In any M&A transaction, risk allocation is a primary concern, with each side wanting the other to hold the lion's share of the risks inherent in the deal. The buyer wants to minimize liabilities inherited from the target company, and will seek to employ various mechanisms to help mitigate these risks. They may negotiate for holdback and escrow mechanisms, seek broad representations and warranties and request comprehensive indemnities with long survival periods.
The seller, on the other hand, wants to limit its exposure under the transaction, make a clean break and receive the full purchase price at the closing of the deal. To this end, sellers will try to avoid escrows and holdbacks, seek narrow representations and warranties with short survival periods, and negotiate for high deductibles and low caps on indemnity obligations.
These competing goals can create tension between parties, cause significant delays and may ultimately threaten to derail an entire deal.
Sensing a window of opportunity, insurance companies have created Transactional Risk Insurance ("TRI") products, providing solutions for parties concerned about encountering hold-ups in negotiations due to these contrary motivations. Various forms of TRI exist, including:
- Representation and Warranty Insurance ("RWI"), which exists to provide protection in the event of an inaccuracy or breach of a representation or warranty that results in a loss;
- Tax Liability Insurance ("TLI"), which is designed to provide protection for costs arising from a challenge by a tax authority to a specific tax position taken by a party to an M&A transaction; and
- Contingent Liability Insurance ("CLI"), which provides coverage for known exposures within the context of a particular transaction.
This article takes an in-depth look at RWI, and briefly considers TLI and CLI.
TRI products have been offered in Canada since the 1990s, and these products are becoming increasingly popular as a risk-allocation tool in negotiated M&A transactions.
In recent years, there has been a significant increase in the Canadian market for TRI. Estimates say that in 2014, the amount of policy limits placed was $12 billion, as compared to $3 billion in 2012. While estimates suggest that only 2% of Canadian deals employ TRI, policies are used in approximately 5-10% of US deals and as high as 85-90% of Australian private equity deals.2
Representation and Warranty Insurance
Inaccuracies in representations and warranties made in the course of a negotiated M&A transaction can result in costly liabilities. Buyers may find themselves without recourse to recover losses and sellers may be forced to return a portion of the purchase price. Because of the incredibly high stakes, negotiations regarding representations and warranties can become heated. RWI can facilitate negotiations by bridging gaps on contentious deal points.
What is RWI?
When a party suffers a loss as a result of a breach of a representation or warranty provided for in a purchase and sale agreement ("PSA") — RWI comes into play. The RWI policy supplements indemnification provisions in the PSA and shifts transactional risks from the contracting parties to a third party insurer. Either a buyer or a seller may purchase an RWI policy, and each would have unique motivations for doing so.
Some of the reasons a buyer may be motivated to purchase an RWI policy include:
- to enhance and distinguish a bid and gain a competitive advantage over other bidders in an auction scenario;
- to offset the credit risk of collecting from the seller in the case of a breach; and
- to preserve key relationships in cases where members of the seller's management group are remaining with the company — for example, the buyer may wish to avoid the awkward situation of having to sue its own management team in the case of a breach.
Some of the reasons a seller may be motivated to purchase an RWI policy include:
- to obtain proceeds immediately (RWI minimizes the need for escrow or holdback mechanisms);
- to relieve future risk of having to repay a part of the purchase price at a later date, providing for a clean exit for the seller; and
- to create value — a seller may rely on RWI to negotiate a higher purchase price in exchange for agreeing to enhanced representations, warranties and indemnities in the PSA.
Most reputable insurers now have sophisticated M&A groups and processes, dedicated exclusively to dealing with RWI. Members of these groups are experienced in M&A transactions in a variety of roles. The key steps to putting an RWI policy into place include:
- Non-Disclosure Agreement: The insurer and the party seeking insurance typically execute a non-disclosure agreement.
- Submission of Materials: The party seeking insurance submits the draft PSA and related materials in order for the insurer to come up with a preliminary price and coverage quote (this typically takes between 2 to 3 business days).
