By Richard D. Harroch, David E. Weiss, and Richard V. Smith
There is a significant emerging trend in the use of M&A representations and warranties insurance in mergers and acquisitions of privately held companies. Both strategic acquirers and private equity buyers have gotten increasingly comfortable in using such insurance for their acquisitions, providing meaningful benefits to both the buyer and seller in an acquisition.
As a prelude, representations and warranties by a seller are key components of an acquisition agreement and are often heavily negotiated by the parties. In a traditional M&A transaction, the seller (or its shareholders) agree to indemnify the buyer (subject to caps, exclusions, and time limits) for breaches of the seller’s representations and warranties. Often, the indemnity has been backed by an escrow of a portion of the proceeds otherwise payable at the closing (typically 10% to 15% for one to two years). The emerging use of representations and warranties insurance is modifying or eliminating this traditional structure.
This article provides a comprehensive overview of representations and warranties insurance, its benefits, the scope of coverage and exclusions, and other key issues.
What Is Representations and Warranties Insurance?
Representations and warranties insurance is an insurance policy used in mergers and acquisitions to protect against losses arising due to the seller’s breach of certain of its representations in the acquisition agreement.
The key points of such insurance policies are as follows:
- The insurer will charge a fee (the “premium”) for issuing the policy, typically 2% to 3% of the coverage limits. For example, if the coverage amount of the policy is $20 million, the premium could be $400,000 to $600,000. Insurers typically charge a minimum premium of $150,000 to $200,000. The premium for such policies has been decreasing as more competitors have jumped into the market. The insurer will also charge an underwriting fee, which could be as high as $50,000 for deals over $50 million. In addition, premium taxes will need to be paid to the state of domicile of the buyer. There also might be an insurance broker fee in some situations.
- The policy coverage is typically a dollar amount equal to 10% of the M&A purchase price.
- There will be a deductible amount under the policy that is excluded from coverage (the “retention”), typically a minimum of 1% of the M&A purchase price.
- There are “standard” exclusions to coverage; for example, the insurance does not cover covenant breaches by the seller or purchase price adjustments, and there may be specifically tailored exclusions based on the results of the insurance company’s due diligence/underwriting.
- Not all representations and warranties of the seller are covered (see “The Limits and Exclusions of Coverage” below).
- The buyer or the seller can be the insured party, but 90% of the time the insured is the buyer.
- The premium payment is typically a onetime fee paid up front.
- The policy term is typically for 3 to 6 years, to be negotiated with the insurer.
The Typical Process for Obtaining Representations and Warranties Insurance
The process for obtaining a policy usually starts with the buyer or seller approaching an insurance broker to solicit quotes from insurers. An application for insurance must be completed.