The use of reps and warranties insurance (RWI) is becoming an increasingly popular risk allocation tool in corporate transactions. According to trade press reports, the volume of RWI doubled from 2011 to 2012, with the value of the insurance bound last year exceeding $4 billion.
RWI covers losses related to breaches or inaccuracies in reps and warranties, and can be purchased by either buyers or sellers. An RWI policy can add flexibility to a deal and help parties resolve key transactional issues such as the scope of the reps and warranties, the size of indemnification deductibles and caps, reduce or eliminate the need for escrow as well as extend the survival period. A buyer can use RWI to distinguish its bid in an auction process since the buyer could propose lower or no escrows or indemnification caps. In an odd twist, buyers willing to rely on RWI may actually be able to negotiate longer survival periods and higher indemnification caps since the risk for breaches or inaccuracies would be shifted from the seller to the insurer. RWI is also useful when the buyer has concerns about the seller’s credit such as in distressed asset sales since the RWI can backstop or collateralize the seller’s indemnity
RWI policies are attractive to sellers because they can used as to substitute or supplement a seller indemnity. In this way, an RWI policy can provide certainty to a seller that its exposure will be capped at the amount of a negotiated escrow. The coverage can also help sellers remove contingent liabilities from their balance sheets or avoid establishing new accruals or reserves. The policies can also facilitate a “clean exit” for private equity and “end-of-life” funds to maximize distributions, reduce risk of paybacks and enhance performance metrics.
The form of the policy and the claims handling procedures will vary, depending if the insured is the buyer or the seller. When purchased by a buyer, the RWI policy is written as first-party coverage. When the buyer learns of a breach or inaccurate rep or warranty, the buyer can simply file a claim directly with the insurer using of proof of loss form and does not have to deal with the seller.
When purchased by a seller, RWI operates as a “third-party” liability policy. After the seller receives a notice alleging of a breach or inaccuracy in the reps and warranties, the seller will tender the claim to the insurer. Often times the seller will remain obligated under the RWI policy to defend the claim but a seller policies is often able to obtain advancement of defense costs.
One key difference between a buyer or seller RWI policy is coverage for fraudulent misrepresentations. Seller policies will include an exclusion for fraudulent statements in the reps and warranties while RWI policies issued to a buyer typically would not exclude claims based on seller fraud. Thus, the buyer policy provides broader coverage.
The RWI policies can be structured to cover specific representations and warranties or provide “blanket” coverage for all representations and warranties contained within an agreement that are not otherwise excluded by the insurer. RWI policies generally do not cover known issues, such as issues discovered during due diligence, known to members of the deal teal or described in disclosure schedules. The policies also usually do not cover breaches for covenants or indemnification for specific contingent liabilities. However, a buyer could agree to look to the RWI for breaches of reps and warranties but continue to hold the seller responsible for other indemnification obligations, possibly allowing the parties to reduce any escrow or lower an indemnification cap. Other standard exclusions may include consequential or damages, fines and penalties and claims for injunctive or other equitable (non-monetary) relief.
Parties should be aware that the RWI underwriters will carefully review the transaction documents and discuss the transaction structure with the deal team. Insurers will particularly focus on the thoroughness of the seller’s disclosure process and the risk management policies of the target company. Underwriters may exclude provisions that they believe are easily breached or perhaps too buyer-friendly.
The pricing for RWI coverage depends on a number of factors including the nature of the risk, the extent of the due diligence performed by the parties and the relative size of the deductible. Coverage limits can be as high as $50MM though higher limits are available by aggregating policies. Premiums have been dropping and now commonly range from 2%-3.5% of the coverage limits. Even at those levels, sellers often prefer the cost of the insurance premium rather than having portions of the sales proceeds tied up in escrow or having to reflect indemnities on their balance sheets. Self-insured retention (deductible) also varies from deal to deal but often ranges from 1% to 3% of the transaction value.
It is important to know that not all RWI policies will cover environmental reps and warranties—especially if the environmental liabilities are potentially significant. In such cases, the parties would be better suited obtaining an environmental insurance policy. However, even where a buyer insists on an escrow or indemnity for environmental liability, an RWI policy can still be useful. By covering claims for breaches of other reps and warranties, an RWI policy could enhance the chances that the escrow would not be exhausted by non-environmental claims.