Representation and warranty insurance (R/W insurance) continues to gain momentum. As recently as two years ago, presenting a R/W insurance policy was a way to enhance the attractiveness of a bid in a competitive auction. Today, some targets are demanding that all bidders come to the table with such policies. Further, some private equity firms are using the policies in every deal. Bottom line — if you have not worked on a deal with R/W insurance yet, you probably will very soon.
Recent Trends in the R/W Insurance Market
As a result of the increased demand, we have seen a tightening of the market over the past year in pricing, exclusions from coverage and attention from insurers.
Insurers have shifted their focus to larger transactions. A year ago, insurers generally targeted middle-market transactions ranging in size from $15 million to $1.5 billion. More recent information sets the target at $50 million to $2 billion. While lower-middle-market deal participants are still able to find R/W insurance, it is often coming at a higher premium than a year ago (closer to 5 percent of the policy limit instead of the 2-4 percent range typically quoted by insurers). In addition, some brokers are charging a fee beyond the typical 15 percent brokerage commission that is paid out of the premium. That additional fee, which is paid directly by the insured, is typically 75 bps of the premium amount.
The scope of R/W insurance coverage also appears to be tightening. In addition to the common exclusions (issues identified in the disclosure schedules and environmental reports; asbestos claims; losses covered in purchase price adjustments; issues that were known by a deal team member; breaches of covenants; claims for non-monetary relief; criminal fines/penalties; and, if a seller-side policy, fraud of the seller), it is becoming harder to insure matters that tend to lead to large losses, such as product liability claims, underfunded benefit plans, health care billing practices, California wage and hour laws, and big pharma issues.
Reasons to Obtain a Policy
The potential reasons to obtain a policy only appear to be growing. In particular, the Delaware Chancery Court’s decision in Cigna Health and Life Insur. Co. v. Audax Health Solutions, C.A. No. 9405-VCP (Del. Ch. Nov. 26, 2014), which further called into question the ability to bind a non-signatory shareholder to post-closing obligations under a merger agreement, may be another reason to seek a policy in a private company merger.
Despite the tightening of the market, R/W insurance is becoming increasingly common. Following are a few practice pointers for negotiating your first policy:
Hire a Reputable Broker.
Not all brokers are created equal in this space. The best are former deal attorneys who understand the issues well and know how far you can push particular insurers on policy points. Brokers are typically paid a commission out of the policy premium (generally 15 percent of the premium), but some have started charging an additional fee (approximately 0.75 percent of the premium) directly from the insured.
Conform Relevant Policy Terms to your Purchase Agreement.
You should minimize the gap in coverage between indemnification under your purchase agreement and matters covered by the policy. In particular, you should pay attention to the following:
- Definitions of “loss” (including coverage of defense costs — costs of defending against excluded types of policy claims may be covered by the insurer even though the underlying claim is not covered).
- Provisions regarding the calculation of losses, such as: materiality scrapes, impact of recovery of insurance proceeds and tax benefits, requirements to mitigate losses, etc.
- Whether amounts recovered from the purchase agreement escrow, other insurance or third parties will count toward the retention under your policy (they should).
- Survival periods, including longer periods for fundamental representations (and related definitions), recognizing that an insurer will not give coverage that survives indefinitely. R/W insurance policies are claims made policies, but you can usually obtain a 30-day tail to make a claim so long as the breach occurred during the policy period.
- Scope of covered parties.
- The type of information that must be included in claims notices under the purchase agreement vs. to the insurer.
- The rules of interpretation for information included in the disclosure schedules (i.e., whether such information is imputed to other schedules).
Don’t Fall on Your Sword Trying to:
- Obtain coverage for the common exclusions noted above.
- Delete the requirement that the insured attempt to recover against other applicable insurance policies first. But, deductibles paid under those other policies should count toward your retention.
- Delete the requirement to mitigate losses. Depending on the insurer, you may be able to limit the requirement to provide that the insured is required to mitigate to the extent required by the purchase agreement and applicable law (vs. a commercially reasonable efforts standard).
- Delete subrogation rights. But, the insurer should not have a right of subrogation against the deal parties (other than seller in the limited case of seller fraud).
Limit the Knowledge Exclusion.
The policy will not cover matters that are known to the deal team — you can’t sandbag the insurer. The deal team should be limited to 2-3 people. Also, “knowledge” should be limited to the actual (not constructive) knowledge of those individuals. Coverage should only be excluded if a team member knew of a fact and knew that it was a breach.
Indemnification Process for Third Party Claims.
The insurer will want to be involved in the third party claims process to the greatest extent possible. You are not going to be able to settle a claim with the insurer’s money.
You Don’t Need to Arbitrate.
Most policies will be drafted to require arbitration of disputes with the insurer. Insurers are flexible on this point.
Your Diligence Reports Will End Up in the Hands of the Insurer.
Obviously, the reports need to be accurate. But, resist the urge to suggest in the report that line item indemnities be used to mitigate risk. As you might imagine, the result could be decreased coverage under the policy.
Confidentiality, Privilege and Non-Reliance.
Insurers and brokers are accustomed to entering into confidentiality agreements and non-reliance letters in connection with obtaining access to deal information and due diligence memos. You will also want to properly contemplate and protect any attorney-client privileged information during the process.
Lenders as Loss Payees/Additional Insureds.
If you have financing in connection with the transaction (or otherwise), you should consider including the lender as an additional insured or loss payee under the policy. This will typically come without a price from the insurer and will save you a headache with the lender.
Buy-Side Policies Typically Provide More Coverage.
Coverage under a buy-side policy will not be subject to exclusions for the actual knowledge, fraud, or willful misconduct of the seller, which may remove significant obstacles to obtaining coverage for a claim. Either party may pay for the insurance, regardless of who is the insured. The vast majority of policies are issued to the buyer.
This update was re-published on DealLawyers.com.