Reps and Warranties Insurance
Representations (Reps) and Warranties insurance has been available in the domestic insurance marketplace since the mid-nineties. The insurance is designed to protect the policyholder against damages suffered as a result of breaches of the representations and/or warranties contained in a purchase and sale agreement (P&SA). The policy can be purchased in the name of either the buyer or the seller. It generally is most effective in transactions where the purchase price is at least $25 million but less than $750 million. The policy can be written on a broad basis to respond to claims arising out of breaches of any representation or warranty in the P&SA, or on a specific basis to cover a particular representation or warranty or a particular group of representations and warranties. It generally offers protection only when the parties are unaware of any breach of a representation or warranty; however, other transactional risk insurance policies (such as a tax insurance policy or a contingent liability insurance policy) may be used in situations were there is an acknowledged problem and the parties to the transaction prefer to transfer the risk of uncertainly and unanticipated bad financial outcomes (e.g., outstanding litigation or tax problems) to the Insurer. The policy period normally matches the survival period for the representations and warranties in the P&SA. Premiums for reps and warranties policies generally range from 2% to 4% of the policy's coverage limit, which is typically equal to the escrow amount or a portion thereof. So for example, a $10 million policy will generally cost between $200,000 and $400,000. The policy deductible will generally be equal to 1% to 2% of the value of the transaction. In many cases, the insurer will charge an up-front underwriting fee due to the fact that a tremendous amount of due diligence is required in the underwriting process. Several carriers are willing to offer an indication so that a prospective insured can make a more educated decision on whether to pay the underwriting fee and move forward with formal underwriting.
These are some of the situations in which a Seller should consider the purchase of a Reps and Warranties insurance policy:
- The Seller is disposing of assets, a division or a subsidiary and it wants to rid its balance sheet of the contingent liabilities created by representations and warranties made in connection with the disposition. The Seller can purchase the policy even after the sale occurs.
- The Seller wants to cap its exposure to the Buyer at the amount of a negotiated escrow.
- Significant shareholders of the Seller, such as venture capitalists or family trusts, may want to cap their exposure so that they can distribute proceeds without being subject to repayment as the result of an indemnification obligation.
Seller based Reps and Warranties insurance is generally not purchased for public company transactions since the reps and warranties made in connection with the sale of a publicly traded company do not survive the closing.
This type of coverage is a Reps and Warranties policy purchased by the Buyer. One of the advantages from the Buyer’s perspective is that it is "first-party" coverage, meaning that after having suffered a covered loss the Buyer presents its claim directly to the Insurer. The retention or deductible in the acquisition of a private company Seller is generally the value of the escrow. In an acquisition of a public company Seller, an acceptable retention will be negotiated.
There are several situations in which a Buyer should consider the purchase of this coverage:
- It wants to cap its exposure to losses caused by the Seller's breach of representations or warranties.
- It can negotiate a lower purchase price in exchange for a reduced or eliminated escrow. Some Sellers are willing to reduce the purchase price in exchange for certainty.
- It is acquiring assets and wants protection against excluded liabilities, especially where the Seller's ability to provide indemnification may be in doubt.
Examples of Reps and Warranties Coverage Applications
- Disagreements Over the Amount of Indemnity - Broad
The buyer and seller have agreed upon all issues other than the amount of indemnity supporting the representations and warranties in the P&SA. The buyer requires a $30 million indemnity, while the seller has already earmarked a substantial amount of the anticipated proceeds and will only commit to $10 million.
A Reps & Warranties policy is issued for $20 million excess of the $10 million agreed to by the seller.
- Disagreements Over the Amount of Indemnity - Specific
The buyer and seller have agreed to all of the terms surrounding an acquisition, other than the amount of the indemnity that will support the representation made by the seller to the buyer regarding tax matters. The buyer is requesting a $15 million specific indemnity to cover a breach of the tax matter representation, while the seller is only willing to a $5 million indemnity.
A Reps & Warranties and/or stand-alone tax insurance policy insuring only breaches of the tax matters representation is issued for $10 million excess of the seller’s agreed upon $5 million indemnity.
- Disagreements of the Term of the Representations and Warranties
The buyer in a transaction is requiring a 3 year indemnity period to respond to breaches of the representations and warranties in the P&SA, while the seller will only provide a 12 month indemnity.
A Reps & Warranties policy is issued that insures breaches of the representations and warranties of the seller discovered after 12 months and prior to 36 months from the date of closing of the transaction.
- Disagreements Over the Securitization of Indemnity
A buyer and seller have agreed to all of the terms of the transaction, including an indemnity of $10 million to support the representations and warranties in the P&SA. However, the buyer requires that the full amount of the $10 million indemnity be held in escrow, while the seller will only commit $4 million of the proceeds from the sale to be held in escrow. A Reps & Warranties policy is issued for $6 million in excess of the $4 million placed in escrow by the seller.
As noted above, there are separate yet related categories of policies that should be considered in appropriate circumstances. Contingent liability insurance policies can transfer the risk of loss relating to pending, threatened or potential litigation. For example, if a purchaser of assets is concerned about “successor liability”, it may obtain contingent liability insurance, which will not necessarily require that a breach be established in the PS&A. A pending litigation may be insured against an adverse final judgment. They are relatively more expensive, but can be very helpful in an acquisition where neither party wants to bear the risk of loss - or whenever a company has litigation exposure it wants to eliminate from its balance sheet. In addition, tax liability policies can be extremely useful in situations where uncertain tax positions have been identified with respect to the company being acquired or with respect to the intended results of the transaction (e.g., whether NOL’s will be or should already have been limited, whether an election will be respected, whether the transaction will be recast and/or whether the transaction will qualify for deferred tax status, such as tax-free spin-offs, etc.)
Securing the best program
Through careful planning and effectively negotiating policy terms companies can, in most situations, obtain valuable protection from losses incurred in connection with M&A activity. Further, the active and knowledgeable interaction of a prospective insured’s attorneys and a skilled insurance broker can facilitate securing the best possible results.
This material is provided for informational purposes only and is not intended to provide legal advice. The issues and suggestions presented in this article should be reviewed with outside counsel.
Swingle, Collins & Associates specializes in reps and warranties insurance coverage. The descriptions of coverages listed on this website are brief and subject to the provisions, limitations, and exclusions that can only be expressed in your policy and related endorsements. For additional information of how Swingle, Collins & Associates can assist in meeting your coverage needs for reps and warranties insurance, mergers insurance, or M&A insurance, please contact your dedicated risk manager to discuss the benefits and services of reps and warranties insurance coverage.
The information contained on this page is provided for informational and educational purposes only. It contains general information on insurance issues and may not reflect the most current developments in insurance coverage and is unlikely to apply in all factual scenarios. The information does not include all the terms, coverages, exclusions, limitations or conditions that may be contained in the actual insurance contract language. The policies themselves must be read for those details. Sample policy forms will be made available upon reasonable request.