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About Rep And Warranty Insurance

Preamble

This content is independent of any content coming from insurance brokers or insurers or law firms. Commercial insurance is rarely taught in schools, and when it is it’s mostly done through the lens of brokers or insurers. There are many misconceptions around Rep and Warranty Insurance, just like many topics in commercial insurance, due to bad habits acquired through the over reliance on insurance brokers or insurers or information providers who are lobbied by them. It is also important to note that insurance has both an operational aspect and a legal aspect, on which we put weights of 95% and 5% respectively in terms of importance to protecting a business and its investors (the point is that going to court to enforce coverage defeats the purpose of buying insurance, so you want to make sure that whatever insurance you buy protects your business right and pays out fast on large losses).

What Is Reps And Warranties Insurance

It is a form of contract insurance protecting one party in case of a breach by another party of one or more representations and warranties outlined within the contract or agreement between them and which results in a financial loss. It is also known as R&W insurance or transactional liability insurance. The large majority of times, reps and warranties insurance is used on Purchase and Sale Agreements or similar agreements involving a Buyer and a Seller. The term M&A insurance is typically used interchangeably with reps and warranties insurance since the latter is most often used within transactions involving mergers or acquisitions (in fact various people search online for ‘rep and warranty insurance m&a’). Nevertheless, the technical usage of transactional liability insurance can extend beyond M&A transactions (ex. credit agreements, supplier agreements, etc.) so long as there is an agreement in place in which there are representations and warranties made by one party to another.

Cost Of Rep And Warranty Insurance

1 to 1.5% of the limit of insurance is typically the rep and warranty insurance premium that can be negotiated. Such premium started off much higher than that and dropped over the years as more and more insurers entered the R&W insurance market, however it is subject to a minimum premium which varies from one insurer to another and depending on the jurisdiction. A minimum premium range of $30,000-$50,000 could be attained for a plain vanilla transaction in specific jurisdictions. Many brokers charge a consulting fee of 50-75bps of the limit of insurance, in addition to their commissions earned on the insurance and in addition to the rep and warranty insurance premium, which can be negotiated or even waived depending on the transaction.

Pros And Cons Of Rep And Warranty Insurance

Pros to the Buyer of R&W insurance include protection from a Seller’s breach of warranties, and Pros to the Seller of the insurance include liquidity upon sale especially if escrow capital is tied to the transaction at hand. Cons include cost for both the Buyer and Seller and the probability that the insurance does not pay out as intended. It is important to note however that the pros and cons of rep and warranty insurance largely depend on the nature of the transaction, and a detailed cost/benefit analysis must be done accordingly. More information is available.

Rep And Warranty Insurance Claims

There are not many claims, as a percentage of written policies, on rep and warranty insurance when it is sold by brokers without it being reworded by independent risk experts, and in some jurisdictions there are none, in spite of numerous theoretical loss scenarios being presented by insurance brokers to businesses. This makes the insurance highly profitable to insurers the way it is mostly sold through brokers, and contrary to the expectations of many. In fact, numerous law firms, private equity firms, and other buyers of rep and warranty insurance are at an information disadvantage when buying the insurance through brokers.

With that said the following are some observations from R&W claims data worldwide:

  • More than half of the claims occur within the first year of the policy;
  • The frequency of claims on mid-sized deals is much higher than large-sized deals;
  • Around a third of the claims in Europe are tied to tax matters;
  • Cyber claims have been trending higher year over year;
  • Accounting issues remain the largest source of large claims.

Rep And Warranty Insurance Providers 

Providers of R&W insurance include insurance brokers (such as Marsh, Aon, Willis, Lockton, etc.) and/or insurance companies (such as AIG, Everest, QBE, etc.). There are now numerous insurance brokers or insurers around the world acting as providers of this insurance.

Rep And Warranty Insurance Public Deals

R&W insurance on public deals can be done, however it is rare because of the fact that public deals are typically associated with more transparency and an easier and more accurate due diligence process.

Accounting For Rep And Warranty Insurance

Accounting for R&W insurance should be done based on the term of the insurance. In most instances, the term of such transactional liability insurance is for 3-6 years, which enables the amortization of the cost of rep and warranty insurance over the term of the insurance accordingly.

Retention In Rep And Warranty Insurance

This is negotiable depending on the nature of the transaction despite many sources outlining that a retention of 0.75% to 2% of the transaction value is applicable.