- Underwriting Process: The insurer collects a non-refundable underwriting fee (typically between $25,000 and $50,000, credited against the final cost of the policy when issued) before it begins its review of any due diligence materials. This fee is intended to cover the insurer's costs of retaining outside legal counsel to assist with the due diligence process, as well as the negotiation of the policy. The underwriting process is typically completed in 3 to 10 days.
- Negotiation of the Policy: Each policy will have unique considerations for the insured and insurer to take into account during negotiations, but some key issues they must deal with include defining the scope of insured losses and exclusions, the coverage term and subrogation rights.
- Cost: Premiums will vary from deal to deal, but typically range between 2 to 4% of the amount of insurance purchased. Various factors will influence the cost of an RWI policy, however in sum, the premium will depend on the insurer's assessment of the deal's risk profile.
Insurers indicate that RWI is best suited for companies valued between $25 million and $1 billion, and that generally speaking, coverage up to $50 million is available per transaction.6
Making a Claim under an RWI Policy
In order to make a claim under an RWI policy, the insured must establish that a breach of one or more of the representations or warranties contained in the PSA occurred and that it suffered a loss as a result.
Some parties that are new to the TRI scene may be hesitant to buy-in due to the possibility that an insurer may not pay out on a claim. However, in the U.S., reputable insurance providers have developed a track record of paying out claims. Canadian insurers will most likely continue this trend, as it is in their best interests to build up confidence in the use of their products.
Tax Liability Insurance
Another TRI product is TLI. Often, parties cannot agree on the allocation of the potential costs arising from a challenge to a specific tax position taken by a party to an M&A transaction. TLI allows parties to reduce or eliminate these known tax exposures, enabling them to negotiate the rest of the deal more efficiently.
Parties typically purchase TLI when the likelihood of a tax liability is low, but the potential amount of liability is substantial. Parties may also purchase TLI where tax authorities refuse to provide advance rulings on identified tax issues. 8
Contingent Liability Insurance
Finally, CLI is another form of TRI. Known exposures, such as litigation exposures, environmental issues and employment matters can be addressed through the use of CLI.
As with TLI, parties often purchase CLI when the likelihood of a contingent liability is low, but the potential amount of the liability is substantial. Insurers will only issue a CLI policy where the risk is quantifiable, where a probability assessment is possible and where no moral hazard exists (in other words, when the seller or buyer knows a liability will arise, yet seeks insurance for that liability anyways, CLI will not be available). 9
The popularity of TRI products in the Canadian M&A marketplace continues to grow. These products provide flexibility in M&A transactions, allowing parties to negotiate deals quickly and efficiently. As more people learn about the benefits of using TRI products, parties will increasingly rely on them as a risk-allocation tool.
1 Law 360, Insurers Fight To Keep Up As Deal Insurance Goes Mainstream Law 360 dated January 26, 2015, accessible online at: http://www.kirkland.com/sitecontent.cfm?contentID=230&itemId=11410.
2 Presentation Using Transaction Insurance to Solve Risk Allocation In the Current M&A Transaction Environment co-hosted by Burnet, Duckworth & Palmer LLP, Gallagher Energy Risk Services and Ironshore Canada, June 10, 2015, estimate provided by Ironshore Canada.
3 Presentation by AIG, "Transactional Insurance: Winning Deals and Eliminating Liabilities", Mergers & Acquisitions.
5 AIG, "Representations and Warranties Insurance", Financial Lines (Newsletter), online: http://www.aig.com/Chartis/internet/US/en/RepsandWarranties_FINAL_0513_tcm3171-423913.pdf.
7 Marsh, "Transactional Risk Insurance" (2011), Private Equity and M&A Services (Newsletter), online: http://canada.marsh.com/Portals/15/documents/Marsh%20Transactional%20Risk%20Primer.pdf
8 ACE Insured, "Transactional Risk Insurance Products" ( 2015), (Newsletter), online: http://www.acegroup.com/us-en/assets/617519-transactional-risk-products-01.15.pdf.
9 Supra note 7.
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.