Representation and Warranty Insurance – To Insure, or Not to Insure, That is the Question

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In today’s competitive, seller-friendly M&A environment, buyers are often left with the choice to insure using representation and warranty insurance or to self-insure by accepting all post-closing risk. The days of sellers standing behind their representations and warranties in the purchase agreement appear to be trending away. This note highlights several considerations for a buyer facing this decision as it looks to optimize the path forward.

Insure? Self-Insure?
R&W Insurance continues to get cheaper, and retention (deductible) amounts are decreasing, so who can blame a buyer for purchasing the insurance just in case?

Competition in the insurance market, driven by significant new entrants into the market, has pushed down the costs – premiums and retentions are at all-time lows. Rates-on-line are now often 2.5-2.8 % (i.e., 2.5-2.8 cents per dollar of insurance coverage purchased); whereas 1-2 years ago, rates were ~4%. Retentions have dropped from 1.5 – 2.0% of enterprise value to 0.75 – 1.0% of enterprise value (even with no seller indemnification).
For years, buyers in public company deals have not insured these types of risks, so is this added cost worth it on larger deals? Maybe not.

In larger transactions, the retention still represents a relatively large expenditure for the risk covered.  If purchasing $50M of coverage, it will cost roughly $1.3-1.8M all-in, and buyer will still have to bear substantial damages before the insurance kicks in (e.g., $10 million retention in a typical $1 billion transaction).
Generally speaking, market pressures like those that have pushed pricing down are also leading to relatively broader insurance coverage with fewer exclusions. This trend weighs in favor of insuring to protect against losses and avoid unnecessary unknown risks. For example, underwriters are now covering healthcare and other regulatory risks, among other traditionally excluded issues. Risks identified during diligence, interim breaches discovered after signing, asbestos, NOLs and other standard exclusions still remain in the policies. In addition, underwriters scrutinize industry-specific risks, such as destruction of property or injury to persons for targets where products are produced or used, or cyber and data security for technology companies for possible exclusion in the policies so what risks are underwriters really protecting against? Is it worth the cost of the policy when the main potential liabilities may be excluded and the premium is not reduced in light of these exclusions?
According to the latest AIG study, insurers do pay – the study states that AIG incurred a seven-digit cost in 55% of claims submitted for more than $100K during a recent multi-year period. Thus, the policy can help avoid disputes with a target company’s management team or a joint venture partner in relation to such loss by shifting the relevant risk to an insurer, and you may well get money back. Specific insurers’ creditworthiness, claims payment history and user-friendliness, as well as prospects for remaining in the R&W market are important factors to vet, to determine whether it is worth the up-front payment.

For many, clearly the answer to these issues must be to insure, since statistics prove this out.  There are now more than 20 R&W insurers in the US and, according to market data, more than 1,400 policies were placed in 2017, representing tens of billions of dollars in coverage limits and roughly $1 billion in premiums. Nevertheless, repeat buyers such as private equity sponsors may question the value of obtaining R&W insurance in a particular transaction, particularly if they have done so frequently in past transactions but have not submitted (or received payment for) many claims. The initial outlay of premium and costs required to procure the insurance, coupled with the retention and potential exclusions may cause buyers (particularly those with large, diversified acquisition portfolios) to prefer to retain the risk of losses resulting from seller rep breaches by self-insuring. An obvious risk of self-insuring is an unexpected, catastrophic loss that materially diminishes the value of the buyer’s investment – the type of loss that R&W insurance is essentially designed to cover. Ultimately, the question devolves into a commercial, risk-tolerance and cost-benefit-analysis that each buyer must perform on a case-by case basis.