Representations and warranties insurance (“R&W Insurance”) has been increasingly used in corporate transactions to facilitate successful negotiations. R&W Insurance is an insurance policy purchased by a party to a corporate transaction to indemnify against unknown risks and breaches by Seller of its representations and warranties made in the acquisition agreement. The following are key points to note about R&W Insurance:
- It can be purchased by either the Buyer or Seller in a corporate transaction, although most policies are purchased by the Buyer, and the parties may negotiate division of payment of premium and retention fees, often splitting them 50/50.
- Policy coverage is usually equal to 10% of the purchase price of the transaction.
- Policy deductibles are typically 1% of the purchase price.
- Policy term lengths are negotiated with insurers, but are typically 3 to 6 years.
- It requires payment of a premium and underwriting fee, with underwriting occurring following the preparation of schedules of the transaction.
- It does not cover covenant breaches by Seller or special indemnities and may also have other specific exclusions based on insurance companies' due diligence.
- It does not cover breaches of Seller's representations and warranties known to the Buyer.
Benefits of R&W Insurance
R&W Insurance offers various benefits to both Buyers and Sellers in corporate transactions.
Benefits to Buyer: R&W Insurance affords a Buyer flexibility in that it allows the Buyer to offer a reduced escrow or holdback, which may be more attractive to a Seller. A Buyer can purchase higher amounts of insurance with longer coverage durations than Buyer might otherwise be able to negotiate with Seller. R&W Insurance also typically covers Seller fraud, with the insurer maintaining subrogation rights. Finally, a Seller may be more willing to agree to more extensive representations and warranties knowing that its liability may be limited to the escrow or holdback in certain respects.
Benefits to Seller: A Seller benefits from R&W Insurance in that it can allow for reduction of an escrow or holdback, allowing Seller's shareholders to receive more proceeds of the transaction up-front. R&W Insurance can also allow a Seller to have fewer contingent liabilities post-closing, and may make a Seller feel more comfortable agreeing to broader representations and warranties, making for smoother negotiations between the parties.
Drawbacks of R&W Insurance
R&W Insurance is not a perfect solution for either a Buyer or a Seller because its coverage may be less broad and it does not cover known breaches of Seller's representations and warranties, breaches of covenants or special indemnities and may have various exclusions.
Contingent Risk Insurance
For known risks that are not covered by R&W Insurance or risks with liability potential of a greater magnitude than an agreed upon escrow or holdback would cover, parties to a corporate transaction can obtain contingent liability insurance, also known as contingent risk insurance (“Contingent Risk Insurance”). Unlike R&W Insurance, which insures against unknown risks, Contingent Risk Insurance is purchased by parties to cover certain contingent, known risks. Contingent Risk Insurance may be purchased alone or in addition to R&W Insurance. Contingent Risk Insurance transfers a known or uncertain contingent liability, often identified during the due diligence process of a transaction, from a company's balance sheet to an insurance company. Contingent Risk Insurance might also be purchased by a company in the context of a financing transaction to quell concerns of investors or lenders concerning a specified known risk faced by the company. Types of known risks for which Contingent Risk Insurance coverage may be offered are the following:
- Shareholder disputes
- Contractural liability
- Appeal risks of favorable first-instance decisions
- Intellectual property or employment disputes
- Accounting treatment
- Contingent environmental risks
- Regulatory exposures
- The rejection of a favorable tax approach with respect to the structure of the transaction itself
The following are key points to note about Contingent Risk Insurance:
- It may be obtained by either the Buyer or Seller in a transaction, although such policies are typically purchased by a Buyer of an acquired business with which the risk is associated.
- Risks covered typically have a low probability of coming to fruition, but could have significant damaging consequences if they were to occur.
- Allocation of premium payment is usually negotiated between the parties to a transaction.
- Premiums are typically 8-15% of the potential risk of loss, and are typically a one-time, upfront payment.
- Other terms depend on a variety of factors such as the magnitude of the risk and potential loss, the stage of the risk at the point of attachment of the policy, and the information available to assess the risk, among other factors.
Benefits of Contingent Risk Insurance
The central benefit of Contingent Risk Insurance is that it can be used to eliminate obstacles to consummation of a transaction because the risks covered by Contingent Risk Insurance are often issues that might otherwise cause a Buyer to cease negotiations or request a purchase price adjustment or special indemnity to compensate for material issues discovered in due diligence. With Contingent Risk Insurance, neither Buyer nor Seller assume the potential risk, facilitating successful negotiations and consummation of transactions.
While it is most time-efficient to obtain Contingent Risk Insurance prior to entering into negotiations, as discussed below, a contingent risk may arise while negotiations are ongoing. For instance, if a Seller is named as a plaintiff in litigation in the midst of negotiating a transaction, Contingent Risk Insurance may be an option to cover a potential adverse verdict that may exceed Seller's existing liability insurance policy limits. Contingent Risk Insurance can be used to salvage a transaction that might otherwise be put on hold or abandoned altogether due to unforeseen circumstances.
Drawbacks of Contingent Risk Insurance
While R&W Insurance policies can usually be obtained fairly quickly, Contingent Risk Insurance policies may take more time to acquire as insurance companies must evaluate various aspects of the specific risk to be insured. Given this lead time, insurance companies suggest beginning the process of obtaining a Contingent Risk Insurance policy as early as possible.
Ideally, for a known risk that a Seller believe may adversely affect the ability to negotiate a transaction with potential Buyers, the best way for Sellers to insure that closing will not be held up by Buyers' concerns is for Sellers to anticipate what aspects of their business may present known risks and obtain Contingent Risk Insurance in advance of a potential transaction. Having Contingent Risk Insurance for certain known risks prior to initiating negotiations may make negotiations proceed more smoothly.
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.