How reps and warranties work
Transactional risk insurance has become a valuable tool in mergers and acquisitions to help buyers and sellers facilitate transactions and offset certain liabilities to insurance companies.
Rep and warranty insurance is one of the three products under the umbrella of transactional risk insurance. The other two are tax indemnity and contingent liability insurance, which cover known or highly probable liabilities.
On the other hand, rep and warranty insurance address unknown issues or risks. Therefore, the rep and warranty insurance do not cover anything known or uncovered in the diligence process.
Reps and warranties are typically included in the sale purchase agreement to facilitate a company's sale from a seller to a buyer. It's a set of statements that the seller makes regarding the condition of the company they're selling.
It could be financial or operational information or something that informs the buyer about the value of the target. These statements can be things like companies in compliance with the law. It's not engaged in any litigation, et cetera.
The buyer relies upon these statements to be true and accurate, and if the seller breaches these statements, the buyer can then seek indemnification from the seller for the financial losses as a result of that breach.
In a traditional deal, the seller will set aside 5 - 15% of the purchase price in escrow for a specified period to cover potential breaches of reps and warranties.
While the reps and warranties are statements of facts, they're a means to negotiate the allocation of risks, i.e., what risk the seller and the buyer are willing to take and live by in a transaction. If they're wrong, they will pay for those misstatements.
Through rep and warranty insurance, the buyer or the seller will receive insurance coverage for the financial losses that result from breaches by the target company.
The insurance helps protect the insured from unknown losses that may arise after the signing. So if the buyer can buy the rep and warranty policy by the signing date of the sale purchase agreement and post-closing for a certain period. It preserves the deal value by shifting the risk of loss to ensure a fixed cost, known as the insurance premium.
Advantages of Insurance
Reps and warranty insurance have been around since the 1990s. However, it has gained wide acceptance among deal professionals in the last five to seven years. The pickup and demand have been driven by better pricing and increases in insurance companies willing to underwrite this product.
Today, more than 20 insurance companies are providing this product. They are willing to cover the entire suite of reps and warranties so that the policy coverage closely resembles the indemnity package that a buyer would get in a traditional deal without the insurance.
The policy aims to cover most of the seller's reps and warranties and supplement, enhance, or replace the indemnification provisions in a traditional purchase agreement.
Some benefits to a potential buyer include increased indemnity or a survival period. Buyers typically get a longer survival period of three years for general reps versus the purchase agreement terms of 12 to 24 months.
On the fundamental reps, including the tax or environmental reps, buyers would get coverage of up to six years, which is consistent with the statute of limitation on these reps.
On some of the terms or definitions in the purchase agreement, you can get some enhancement in a rep and warranty insurance coverage versus what you would get in a typical indemnity coverage. The loss definition is an example where you can get a stronger coverage of loss under the policy versus in a traditional purchase agreement.
Consequential or multiplied damages may be covered by insurance, while the purchase agreement may not allow for the recovery of these consequential damages.
Materiality Scrape is another piece that is heavily negotiated or not included in the purchase agreement. But it's possible to obtain insurance without materiality restrictions, which is called a double materiality scrape.
On top of that, the reps and warranties negotiated with the seller in the purchase agreement end up on more buyer-friendly terms. It's also a way for the buyer to distinguish himself in an auction process.
In a competitive auction process with multiple buyers, a buyer can make their bid more attractive because the seller gets a bigger pot of the purchase price upfront with the insurance. Whereas in a traditional deal, they would be held back in escrow of up to 5% to 15%.
Another important advantage to the buyer, particularly for smaller deals, is it protects key relationships, particularly if you're bringing sellers or founders into your company. You would want to avoid being in a position where you have these founders stay on and run the business for you, and then a breach happens, and now you're sitting at a loss.
Do you want to go after the founders you're entrusting to run your business for you and ruin that relationship with them? Or do you want to eat that loss yourself? You're now solving that issue by transferring that risk to a third party. As a result, you can be made whole as a buyer while preserving those relationships you're counting on.
