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Reps and Warranties Insurance is Now Key for Strategic Buyers

Posted on November 12, 2021 By

Reps and warranties insurance is a policy secured for corporate transactions such as mergers and acquisitions. In recent years, the amount of this type of insurance sold has increased significantly. It covers the indemnification for certain breaches of the representations and warranties in transaction agreements, either partially or in full. Reps and warranties insurance usually doesn’t cover losses for breaches of covenants (other than pre-closing tax indemnification) or purchase price adjustments. 

Reps and warranties insurance can be purchased as either sell-side or buy-side coverage. On the seller side, it is a policy that covers the seller’s liability for claims regarding breaches of a representation or warranty. On the buyer side, it’s a type of first-party coverage, paying the buyer for any claimed breaches on the part of the seller.

Typically, a representations and warranties insurance policy covers the insured’s losses over a specified deductible, known as a retention amount. This coverage is not available for the first dollars of loss. The retention amount is usually around one percent of the total transaction value. Under many policies, the retention amount is lowered after a certain amount of time (usually 12 to 18 months after closing). This is known as a “drop-down.” 

The losses covered by reps and warranties insurance typically have a specific coverage limit with an underwriter's approval. The policy limit reflects the insured’s willingness towards risk, what they are willing to pay for coverage, and above which the insured either self-insures or obtains recourse against the seller.

The COVID-19 pandemic affected how reps and warranties insurance policies are written, as well as how much they cost. However, it is thought that this would have occurred anyway due to this type of coverage’s increasing popularity. The general rule is that the more policies are purchased, the more the cost rises. According to a report by Liberty Mutual, rates in the Americas have risen up to 25% since the third quarter of 2020, driven partially by increased claims activity.

Additionally, insurers are now focusing more attention on what exactly is covered in a reps and warranties insurance policy and inserting more restrictions, especially around cybersecurity and data privacy concerns.

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Why Buyers Are Using Reps & Warranties Insurance More Often

For many years, private equity has been using representations and warranties insurance as a deal-making tool to get a competitive edge over other buyers by making their bids more appealing to sellers. In the letter of intent, buyers will state that they will only have limited post-closing recourse and count largely on reps and warranties insurance. But strategic buyers are now looking toward this type of coverage for deal-making because it can be useful in bridging the fundamental expectations gap between buyers and sellers. Special purpose acquisition companies (SPACs) are also contributing to the growth of this type of coverage. So what took so long?

For the most part, strategic buyers just haven’t needed reps and warranties insurance to meet their M&A growth strategies in the past. They are familiar with traditional seller-indemnification structures and comfortable with having post-closing recourse against sellers who stand behind the representations and warranties that buyers rely on. Sellers typically have a solid balance sheet and can make good on any indemnity obligations, and if they can’t, escrow is used instead. Being so comfortable with this traditional structure, and having certain advantages over other buyers, strategic buyers had very little reason to do anything differently. Plus, using reps and warranties insurance also means bringing a third party into the mix, which can slow things down and cost more in fees. And for a long time, there was no reason to change this process because strategic buyers either held the upper hand in negotiations or had the ability to pre-empt auctions to demand exclusivity. 

But the M&A market has been strong these days, and the reps and warranties insurance has matured and become more efficient, so strategic buyers’ negotiating leverage has changed. Sellers have become more familiar with this kind of insurance and are demanding it in order to remove or minimize their post-closing exposure. With so much money out in the market pursuing deals, strategic buyers are being left without a choice but to use reps and warranties insurance because sellers have more negotiating power. 

Also, on occasion there are instances where reps and warranties insurance is the only way for a strategic buyer to receive any worthwhile post-closing indemnity coverage. This includes distressing circumstances or when purchasing a company owned by an ESOP when indemnification isn’t available outside of escrow. 

Another benefit of using representations and warranties insurance in strategic transactions is that it can keep the parties on more friendly terms, even after a transaction results in a post-closing indemnification claim. These deals are usually between players in the same sector who are familiar with each other and will still rub shoulders outside of the M&A arena, so they want to maintain a good relationship and don’t want to risk it over an indemnity claim. Reps and warranties insurance can also put another party between the buyer and seller, having to work together in other contexts, which can help maintain a valuable working relationship moving forward.

For these many reasons, reps and warranties insurance coverage is expected to be part of the M&A landscape for strategic deals well into the future. 

End of Year Status

Benchmark International maintains relationships with numerous reps and warranties insurance brokers and underwriters. Back in the third quarter, these contacts began to warn us that by the time November arrived, carriers would both become highly selective as to which year-end 2021 transactions they would underwrite and that premiums for their policies would climb 33 to 50% above recent averages. They cautioned that smaller deals would be the first to be squeezed out of the market as the carriers focused their limited resources on the larger, more lucrative transactions. To date, we have been able to push the focus on obtaining insurance to the front of the process, getting acquirers focused on it the day after signing their letter of intent. This has ensured that all of our clients who negotiated for the insurance in their LOIs have obtained it. While the anticipated cost increases have materialized, we have been pushing harder and harder to ensure those costs are shared with the acquirer. 

As the new year emerges and deal levels fall back to normal, we anticipate that costs will return to historical norms; the carriers in the market already, having seen themselves overburdened in 2021, will expand their coverage; and new carriers will enter the markets, all making the insurance product more readily accessible to all transactions in the future.

Schedule A Call

 

Americas: Sam Smoot at +1 (813) 898 2350 / Smoot@BenchmarkIntl.com

Europe: Michael Lawrie at +44 (0) 161 359 4400 / Lawrie@BenchmarkIntl.com

Africa: Anthony McCardle at +27 21 300 2055 / McCardle@BenchmarkIntl.com 

ABOUT BENCHMARK INTERNATIONAL

Benchmark International’s global offices provide business owners in the middle market and lower middle market with creative, value-maximizing solutions for growing and exiting their businesses. To date, Benchmark International has handled engagements in excess of $7B across various industries worldwide. With decades of global M&A experience, Benchmark International’s deal teams, working from 14 offices across the world, have assisted hundreds of owners with achieving their personal objectives and ensuring the continued growth of their businesses.

Website: http://www.benchmarkintl.com
Blog: http://blog.benchmarkcorporate.com

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