Misconceptions About Rep And Warranty Insurance

·     R&W insurance should be underwritten by lawyers (refer to Preamble);

·     Insurance brokers will provide cost effective R&W insurance;

·     R&W insurance policies include standard terms and conditions that cannot be changed;

·     The coverage amount, or rep and warranty insurance limit, is typically and should be equal to 10% of a transaction’s price or valuation;

·     Transactional liability is a high risk and unprofitable line of business to insurers;

·     Procurement of M&A insurance should be left solely to the financial sponsors;

·     Various other misconceptions related to operational and insurance specific matters, contact us for more information.

Tax Treatment Of Rep And Warranty Insurance

The tax treatment of R&W Insurance should largely be the same as other types of commercial insurance in general while incorporating the dynamics of multiple insureds, and largely depends on the jurisdiction. It is best you consult an expert accountant on these matters.

Rep And Warranty Insurance At Signing Or Closing 

It is recommended that the procurement process of transactional liability insurance be initiated before a Letter of Intent (LOI) or Term Sheet is issued. The main reason being that the insurance should be reworded operationally by a risk expert, independently of insurance brokers or insurers, which is part of the risk due diligence process of the transaction. While R&W insurance can be procured even after a transaction is closed, that would create gaps in coverage and potentially produce higher premiums overall.

Rep And Warranty Insurance Asset Purchase

R&W Insurance can be used for asset purchases (aside from being used for stock purchases and other types of transactions).

Rep And Warranty Insurance Minority Investment 

R&W Insurance can be used for minority investments. Simply put, as long as there are representations and/or warranties made by one party to a transaction, then such transaction is technically insurable through rep and warranty insurance or transactional liability insurance.

Rep And Warranty Insurance vs Escrow

R&W Insurance is, to a fair extent, a substitute to escrow agreements. However, a detailed risk due diligence is required to identify the extent to which R&W insurance or transactional liability insurance can fully replace escrow agreements while releasing escrow capital. Just like any type of commercial insurance, R&W insurance entails Insurance Basis Risk (the risk that the insurance does not perform as intended). That said, the input of legal experts is also required in this matter to cover the non-operational legal issues tied to escrow.

Rep And Warranty Insurance Fundamental Reps 

R&W Insurance typically provides coverage on fundamental reps for up to 6 years (as opposed to 3 years for non-fundamental reps).

Frequently Asked Questions (FAQ)

How Does Rep And Warranty Insurance Work? 

First, terms of a R&W Insurance should be drafted upon setting eye on a specific transaction preferably before an LOI is issued as part of the risk due diligence process. As the transaction progresses, a risk expert would negotiate with insurance brokers the desired terms of rep and warranty insurance. Upon a bindable quote being delivered by the insurance broker, insurance terms can be incorporated into the deal process including waiving the need for escrow capital if applicable, and with related amendments to the Purchase Sale Agreement or M&A agreement. Please note that this process could even impact valuations depending on the transaction. Once terms are finalized and the transaction agreement is signed, the insurance can be brought into force. When a loss happens that is insurable by the rep and warranty insurance, the risk expert would trigger the insurance for effective payout (the broker is largely absent from the claims process).

Who Pays For Rep And Warranty Insurance?

It is the Buyer in an M&A transaction who pays for the rep and warranty insurance premium most of the time. However, there are various instances when the premium is either shared between Buyer and Seller, or when the Seller picks up the bill. Technically, any party who has a vested interest in the transactional liability insurance can pay for its premium, this could include advisors.

What Does Rep And Warranty Insurance Cover?

R&W Insurance covers breaches in representations and warranties made within a Purchase Sale Agreement or M&A agreement or other transactional agreement. The insurance can also be reworded to cover core operational risk of the transaction at hand.

Who Buys Rep And Warranty Insurance?

Buyers of R&W Insurance include one or more parties to an M&A transaction (Buyer and/or Seller) or to a financial transaction involving representations and warranties, escrow capital, and/or transactional risk that can be hedged.

How Much Does Rep And Warranty Insurance Cost? 

Between 1% and 1.5% of the amount of insurance sought, which can be negotiable. For example, if $10,000,000 in insurance protection is sought, then the rep and warranty insurance premium will be around $100,000-$150,000. Please refer to the section above ‘Cost Of Rep And Warranty Insurance’.

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