The use of representations and warranties (R&W) insurance in mergers and acquisitions has risen dramatically over the last decade. An R&W insurance policy typically protects buyers against losses that arise when sellers breach certain of their representations in an acquisition agreement.
The benefits of R&W insurance
An R&W insurance policy generally covers breaches of general and fundamental representations and warranties within a purchase agreement that buyers did not know about at the time of the deal. Examples of covered events range from errors in the seller’s financials to unknown third-party claims over the seller’s intellectual property. According to a report by insurance giant AIG, the most common R&W insurance claims relate to financial statements (18 percent), tax (16 percent), compliance with laws (15 percent) and material contracts (14 percent).
Beyond protection from losses, another benefit of R&W coverage for buyers is that post closing deal problems are now in the hands of a third party – the insurance company – rather than former principals of the company the buyers acquired. This is particularly helpful when key employees of the seller are still with the company.
Absent representations and warranties insurance coverage deals typically include a seller indemnity backed by escrowed funds, which normally requires a retention of 10 to 15 percent of the total acquisition price for one to two years. R&W insurance eliminates or substantially reduces the escrowed funds requirement, a significant benefit for the seller. The insurance also provides sellers with a cleaner exit by reducing contingent liabilities that could arise after the deal closes.
While R&W insurance could be procured by either the buyer or the seller, buyers procure these policies in the vast majority of cases. A buyer who is offering to procure R&W insurance can tender a more attractive bid when competing against other potential buyers, because the insurance eliminates or reduces the need for the seller to place money in escrow and can be used to limit seller indemnity obligations.
Because of its many benefits, R&W insurance also accelerates the merger and acquisition process.
R&W insurance details
Generally, R&W coverage costs 10 percent of the merger and acquisition purchase price, and contains a deductible equal to 1 percent of the purchase price.
The policy will enumerate specific representations and warranties and contain dispute resolution clauses, which typically require binding arbitration. Policy terms usually span from three to six years.
What is not covered
Like other types of insurance, R&W policies have multiple exclusions. Breaches of representations or warranties that were known to the buyer prior to the policy inception are not covered. Other common exclusions include covenant breaches by the seller, purchase price or working capital adjustments, claims related to projections or forward-looking statements, net operating losses, criminal/civil fines or penalties, environmental impairment, political risk and breaches during the period between deal signing and closing. Claims that are covered by other types of insurance are often excluded or limited as well.
Depending on the exclusions, a considerable downside to taking out an R&W policy is that the coverage may be less broad than what would be covered by a seller’s escrow.
Given the complex nature of representations and warranties insurance and the tendency of insurance companies to manipulate the policy language to limit their liability, legal counsel is recommended when acquiring a policy, as well as when making a claim or responding to any denial of coverage. Call us for assistance with any difficulties you are experiencing with your R&W coverage. It is our mission to make sure insurance companies keep their promises to you and your business.
Contact us today for a free consultation.
Evan S. Schwartz
Founder of Schwartz, Conroy & Hack