From a claims perspective, while the process for the buyer to file a claim is very similar in a rep and warranty insurance deal versus a traditional deal, it's a much more sophisticated process if you're dealing with an insurer on the other side versus a small seller.
Also, the buyer will have reduced credit risk since any future claims are asserted against an insurance company with a credit rating of A-plus or higher rather than the prior owners of the seller firm you've just purchased.
Another advantage is that the rep and warranty insurance can provide recourse in a public deal, where no recourse is available, as reps and warranties typically don't survive post-closing in those deals.
Cost of Insurance
Let's take the example of a deal with a total purchase price of $100 billion. The insurance coverage will depend on how much a buyer is willing to purchase. It could be 10% or 20% of the purchase price.
Let's say they purchase $10 million, consistent with a typical escrow amount set aside in a traditional deal with no rep and warranty insurance.
The premium cost is around 2.5% to 3% of the coverage purchased, and the total all-in cost is typically 3.0% to 3.5%, which includes the premium, diligence fees, taxes, broker fees, etc.
Usually, the buyer will end up paying for it, especially in an auction process. Whereas in a bilateral process, it could be a matter of negotiation.
In addition to the insurance premium, there's also retention, which is essentially a deductible amount. This is the amount the insured party must absorb before the insurer steps in. The retention amount will typically be around 1% of the purchase price.
In some deals, buyers and sellers may split that cost 50-50, and buyer retention will get exhausted first, and then the seller's, before insurance kicks in. But for larger deals of greater than a billion dollars in the purchase price, retention may be smaller up to 0.75%, dropping to 0.5% after one year.
In that case, usually, seller retention will go away, and then the buyers will remain. There are no seller indemnity deals wherein the buyer pays all the retention.
It's a pretty streamlined process. Typically we'll have to find a broker that is involved in this particular product you should not go to any insurance broker because this product is very customized and they may not be very familiar with it. But once you reach out to a broker, it's typically a two to three weeks process.
Timeline of reps and warranties
It depends on the status of your deal documents, the depth of your diligence, and the ability to negotiate with the sellers. The buyer has to engage with the broker two to three weeks before signing the purchase agreement.
You will still be able to bind the policy at the same time as the purchase agreement execution. Still, it's always good practice to keep some flexibility and initiate the process once the purchase agreement is being negotiated.
The first step is to engage with an insurance broker and specialists who understand the product. Once you've selected your broker, they will execute a joiner agreement to the NDA, which the buyer has already executed with the target company.
Once the NDA is executed, the buyer will share the required documents with the broker. These will include:
- confidential information memo (CIM)
- financial records for the target company
- letter of interest (LOI) which was executed with the target
- buyer's markup of the purchase agreement
To the extent that you don't have any audited financials, which may very well be the case for many of these smaller FinTech companies, the broker will want reviewed financials or the quality of earnings analysis at the minimum.
Also included in the package will be the buyer's desired indemnity structure, i.e., how much coverage the buyer wants. Next, the broker will reach out to 4 to 8 insurance companies and get the initial quote, usually in the form of a non-binding indication letter (NBIL). This usually comes in within 3 to 4 days after the broker reaches out to the insurance companies.
The buyer will review the quotes or pricing, the broker and the external council, and other considerations included in the proposal. These include exclusions to the policy or other heightened risk areas as provided in the NBIL.
The pricing doesn't vary much, so the focus is usually on the deal-specific considerations and exclusions or any special treatment of the purchase agreement.
Once you zero in on the insurance company or the underwriter, the underwriting process kicks off. It typically takes about ten business days to get the policy in place. Once you have the underwriter or the insurance company picked, the buyer will sign the NBIL received from the selected underwriter and pay them a non-refundable underwriting fee through the broker to kick off the underwriting process officially.
The buyer will then provide diligence reports to the insurer and request the seller also to provide the insurer access to the data room and all the diligence information, including:
- any internally prepared diligence reports
- any external third-party accounts such as QoE or tax reports
Suppose any third-party reports are being provided as part of the diligence effort. In that case, the third-party consultants will ask insurers to execute a non-reliance letter before they share those reports.
