In the context of the purchase and sale of a company, when sellers seek to negotiate a "clean exit" and limit exposure to indemnification claims and buyers seek to avoid unknown pre-closing risks, the question increasingly arises: can't insurance cover these risks?
Canadian M&A participants have been slower than participants in other markets to regularly seek this type of insurance, known as Representation and Warranty Insurance ("RWI"). However, insurers have been quick to offer RWI products and interest is growing. The rationale for purchasing insurance can be unique for each party.
Below are answers to some frequently asked questions about RWI.
1. WHAT IS REPRESENTATION AND WARRANTY INSURANCE?
RWI provides protection to the insured against unintentional and unknown breaches of representations and warranties made in an acquisition agreement. RWI can either supplement or replace a seller's indemnity.
The policy period typically matches the survival period in the underlying agreement, but can be extended if necessary. RWI policies generally provide coverage for policy terms of three years for "general" representations and six years for certain representations, such as tax and employee benefits representations.
Certain breaches are excluded under RWI policies. For example, pension plan underfunding/ withdrawal liability or adjustments to the purchase price related to working capital are standard exclusions. RWI policies specifically exclude coverage for breaches of representations and warranties actually known by the insured to be inaccurate at the time the policy was bound (i.e., coverage for pro-sandbagging will not be permissible). However, a party may be able to negotiate the definition of "knowledge" with the assistance of legal advisors and insurance brokers, thereby limiting the application of the exclusion provision of the policy.
2. WHO CAN PURCHASE COVERAGE AND WHAT ARE THE TYPICAL REASONS TO SEEK COVERAGE?
Both buyers and sellers are able to purchase RWI. For sellers, it offers liability protection (defence costs and settlement). For buyers, it offers protection for losses resulting from breaches of warranties or claims on indemnities.
The majority of RWI policies issued are buy-side.
Reasons for Buyers to Purchase RWI
- Ease of Reimbursement: The buyer is able to recover losses directly from a financially secure insurer rather than a seller that may no longer have assets to satisfy claims.
- Increased amount of reimbursement: The buyer can enhance the quantum of protection.
- Extended duration of representations and warranties: The buyer can benefit from longer periods to identify and report problems with the acquired business and seek reimbursement.
- Unique risk coverage: The buyer can choose to extend coverage in specific areas where diligence has identified higher risks, such as tax liability insurance, multiplied damages payouts and coverage for indirect/consequential damages.
- Protects relationships: RWI can potentially reduce friction with certain sellers (i.e. management) who may continue with the business post-acquisition.
- Distinguishes a bid in a competitive auction: RWI enables a bidder to accept more risk (minimizing revisions to the proposed acquisition agreement) and can reduce or eliminate the need for a holdback or escrow account.
- Enhanced confidence: RWI can provide financing sources with confidence that risk exposure is low.
Reasons for Sellers to Purchase RWI
- Locks in return: RWI reduces the risk of contingent liabilities post-sale and provides the confidence to fully distribute sale proceeds rather than tying up funds with the seller or in an escrow account.
- Protects passive sellers: RWI reduces concerns of sellers that have not been actively involved in the management of the business about unintentional non-disclosure or breaches of representations or warranties.
- Eliminates obstacles to closing: RWI provides a potential solution in situations where indemnity negotiations are posing a challenge for mutual agreement.
- Settlement process and costs handled by insurer: In the case of a dispute, the seller is not responsible for the cost or complexity of defending a claim.
3. WHEN DOES RWI COVERAGE MAKE SENSE?
RWI is typically used in transactions with a deal size between CDN$30 million and CDN$5 billion.
While parties to all M&A transactions may be interested in redistributing post-closing risks, because of the added cost and timing considerations, RWI is generally considered for transactions with more than CDN$3 million indemnity exposure, which then becomes the policy limit. For example, RWI would make sense on a CDN$6 million transaction with a 50% indemnity cap, or a CDN$30 million transaction with a 10% indemnity cap.
With respect to cost considerations, the minimum premiums for RWI are typically CDN$100,000 to CDN$150,000 and minimum deductibles are currently around 1-2% of the total transaction value. The deductible is called the "retention amount" and in some policies the retention amount is reduced after a specified period of time (usually aligned with the survival periods). Therefore, for the CDN$30 million transaction with a 10% indemnity cap, the premium payments make RWI less attractive due to the CDN$300,000 – CDN$600,000 retention amount.
Irrespective of whether the size of the transaction permits RWI, a careful review of the policy exclusions is required to ensure that they fit the risk profile of the business and meet the expectations of the parties. Some typical exclusions such as environmental or anti-corruption matters may be of primary concern for the policyholder and such exclusions can diminish the benefits of RWI.
4. WHAT IS THE PROCESS FOR OBTAINING RWI?
When a party is considering purchasing RWI, it should consult its legal advisor and an insurance broker. Using an insurance broker ensures access to various markets and allows the party to choose the insurer that is best suited for the deal. Insurance brokers are also able to advise on the policy provisions and exclusions prior to the payment of fees. The insurance broker will work with the legal advisor to ensure the most appropriate product is selected.
After signing a non-disclosure agreement and providing the insurer with transaction documents such as the acquisition agreement, financial information and the confidential information memorandum, a preliminary quote can usually be obtained within a few days at no cost.
If the party is interested in proceeding, it would pay the insurer an underwriting fee (usually between CDN$20,000 and CDN$40,000 to cover the costs of the insurer's outside counsel's due diligence). The fee depends on the complexity of the transaction and the number of jurisdictions involved in the deal. Due diligence by the insurer will typically consist of a review of the due diligence process conducted by the parties, including the diligence report prepared by buyer's counsel (typically on a non-reliance basis), as well as a diligence call.
5. HOW LONG DOES IT TAKE TO ISSUE A RWI POLICY?
Purchasers of RWI should generally allow for at least 2 weeks between the engagement of an insurance broker and the receipt of a binding policy in advance of entering into a binding transaction.
The steps involved include:
- The insurance broker begins the initial quoting process and the party will receive a non-binding indication letter within 24-48 hours after the insurance broker contacts the insurers.
- Once the insurer is selected and the underwriting fee is paid, the insurer due diligence process is usually 3 to 7 business days, depending on the complexity of the transaction.
- The insurer due diligence call is conducted – this is typically 1-3 hours in length and includes representatives from the company and the company's external advisors (such as tax and legal).
- The issuance of the policy may also take a few additional days.
Once these steps are complete, the binding policy is issued effective as of the signing of the transaction.
6. HOW MUCH DOES COVERAGE COST AND WHAT ARE THE TIMING CONSIDERATIONS?
Generally, the premium charged now ranges from 2-4% of the limit of liability purchased (usually CDN$50 million in coverage is available through one provider, although an "insurance tower" can be created to obtain additional coverage as necessary).
Premiums can be paid by either party, regardless of whether the policy is buyer-side or seller-side. This often forms part of the deal consideration and structuring.
RWI can be purchased at any time during a transaction. In addition to the traditional practice of seeking out RWI to overcome stalled negotiations related to risk allocation, some parties consider RWI earlier in a transaction as an alternative to a more traditional holdback or escrow arrangement.
If there is a timing gap between signing and closing of the transaction, the RWI policy can be effective as at the signing date so that it covers the gap period.
7. HOW DOES THE CLAIMS PROCESS WORK?
Each RWI provider has a dedicated claims process and RWI claims generally work similar to other insurance products. These processes should be reviewed in the context of the binding RWI offer from each insurer, as claims can be subject to deductibles and other limitations.
With special contribution from Robyn Weber, AVP, Private Equity Practice Leader, HUB International
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.