A protective stance: How to fully realize the benefits of Representations & Warranties Insurance
Article originally published in May 2016 edition of Private Capital Magazine.
By Robyn Weber
Vice-president, Private Equity Practice Leader, HUB International
In the past few years, Representations & Warranties Insurance (RWI) has become one of the fastest-growing trends across the Canadian M&A landscape – and for good reason: It is a valuable tool to bridge the gaps in a deal that would have otherwise fallen through.
RWI provides protection against the financial loss suffered by either the buyer or seller (depending on the policy requested) due to a breach of a seller representation or warranty under the acquisition agreement. Although the placement of RWI can be done in as little as 10 days from start to finish, the real benefit is maximized when both brokers and insurers are engaged on a potential transaction as early as possible. We have chosen to focus this article on the broker engagement, and how getting your broker involved early is the best tool to help mitigate the chance of unforeseen expenses and costs while you are mid-way through the deal.
From the buyer’s perspective
Buyers can use RWI as a tool to make their bid more attractive in an auction (by accepting lower indemnity provisions or survival periods from the seller), securing higher indemnity for uncertain risks, or by avoiding having to sue selling shareholders who may be retained on the acquired company moving forward. Many buyers engage their RWI broker as soon as they begin looking at a potential acquisition. A broker can request a Non-Binding Indication Letter (NBIL) from the RWI insurers, which will outline the following:
- Limits with respective deductibles (retention)
- Premiums for each limit/deductible combination
- Non-refundable due diligence fee
- Coverage restrictions
In order to provide a full NBIL, insurers will request to see:
- A draft SPA
- Financials for the target
- A CIM (not always required)
Even if all these documents are not available, a premium range may be obtained based on deal size and the target industry. Having even a preliminary indication of coverage and pricing early on in the process may translate to a more attractive bid to the seller, by having more flexibility for items such as indemnities, escrow, survival period, etc., which may otherwise be addressed through RWI.
The NBIL will also often include two sections of coverage restrictions; exclusions, and areas of heightened concern (“concerns”). The insurers will have common exclusions built into their policy wording for issues that RWI is not intended to cover (pension plan underfunding, breaches of covenants or forward-looking statements, etc.), but will also list exclusions that they know will not be covered based on the target company’s industry or business operations.
The items listed as concerns on an NBIL are flagged risks that may not necessarily end up being excluded from coverage. Insurers list items they need to analyze further before providing a position on coverage, often by looking at diligence provided by the buyer and/or their advisors. Given the fact that the insurers require a non-refundable fee once engaged in diligence, the intent of the concerns listing is to make the buyer aware that these issues do exist, and to avoid any surprise exclusions having to be added after engaging in diligence and paying the fee. For example, environmental matters are often listed as concerns on the NBIL simply because they are difficult to underwrite by anyone other than an expert in the field, and losses are often significant when they happen. However, if adequate diligence has been conducted and an underlying insurance program exists, the insurer may be able to provide coverage for the environmental representations.
Other typical concerns include product warranty/recall, cyber/privacy, international exposures, and wage & hour/ employment Issues.
RWI is intended to provide protection against loss related to ‘unforeseen events’ only – there is no coverage for issues that have been flagged and presented as problematic by advisors during diligence. Tax and litigation issues are two examples of areas that require separate dedicated policies, however coverage can be costly depending on the risk, and may require a more significant underwriting process. A broker will help flag these issues early so that either the bid is amended if needed, separate indemnities are added under the purchase agreements for these exposures, or the ‘known risk’ specific insurance policy is placed.
From the seller’s perspective
Although it is common to see sellers requesting the use of RWI on a transaction, they are often requesting a buyer side policy structure for the deal, which is ultimately up to the buyer to secure. From the seller’s perspective, even though they are not ultimately the insured under the policy, having an idea of the pricing/coverage that is available for the RWI puts them in a stronger negotiating position with the bidders, as well as potentially speeding the process along.
Depending on the relationship, many brokers will agree to collect indications on behalf of a seller that will eventually flip to a buyer (and the buyers’ broker) without charging a fee. For example, the seller could engage the broker to solicit pricing for a $10M limit with a $2M retention (deductible), and the difference in premium if the seller contributes 50 per cent towards the retention ($1M) via an escrow versus an option where the seller is providing no indemnity. Based on the results, the seller may propose nil indemnity, but agree to contribute towards to the premium cost.
In summary, engaging a broker to look at the possibility of placing RWI (and/or any other necessary transactional liability product) as early as possible may help to avoid or mitigate unforeseen expenses down the line in the transaction process. Most brokers are paid through commission on the eventual placement of the insurance (with the commission amount being included in the quoted premium from insurers), and do not charge any sort of upfront or non-refundable fees should the deal fall apart, which should further encourage both buyers and sellers to seek their advice on potential deals as early as possible.
*Robyn Weber currently serves as the Private Equity Practice Leader for HUB International in Canada. In addition to her expertise in the placement and negotiation of transactional liability insurance products, her team at HUB is responsible for the executive liability insurance placements for both private equity firms and their portfolio companies.