Once the insurers have reviewed the diligence reports and digested the information in the data room, the buyer will schedule underwriting calls with the workstream leads and the third-party consultants to answer any questions the insurers may have.
Once the underwriting calls are done, the negotiation process begins, where the buyer will receive the policy, typically 24 hours to 48 hours after that underwriting call is completed.
When the buyer receives the policy and any exclusions that have come about as a result of the diligence call and follow-up questions, that's when the negotiations begin, which take about 2 to 5 days.
The buyer will respond to any follow-up questions on open items related to diligence, and if the buyer has presented a diligence report with a lot of open items, follow-ups will typically focus on confirming that those items have been closed.
If the buyer cannot close some of those open items before the deal's closing, then these provisions or open items can be made conditional exclusions. If you can resolve those immediately after closing, they will be closed out.
A rep and warranty product is very different from other commercial policies as it is much more customized based on a specific deal and the probations in the purchase agreement. As such, there's a lot of big room for the insurers, particularly regarding deal-specific solutions.
The negotiations will typically focus on those, and the buyers will work very closely with their broker and council to eliminate or restrict those exclusions. So, therefore, it's very important as a buyer to have a very robust diligence process, to begin with, so that you can reduce those exclusions and the time to negotiate the document.
The broker goes out to about 5 to 8 insurers, and they get the initial quotes. Within those initial quotes, the insurers will include exclusions or heightened areas of risk. We focus on those things to determine which insurance companies we want to hire in the process because that's where the negotiation plays out. We pick insurance companies that will provide us with minimal exclusions.
We focus on working with one broker to get quotes from multiple vendors. The initial quotes are primarily based on the initial documents we've provided to the broker. Then, the broker provides those documents to the different insurance companies.
Based on this, they will provide us with the initial quotes, and then they'll decide which insurance companies we want to work with.
Sometimes, we negotiate the prices they offer, but the negotiation is more around the exclusions or pricing because pricing tends to be very similar. There have been occasions where the pricing was similar, and we ended up going with an insurance company that had higher pricing but was offering lower exclusions.
Anything known to the buyer, uncovered during the diligence process, and included on the disclosure schedules of the purchase agreement will get excluded from the insurance coverage. While the insurers will cover a full suite of representations, they want to ensure those representations are within a reasonable bound.
For example, the purchase agreement will typically have the knowledge qualifier around litigation. Now, unless provided in the disclosure schedules, there should be no material threat in litigation to the seller's knowledge. That's how the provision would read.
Suppose the knowledge qualifier was missing from the purchase agreement. In that case, the insurers will have to qualify it in the rep and warranty insurance policy, and they'll put the knowledge qualifier back to make it a reasonable representation.
Other typical exclusions in this product are cyber risks, which are excluded from coverage because the insurers maintain that they don't have the expertise to underwrite that risk. The insurers will take the position that they will cover a cyber breach to the extent that it's in excess of an underlying cyber insurance policy already in place at the target company and will continue as a tail policy.
Or they would suggest that maybe the buyer can fold the target into its own insurance policy, which I don't find very beneficial because the deductible and the overall coverage for large buyers like Visa or JP Morgan or any other large firm, is so high that they'll never be able to access rep and warranty insurance on top of that existing coverage they already have at the firm.
Exclusions can also relate to the number of available NOLs or similar tax attributes. Exclusion can also be related to business interruption or losses arising out of Covid-19–we've seen this new exclusion added during the pandemic. Other exclusions could also include wage, labor, and misclassification of contractors.
The insurers will submit a non-binding indication letter providing any exclusion or heightened risk areas. Therefore, buyers need to focus on what those exclusions are before selecting an insurer.
We are totally fine with the standard exclusions, but if an insurer is including something atypical, we will not accept their offer. If we want to work with them, we would tell them that their pricing is competitive but a particular exclusion is unacceptable.
We usually can reach a middle ground in terms of those exclusions and make the deal work, and if we can't, we just don't work with that insurer.
