal specific’,” he continues. “The goal is to keep any deal-specific exclusions as narrow as possible. There is significant interaction between the insurer and the insured as the policy is being underwritten, so there is significant opportunity to fine-tune the exclusions.”
“The surge in deal activity over the last 12 months has greatly stretched the capacity and resources of RWI insurers to meet market demand, which has affected how policies are sourced and processed.”
As Ms Larson notes, the scope of coverage is often dependent on the way in which particular terms such as ‘breach’ and ‘loss’ are defined. “It is important to look for the equivalent of a materiality scrape in the definitions of these terms that removes any materiality qualifiers in determining for purposes of the RWI whether a breach has occurred and the scope of any resulting loss.
“In addition, pay particular attention to whether the fees and costs incurred in investigating and prosecuting a breach are included in the definition of ‘loss’ or another term like ‘claims expenses’, and whether fines and penalties are potentially covered under a most favourable jurisdiction provision,” she adds. “Try to narrow the scope of the exclusions where possible, including where they incorporate defined terms such as ‘actual knowledge’ or ‘interim breach’ that can then also be narrowed.”
In the US, exclusions specifically related to COVID-19 are common, according to Mr Taubenfeld. “One effect of COVID-19 is that all policies will have some form of COVID-19 and Paycheck Protection Program (PPP) loan exclusion, and there are many variations of each,” he says. “Also, the RWI market has hardened significantly in the last few months. There appear to be two forces at work: demand outpacing supply and the number and size of recent RWI claim payments.”
Overall, the RWI market appears to be more guarded for buyers and sellers looking to source policies. “Insurers began including broad COVID-19 exclusions in RWI policies, with each insurer utilising different language for its exclusion – leading to inconsistency among the various formulations of the exclusions, and uncertainty about those exclusions would later be interpreted in the claims context,” says Ms Larson.
“As the pandemic has continued, however, we are starting to observe a greater willingness on the part of insurers to narrow those exclusions to exclude specific known impacts of COVID-19 on the target company,” she adds.
In addition, RWI carriers are beginning to set hard coverage limits to reduce their overall exposure on each individual policy. “If a total coverage limit per carrier is $25m, brokers must stack at least two or more additional insurance carriers on top of the primary insurer in order to effectively and potentially cover a transaction,” says Mr Rodriguez. “This could increase the cost of an RWI policy, particularly in much larger transactions where higher coverage is required.”
Another area of focus is cyber security and privacy risks, with signs that RWI carriers are demanding enhanced scrutiny of these exposures, which in turn requires a separate diligence stream. “As this area becomes more complex and fraught with additional risks, RWI carriers will continue to place additional requirements to obtain coverage and avoid blanket exclusions,” notes Mr Rodriguez.
Despite the disparate approaches to policy definitions, exclusions and qualifications, which give rise to uncertainty, there are predictions that the RWI market will find more uniformity over time. “We believe that convergence on policy terms across carriers will continue and the market will start to see relatively standardised terms that reduce transaction costs, in the same way directors and officers coverage and property and casualty policies have become fairly standard,” suggests Mr Tiger.
Trends in claims
The RWI market has matured substantially over the last few years, appearing in larger and more sophisticated M&A deals. Unsurprisingly, there has been an increase in the frequency of claims on high-end deals, particularly those valued at $500m and above.
Common underlying causes of claims include breaches of representations and warranties linked to financial statements, compliance with laws, tax matters, failure to disclose liabilities, employment and labour, material contracts and material customers. According to AIG, while the frequency of claim notifications has remained constant over the last few years, averaging one claim for every five policies, claims severity continues to increase.
“Financial statements remain a focus for insureds and carriers,” says Mr Tiger. “Because most policies are silent on whether multiple-based damages are permitted, if an insured can demonstrate the target profit and loss (P&L) was misstated, it can then argue it should be permitted to strap a multiple on the overstatement – to basically value its loss in the same way it determined its valuation for the target in the first place. This can meaningfully increase the value of a claim.
“Another common claim is around material customer and supplier representations, usually an assertion that the target had notice the customer or supplier was moving its business elsewhere and terminating the relationship and did not disclose it,” he adds.
These trends are set to have an impact on the RWI market across the board. A continued rise in claim severity and in the average size of claims could translate into increased premium pricing and limited appetite or range of coverage across the market.
Future dynamics
Before the outbreak of COVID-19, RWI was becoming more widespread; as long as dealmaking momentum continues, it will remain in demand. However, the crisis will likely have a lasting impact on how policies are written, premium costs and a number of other factors. There may be a focus on other supplemental coverage too, such as specific tax issues or ongoing litigation, for example.
As the RWI product evolves, one key aim will be to adapt it for transactions at the lower end of the M&A market. “We expect a sort of R&W cover will continue to develop at a simplified level to be appropriate even for the smallest transactions – perhaps a policy that does not require significant underwriting, and that can essentially be applied for online,” suggests Mr Taubenfeld.
In the view of Mr Rodriguez, there are obvious parts of the market that are not fully serviced. “Insurance carriers will continue to develop and expand RWI in underpenetrated business segments such as small- and micro-sized M&A transactions and cross-border transactions involving Latin American targets,” he says.
Over recent years, RWI has significantly increased in importance in the M&A space. As the industry continues to mature, new carriers and capital will enter the market, driving competition, shaping policies and expanding product offerings. “Over the coming months we expect buyers to secure more than the traditional 10 percent of project value in limits,” predicts Mr Taubenfeld. “And we expect the industry to adapt to special purpose acquisition companies (SPACs), which will compose a significant portion of transactions in the near future.” Ms Larson adds that “notwithstanding these somewhat challenging market conditions, RWI policies continue to be an increasingly common feature of M&A transactions.”
Going forward, as RWI becomes increasingly mainstream, buyers and sellers need to be aware of the challenges to overcome, the opportunities that are available, as well as the transactional and pricing issues to be addressed when using this type of insurance.
© Financier Worldwide
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Richard Summerfield