Representations and warranties insurance, which has become more affordable for merger and acquisition transactions, is growing much more prevalent in recent years as the market for such insurance has grown more competitive.
“If you haven’t paid attention or you’re not a regular acquirer of businesses or assets, your opinion of reps and warranties insurance might be dated,” says Kevin T. Wills, shareholder and chair of the corporate and commercial group at Babst Calland.
Smart Business spoke with Wills about how representations and warranties insurance works and what to consider with this risk mitigator.
What are the benefits of utilizing reps and warranties coverage?
These policies can be advantageous for both buyers and sellers.
For a seller, it can reduce or eliminate any need to holdback or escrow a portion of the purchase price with respect to post-closing indemnification claims for breaches of representations and warranties. This provides a seller with a cleaner exit with less contingent liabilities and more certainty as to the sale proceeds. Additionally, if a seller is going to have an ongoing relationship with the buyer, it also avoids the potential awkwardness a lawsuit may cause.
On the buyer side, it can make your bid more attractive if the seller knows that it will not be responsible for post-closing claims for breaches of representations and warranties. It helps with the negotiation of the purchase agreement because a seller is less concerned with their post-closing exposure for breaches of representations and warranties, which saves time and reduces legal fees. Also, in some instances, the coverage limit and duration that the buyer acquires — the amount of the insurance policy and the term thereof— may exceed what the seller would be willing to give in a negotiated indemnification context. Further, liability baskets and caps do not need to be negotiated with an insurance company.
What are some limitations to be aware of?
A representations and warranties policy is not a cure all; an insurance policy is not a guarantee of recovery.
Further, this insurance only covers breaches of representations and warranties. It does not cover, for example, items such as breaches of covenants of a seller; breaches for which the buyer had knowledge at closing; retained liabilities of the seller, unless they can be tied to a breach of a representation; purchase price and working capital adjustments that might be negotiated in a purchase agreement; and extraordinary losses (those exceeding the policy amount). The policy will contain certain exclusions based on the insurance company’s underwriting that won’t be covered as well.
That is why it is critical for buyers to truly understand the policy binder before obtaining the coverage. Just because a buyer has expended $50,000 in underwriting fees, does not mean the buyer should proceed to pay the premium of 2 to 3 percent of the purchase price if the coverage does not look right once the buyer reviews the policy.
Where wouldn’t reps and warranties coverage make sense?
A strategic buyer who conducts robust due diligence and is familiar with the subject matter of the transaction may not want to spend additional money to acquire a policy. Further, the lower the deal value, the higher the sticker shock and impact on the deal may be. Percentages are universal, but 2 to 3 percent of $20 million, which is a typical minimum deal value for an insurance carrier, can have a greater impact to the bottom line than 2 to 3 percent of $1 billion.
How often are claims paid out?
Claims are typically subject to arbitration, so claims payment is not usually public. However, a payment history is being established and there is a growing track record of honoring claims. For example, insurance carrier AIG reported that in 2018 it had a 19.4 percent claims frequency and the average claim payout was $19 million.
What’s your takeaway for business owners?
Representations and warranties coverage appears to be here to stay and is something to seriously consider for your next deal. Further, it may be something that buyers are obligated to do, especially in a bid process. Some sellers with a desirable business or assets are requiring buyers to buy representations and warranties insurance.
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