I haven't taken rep and warranty insurance on some of my smaller deals. That's where you may not have as much leverage as a buyer because there may not be too many companies willing to cover those smaller deals.
But on the larger deals where I have typically used rep and warranty insurance products, we usually get about four to five quotes, so we can pick and choose which insurer we want to work with.
PE firms vs. Strategic buyers
When PE firms and strategic buyers buy reps and warranty insurance, it's the same thing. Interestingly, the demand for the product was primarily driven by private equity sponsors who wanted a quick and clean exit following a sale. So they are very high up in the adoption curve for this product.
However, in the last 3 to 5 years, the strategics are beginning to catch up, too. One of the reasons is that it has been a seller's market for several years now, and sellers have been demanding that the buyers use rep and warranty insurance in a competitive auction process.
Most auction packages or bid instruction letters we see today will require the buyer to provide this product. As such, the product that started as a sell-side product is now formally entrenched as a buy-side product.
We see more buy-side policies in the market today than sell-side policies. We've also seen a pickup in the product from the strategic side.
Rep and warranty insurance is very deal-specific. We don't use it on all the deals, but we'll use it on the ones we feel we need to close quickly.
I remember working on a transaction where we were running against time in 2020. We were trying to close the transaction before the year's end because we were worried that the tax laws could change in 2021.
We wanted to ensure that the negotiation process went smoothly and that we could accelerate that timeline. That was one deal where we used rep and warranty insurance to help us smooth out that discussion process with the seller.
How much time is saved?
The diligence work is still the same, but it does smooth out the back-and-forth process with the seller to that extent. And you get more buyer-friendly reps and warranties in the purchase agreement than in a traditional transaction.
I wouldn't say you save much, but if you know that you will have tough negotiations with the other side, then you'd rather go with a rep and warranty insurance product if you want to make sure you're able to consummate the deal on time.
But typically, it will smooth out the process, reducing the time to some extent.
Downsides of insurance
I don't see a lot of cons other than in terms of the exclusions. You need to make sure that you know when you are looking at any policy that you're aware of all the exclusions in the policy because those are the things you need to negotiate hard with the insurer. Make sure that you're getting those right. Other than that, I don't see any real cons to the insurance policy, except for the cost of it.
How often are reps and warranty insurance policies paid out
One of the challenges in obtaining any claims data is that most of these policies have an arbitration provision, which means that they never get litigated, so there's virtually no case law.
Since these are arbitrated, they're all private outcomes, so all we can do is rely on reports by the insurers and the experience of the brokers to tell us what the claim history is.
One insurer, AIG, provides consistent and valuable data about claims. I've looked at the claim study they've done for the last six years, and the last one they did was back in 2021. The reps and warranties breaches for which claims were made were as follows:
- financial statements breaches, which were about 21% of the claims made;
- tax breaches were next, about 19%;
- compliance with the law, 16% of the claims;
- material contracts breach, which is 12%;
- employee-related breaches, 8%;
- litigation 5%;
- IP, 5%, et cetera
The AIG report also indicates that 1 out of 5 policies results in a claim. Regarding deal sizes, deals over a billion dollars usually have 24% of the policies, are one in four policies that file for claims, and have the highest number of claims being paid out.
They say about 20% of the claims are getting paid out for deals below a hundred million dollar purchase price.
But in making claims, it's very important to remember that a lawsuit filed against the seller company after the acquisition is not necessarily covered unless the buyer can prove that the seller company knew about the breach but did not put it in the schedule.
As such, the buyer has to prove a breach occurred and the losses the buyer suffered arose from that.
A lot depends on the type of claim being presented. For example, a third-party claim like a breach of contract, allegation of unfair trade, or trademark infringement is very easy to quantify in terms of the loss a buyer would suffer.
So you have a settlement that you arrived at, and it's finite, and it's not going to the buyer but to the third party. Those are easier for insurers to wrap their hands around concerning the amount they owe. Therefore the claims are paid out sooner, usually within three months.
On the other hand, first-party claims tend to be more difficult to process. For example, the buyer claims that a breach of financial statements rep has occurred. If you're relying on multiples to prove the damages, it starts to get tricky, and the buyer will perhaps get a forensic accountant to assist in the valuation, and the insurer will do the same.
Therefore, those claims can get drawn out, and it can take anywhere from 12 months to even longer to get paid out. But that said, the claims process is much more efficient and streamlined with the rep and warranty insurance because you're dealing with a sophisticated insurer on the other side versus a representative of the seller who may not be as well worthy in the process.
These are very different from an auto insurance policy. This policy is not mandatory; people take it because they think the product works. The insurers have this motivation to make sure they make good on the claims. Otherwise, no one's going to use the product.
There is this probation called the anti-sandbagging probation in the purchase agreement. Typically, the purchase agreement will say that between signing and closing, if the buyer discovers a breach has occurred and the buyer still goes ahead and closes the deal, the buyer cannot come back and claim against that breach.
Sometimes, the purchase agreement negotiations proceed so that the anti-sandbagging provision doesn't get covered in that purchase agreement, but the insurers will make sure that they will include that provision in their policy.
That's because they want to make sure that it shouldn't be the case wherein the insurance policy has already been signed at the signing of the purchase agreement. Then the buyer gets knowledge that a breach has occurred and they still close the deal and then try to claim that breach from the insurance company. They put the anti-sandbagging provision in the policy to ensure it never happens.
The buyer has to prove that they were unaware of it, but the seller was. So there are a lot of back-and-forths that happen before you can get paid on the claim you've made.
Any insurance fraud can happen under home insurance or against auto insurance. There are always ways to get around these products, but you would hope that the documentation is solid and there's a very robust process in place through which the claims can be made.
Strategy on availing Reps & Warranties Insurance
If it's a small deal, you want to avoid buying insurance because the economics starts to break down at a certain price point. But at the same time, if a buyer wants to obtain insurance, it should not assume that a deal may be too small to obtain the insurance or is in an industry that is not covered because coverage continues to expand.
As such, a buyer in a small transaction may not be able to get that standard package but may be able to get a more customized deal. It's certainly worth exploring the options. Whether it makes economic sense for a buyer to take out rep and warranty insurance for a particular deal, it's more a matter of the policy size or the coverage that's being obtained than the purchase price of the deal itself.
For example, if you're working on a $50 million-sized deal and want 20% coverage, which is $10 million, pricing will usually normalize, and rep and warranty insurance will work. However, if for a $50 million deal size, you want to get 10% coverage, which is only $5 million, the economics will start to break down because the insurers have minimum premium requirements.
Typically, the insurers would want to be able to charge a premium of at least $150,000 to $200,000, which may be high for a $5 million policy because if you think about it, the insurers will charge the same premium for an $8 million policy.
Therefore, if you want rep and warranty insurance on a $50 million deal, you would be better off as a buyer to over-insure and take out an $8 million coverage policy instead of $5 million, which makes more economic sense.
The other issue is the retention amount which is the deductible. Insurers usually are looking for a minimum retention amount of $800,000 to $1 million, which, if you calculate, it's 1% on an $80 million or a hundred million purchase price deal. So, on a $50 million deal, the retention amount at 1% would be $50,000, which becomes too low relative to the insurer's expectations. Be mindful of the total amount you want to pull a policy on instead of the purchase price itself.
My advice would be to ensure you're working with the right broker. It's important because they will connect you with the right insurance companies. In addition, they will advise you throughout the process on what pricing makes sense and whether the quotes you're getting are reasonable.
They'll also advise you on some of the exclusions because they see a lot of deals, so they'll be able to advise you what's market, what's not, and if certain exclusions were not present in the deals prior.
For example, the covid exclusion was very new, so we had to seek advice from our broker on whether it made sense to have that exclusion or whether we should be pushing back. Having the right broker to work with on any rep and warranty insurance is very important.
You could call them and tell them that you're interested in this product. If they're not the right contact, they should be able to connect you with the right person at their firm who deals in this kind of product. These people are specialists. They are SMEs in their field, so firms like Marsh and Aon have dedicated people working on this product.